Stick to sovereign, low-risk India bonds for predictable returns

The bond market in India is under stress since last September, and it may be prudent for investors – both NRIs and domestic, to avoid investment in corporate bonds or corporate bond funds at the present juncture.

Only the informed or experienced investors could show some courage and take a small exposure to “AAA” rated corporate bonds, and that too ideally in quasi government debt i.e. “AAA” rated bonds of government controlled companies that are popularly termed as PSU bonds (bonds issued by Public Sector Units).

The IL&FS Group (erstwhile “AAA” rated) default in September 2018, the liquidity crunch in the market that followed, and rising costs of borrowing (particularly for finance and mortgage companies) led to a string of subsequent defaults as well as rating downgrades by the credit rating agencies. There has been a contagion effect in the financial services sector with liquidity drying up for most non-banking finance companies (NBFCs).

IL&FS Building picture. Courtesy: company website

The NBFCs which presently have smooth access to liquidity are the ones with strong promoters/ controlling shareholders and have historically demonstrated track record of good asset quality and strong corporate governance.

However, even such NBFCs have been impacted by the rising cost of borrowing that is unsettling the whole sector. And the bulk of bonds available for investment both in the primary and secondary -market is from the NBFC sector!

As a fallout of the above situation, sectors and corporates dependent on NBFCs for their financial needs, or corporates with highly leveraged balance sheets have also faced stress.

Further, some of the mutual funds that had exposure to some of these stressed corporates or corporate groups had to mark down some of the bonds in their portfolio, and this resulted in major dilution in the return expectations of investors of such mutual funds. 

Looking ahead, one should be optimistic that the present government in India is seeding macro-economic stability, paving the path not only for growth revival but more importantly for sustainability of growth.

The Union Budget of India, tabled in Parliament recently, aims to provide credit-oriented growth, and in support, the Reserve Bank of India (RBI) has also promised adequate liquidity measures in addition to the Policy interest rate cut.

Keeping fiscal deficit of the government in check and the provision to fund a part of the fiscal deficit through overseas borrowing will indeed help to reduce borrowing in the domestic market and soften the yields further in government securities. 

After witnessing three consecutive quarters of acute tightness in liquidity, the rest of the present year is expected to witness easing of liquidity due to RBI and government actions as well as NPA resolutions (recovery of certain bad loans held by the banks).

RBI file picture. Courtesy: RBI facebook

Credit rating agency CRISIL (An S&P Global Company) said “Asset quality of banks should witness a decisive turnaround this fiscal with gross non-performing assets (NPAs) reducing by 350 basis points (bps) over two years to ~8% by March 2020 compared with a peak of ~11.5% in March 2018 and 9.3% in March 2019. This will be driven by a combination of reduction in fresh accretions to NPA as well as stepped up recoveries from existing NPA accounts.”

Softening sovereign yields in times of easing liquidity conditions will aid to compress the spreads between government securities and corporate bonds, thus eventually making corporate bonds an attractive investment.

But till such time credit risk reduces significantly, one must be wary of exposure to corporate bonds or in corporate bond funds. After all, the large corporate defaults that shook the corporate bond market were triggered by IL&FS and DHFL bonds that originally carried the highest credit rating of “AAA”.

Low industrial growth, benign inflation, developed market central banks turning more dovish and about 50% of the global sovereign yields trading below 1% bodes well for Indian bond yields to head further downwards and bond prices to maintain their upward trend. The noise on the feasibility of budget numbers and risks to sovereign borrowing in overseas markets would persist in the near term, but lower interest rates and lower bond yields are to be witnessed over the long term.

Therefore, market risk is low at this point of time for bond/ bond fund investors. The only worry is high credit risk that is dogging the Indian bond market, and therefore prudence demands that investors stick to sovereign bonds for decent and predictable returns and may risk a small exposure to highest rated quasi-sovereign PSU bonds for the “yield kicker” to their portfolio. 

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Note: Connected to India articles on NRI personal finance are intended to help Non-Resident Indians (NRIs) understand the increasingly complex world of financial investments. It is not a solicitation, recommendation, endorsement, of any third party service provider to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction.

 

Author
Indraneel Basu
Indraneel Basu – Contributor

After 26 years in portfolio management & investment banking, Indraneel Basu is a consultant to insurance companies, a guest lecturer at business schools and a moderator for Insurance Institute of India exam papers on investment and accounts. He last worked as Chief Investment Officer at Universal Sompo General Insurance Co. Ltd. (June 2009-July 2016).  In the 90s, he had headed fixed income securities research & dealing at one of the largest finance companies in India, was head of business development at DebtonNetIndia.com (an IL&FS-NSE joint venture) 2000-2001, was VP (Debt Markets) with investment banking firms 2002-2005 and Director- Debt Capital Markets at IDFC 2006-2009.

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