Action
Investments in NBFC NCD’s are avoidable given that rates are likely to come off on the back of economy slowing down. Credit spreads seen as attractive at present will no longer look attractive as returns on government bonds and highly rated corporate bonds will be higher given credit and liquidity risk.
The correct way to look at investments in NCD’s floated by companie
There have been a few NCD (Non Convertible Debenture) issues floated by companies in the AA and AA- rating scale and there will be more to come down the line. The yields offered in the NCD’s are eye catching prompting the NCD issues to be oversubscribed many times over. Investors are rushing to take advantage of the high yields offered by these companies. The common approach to such NCD investments by investors is the yield offered and the visibility of the company in the press and media.
The correct way to look at investments in NCD’s is the way a bond trader or a bond fund manager will look at the investment. The trader and the fund manager will look at credit spreads, liquidity and the opportunity cost of not investing elsewhere. The bond fund manager will have constraints on the amount he can invest in the NCD given scheme objectives and regulatory limits. Let us look at the recent NCD issues and judge whether it is attractive to a trader or a fund manager.
Credit spread is the difference in yield between the NCD and the corresponding maturity government bond. IIFL NCD, which matures in 2014, is compared to a government bond maturing in 2014. The government bond yield annualised is 8.35% and hence the credit spread of IIFL three year maturity NCD yielding 11.70% is 235bps.
Are the credit spreads attractive for the NCD’s?
Credit spread reflects the credit potential of the issue of the NCD and the liquidity of the NCD in the secondary market. The issuers are rated AA or AA- by rating agencies, which reflect reasonable safety. The fact that all the issuers belong to the NBFC sector, liquidity is a question mark. The secondary market liquidity for NBFC NCD’s in the secondary market is low and for NCD’s rated below AA+ it is even lower. Traders will definitely think twice about looking at such bonds despite credit spreads at over 200bps. Bond fund managers may look at it if their view on the credit is good and that potential for downgrade is low.
On a credit spread basis, the NCD’s are in line and not very attractive with the current state of interest rate markets where government bond yields are trading at close to multi year highs. However, the spreads are unlikely to go down soon given that liquidity is low and there are credit concerns in the economy. The Indian economy is in a rough patch with RBI raising policy rates to multi year highs on the back of rising inflation expectations. GDP growth is forecast to come off by 50bps to 100bps from 2010-11 growth levels of 8.6%. High interest rates coupled with slowing down economy will place stress on loan books of banks and NBFC’s.
Opportunity cost of investing
There are other fixed income investment opportunities. Government bonds are the first choice given its risk free status and its correlation to interest rates. Interest rates are at multiyear highs with five year maturity government bond yields trading at around 8.25% levels. Interest rates are expected to come off down the line as inflation cools off on the back of monetary tightening, fiscal control and a slowing economy. Lower interest rates will benefit government bonds the most and returns on these risk free and liquid bonds can go up to levels of over 12% if interest rates cool off by 100bps in one year.
Highly rated AAA corporate bonds in the three and five year maturity bracket are trading at yields of 9.4%. Falling interest rates will benefit AAA corporate bonds more than AA or AA- NBFC bonds and yields on the former will fall much faster than the yields on the latter. Investments in three and five year corporate bonds can yield as much as 11.4% and 13.4% if yields fall by 100bps in one year. Highly rated corporate bonds have much better liquidity than low rated NBFC NCD’s.
The opportunity cost of investing is high in NCD’s of NBFC issuers as interest rates are expected to fall down the line. The lack of liquidity will prevent investors from exiting the NCD’s to invest in longer maturity government bonds or corporate bonds. If the economy suffers a downturn, NBFC portfolios will be under stress leading to credit spreads moving higher due to worries on downgrades. Investors lose out on falling interest rates plus rising credit spreads and yields on NBFC NCD’s will not be attractive.
