Corporate bonds carry Interest Rate Risk, Credit Risk and Liquidity Risk and in India there are no real hedges for all the three risks. However, despite the risks and lack of hedges, the corporate bond market has almost doubled over the last four years from INR 7.94 trillion (USD 132 billion) to INR 14.80 trillion (USD 232 billion) as of June 2014 (SEBI Data).
Corporate bonds find favour with Mutual Funds that have investments of around USD 2 trillion (USD33 billion). FIIs have investments of around INR 1.15 trillion (USD 19 billion). Banks have negligible investments in corporate bonds while insurance companies and provident funds would have investments of around INR 11.65 trillion (USD 194 billion).
Mutual Funds and FIIs are mark to market investors. Corporate bond investments for mutual funds would form around 20% of total assets. FIIs investments are subject to interest rate risk and credit spread risk, both on the domestic and global front and also currency risk. Given the lack of liquidity in the corporate bond markets, which at around INR 30 billion daily average, which is just one-tenth of the government bond market volumes, both mutual funds and FIIs carry significant liquidity risk.
Corporate bonds are not repoable with the RBI adding on to the liquidity risk.
Given the risks corporate bonds carry, it is extremely important to understand credit spreads as the spreads factor in the risks to investments in corporate bonds. Credit spreads at present range from around 50bps to 120bps for AAA/AA+ bonds across maturities. Going down the rating curve, spreads rise to around 250bps for BBB rated bonds (FIMMDA).
Are the spreads reflective of the risks that corporate bonds carry in India? FIIs have increased their exposure to corporate bonds from USD 8 billion to USD 19 billion over the last one year. Mutual funds are attracting investors to high yield funds that invest in lower rated bonds. High yield funds have doubled in assets over the last one year from around INR 150 billion to INR 300 billion. The risk of rise in credit spreads is higher for FIIs and mutual funds at present than what it was last year.
The lack of secondary market liquidity in corporate bonds leaves credit spreads vulnerable to sudden risk aversion. Given that banks do not invest in corporate bonds as it lacks SLR (Statutory Liquidity Ratio) status, the only buyers for corporate bonds when liquidity dries up are insurance companies and provident funds. This segment of investors is not mark to market investors and look at absolute levels of yields rather than credit spreads. However the buyers extract their price from the sellers when markets turn risk averse.
On the other hand, when liquidity is in excess, there is a search for yields and that is seen in falling credit spreads. At present the global system is flooded with liquidity given unprecedented easing by central banks from the Fed to the ECB, BOJ and BOE. Junk bond yields are at all time lows and credit spreads have collapsed since highs seen post the credit crisis in 2008. Will liquidity continue to drive credit spreads down?
Credit spreads are definitely vulnerable to liquidity reversals but given that it is unlikely to drain away in a hurry given pledges of low rates by the Fed, ECB and BOJ, credit spreads may stay down or even trend down in countries like India where yields are still attractive for FIIs. View our presentation on Global Central Bank Liquidity.
Interest rates in India are looking to trend down going forward as the government curbs fiscal deficit, RBI focuses on lowering inflation expectations and the INR stays stable on improving domestic macros. Read our analysis “Why the INR will Withstand USD Strength.
The risk of deteriorating credit quality of issuers is also mitigated by expectations of higher economic growth. India’s economy is expected to growth at 5.5% in this fiscal and over 6% levels in the next fiscal from levels of 4.7% seen in the last fiscal.
It is important to watch out for risks of global liquidity reversals, threat to domestic macros from internal and external forces and deterioration in credit quality of issuers while investing in corporate bonds in India.