(Co-authored with Harsh Vardhan)
The banking sector is the most important financial intermediary in India’s debt market. Over the last few years the bond market has emerged as an alternative to the banking sector especially for the top rated firms. This trend has been pronounced ever since the banking sector started reporting high levels of non-performing assets from 2016 onwards. Figure 1 below shows the flow of commercial credit in India from various sources and highlights the growing relative importance of bond issuance.
Figure 1: Flow of Commercial Credit in India
Note: Bond issuances include those issued to banks ; Source: RBI
Figure 2: Credit Spreads on 5 Year AAA Paper
Source: Bloomberg and authors’ estimates
While in the pre IL&FS default period the spreads of all three categories of bonds were closely bunched together, the difference between them began increasing from October 2018 onwards. The difference was particularly acute between the NBFC and private corporate bond spreads on one hand and the PSU bond spreads on the other hand especially in the second half of 2019. This is despite the fact that these bonds were all rated AAA. This reflects the implicit government guarantee enjoyed by the PSU bonds.
The government and the RBI took several actions to deal with the ensuing crisis in the NBFC sector. Government appointed a new Board for IL&FS. RBI took several steps including open market operations to inject liquidity into the system, reducing the risk weights on bank lending to NBFCs, instructing banks to disburse sanctioned but undisbursed credit to NBFCs etc.
These eventually resulted in enhanced credit flow to the NBFCs which reduced the credit spreads in the later part of 2019. For both NBFCs and private corporate sector, the spreads declined by about 50 basis points to settle at about 100 and 50 basis points respectively. These spreads, especially for the NBFCs, were still higher than pre-IL&FS episode but much lower than their peak. We see a similar dynamic with the 3 year maturity bonds as well except the absolute levels of the spreads were different.
Figure 3: Credit Spreads on 3 Year AAA Paper
The Covid-19 outbreak
Just as the bond market was recovering from the shock of IL&FS default followed by crises in DHFL and Yes bank, the Indian economy got hit by another massive shock in the form of the ongoing Covid-19 pandemic. Credit spreads in the bond market began rising sharply from the middle of March once again reflecting growing risk perceptions. Figure 1 shows the increase in the spreads around the time when the nationwide lockdown was announced on 24 March.
For both NBFC and corporate bonds, the spreads rose by about 30-40 basis points between February 2020 and April 2020. For both categories of bonds the credit spreads reached their peak in the first half of May, close to 180 basis points for NBFCs and 170 basis points for the corporate bonds. The peak of the spreads during the pandemic has been even higher than the peak reached in the aftermath of the IL&FS default episode.
Spreads on PSU paper also went up, but by a smaller amount. The average spread on these bonds in March and April was only 30-35 basis points. The gap between the credit spreads on NBFC and corporate bonds on one hand and PSU bonds on the other widened significantly to about 100 basis points. The large gap in spreads for bonds of the same ratings is worth noting. Similar to the post-IL&FS period, this too is a reflection of the market's perception of implicit government guarantee to the public sector units.
The impact of policy actions on credit spreads
The sharp rise in credit spreads in April 2020 could be attributed to the announcement by the RBI to grant moratorium on loan repayments for all borrowers in order to temporarily alleviate their financial stress triggered by the pandemic and the lockdown. Following this announcement, NBFCs had to offer moratorium to their borrowers but at the time it was not clear whether they themselves would also receive a moratorium from banks on their repayment obligations.
In the second half of May, the government announced a package to boost the economy included Rs 20 lakh crore of ‘benefits” and effectively entailed an outlay of around Rs 3 lakh crore for 2020-21. RBI also adopted several policy initiatives such as cutting the policy interest rates aggressively and establishing new long term targeted repo operations (T-LTRO) that would provide 3 year funding to banks under a repo arrangement. RBI made the repo arrangement ‘targeted’ so as to ensure that the funds raised by the banks was made available to the NBFCs.
These policy actions increased the credit supply to all issuers. Consequently, by the 3rd week of June, the credit spreads on both NBFC and corporate bonds came down from their respective peak levels of mid May by about 50 basis points.
However, the RBI and government actions notwithstanding, the credit spreads for NBFCs and private corporations continue to be substantially high. In fact the spreads in June 2020 were similar to the spreads in December 2018 in the aftermath of the IL&FS default. On the contrary, for PSUs the spreads have come down to around the same levels that prevailed before the IL&FS crisis.
This shows that the bond market remains concerned about the riskiness of the corporate sector and the NBFCs. PSUs on the other hand, benefit from implicit government guarantee. The significantly lower credit spreads they are experiencing in the time of the pandemic reflect a ‘flight to safety’ by the bond investors.
Credit spreads and funding costs
As we interpret the bond market data, it is important to understand the difference between credit spreads and funding costs. Credit spreads going up does not necessarily mean that the cost of funding for the issuer is going up. Cost of funding for a company that raises capital in the debt market depends on the market determined yield on the security it issues This yield on debt consists of two components: risk free rate and credit spreads. RBI's monetary policy impacts the risk free rate but not the credit spreads. Credit spreads reflect the premium that the investor charges over and above the risk free rate, taking into account the inherent riskiness of the underlying bond.
Since the IL&FS episode, the risk free rate has been coming down steadily due to the policy actions by the RBI such as reduction in the policy interest rate (repo and reverse repo rate) and large scale open market operations to inject liquidity in the financial system. Figure 4 depicts the yield on 5 year and 3 year government securities from the April 2018 to June 2020 period.
Figure 4: Government Securities Yield
The 5 year risk free interest rate has come down from about 8.4% in September 2018 (before the IL&FS episode) to about 5.5% in June 2020 indicating a decline of 300 basis points. The 3 year risk free interest rate has declined even more, to about 4.5% over this period, a decline of nearly 350 basis points.
RBI's monetary policy impacts the risk free rate but not the credit spreads. The impact of policy action on the actual cost of funding will therefore not be the same as the reduction in the risk free rate. If risk aversion in the market goes up, then investors will demand higher price for the credit risk which will result in rising credit spreads. Thus, the net cost of funding for an issuer may decline to a lower extent compared to the reduction in the policy rates.
This is what has been happening since the IL&FS episode. Risk free rate has been declining but owing to high risk aversion, credit spreads have remained elevated. As a result, funding costs of companies have not come down by as much as the risk free rate. This implies that in an environment of high and rising risk perception such as the ongoing Covid-19 period, the effectiveness of policy rate cuts will be constrained.
The widening gap between the credit spreads on PSU debt versus private sector points to lower risk perception for PSU entities which are perceived to have implicit sovereign guarantees. The combined effects of rising risk perception, widening gap between credit spreads of identically rated issuances and reduction in the policy interest rates would mean that the debt market will skew towards government owned issuers who might experience the greatest reduction in funding cost.
Bond market credit spreads provide important information about the risk perception of an important class of investors. Sustained high credit spreads (compared to long term average levels) suggest elevated risk perception and imply heightened risk aversion. Specifically, it also points to the role that individual episodes of corporate defaults and the associated policy responses (or lack thereof) play in shaping risk perceptions.
Wide spreads between bonds of the same ratings issued by private companies and those owned by the government clearly indicates a strong perception of the implicit government guarantee enjoyed by public sector companies. This raises important questions as to whether the debt of government owned companies should be treated as a part of government's debt.
Finally, economic recovery in India in the post Covid-19 period will depend crucially on the flow of credit in the economy. The economic package recently announced by the government depends largely on the financial sector. Nearly 70% of the 'benefits' of Rs 20 lakh crore in the package are expected to be routed through the financial sector. In a recent article we discussed the rise in risk aversion in the banking sector. With both the banks and the bonds markets showing high levels of risk aversion, growth of credit may be less than envisaged in the package. This may dilute the overall effectiveness of government's monetary and fiscal policy actions.
Rajeswari Sengupta is an Assistant Professor of Economics at IGIDR, Mumbai. Harsh Vardhan is an Executive-in-Residence at the Center for Financial Studies and an Adjunct Faculty at the SP Jain Institute of Management and Research, Mumbai.
The views expressed in the post are those of the author only. No responsibility for them should be attributed to NIPFP.