Investors shun bonds of banks under RBI's prompt corrective action

The Reserve Bank of India (RBI) on Thursday bought bonds of Rs 100 billion from the markets to aid liquidity in the system at a time when banks, already under stress due to heavy bad debts, are struggling to raise funds from investors.

Experts say this should be the first of a series of bond buybacks that the central bank would have lined up to keep the banking system afloat.
The bonds bought on Thursday are illiquid and mostly held by banks. The buyback injects direct liquidity in these banks. The situation is direr for the 11 banks under RBI’s prompt corrective action (PCA) framework. Restrictions in normal business activities mean that these banks are struggling with liquidity. If the RBI does not provide ample liquidity support, banks can be in serious trouble, including potentially defaulting on their bonds. 
“While corporate deleveraging is still underway, a tight liquidity condition and volatile credit market could accentuate liquidity shock with amplified spectrum,” said Soumyajit Niyogi, associate director at India Ratings and Research. 
“Rising external adversities may cause unanticipated complexities for a twin deficit country. Thus, easy durable system liquidity has become essential at the current juncture and the need of OMO (open market operation) purchase is imperative," Niyogi said.
Indian Overseas Bank was the last of the 11 banks under PCA to recall its additional tier-1 (AT1) bonds on Thursday. The issuing banks had the option of delaying payment of coupons, or even denying it, if there was a financial distress. 
By allowing the banks to recall bonds, the government and the RBI managed to do a mini-bailout, say experts. The government has its own reasons to do so. Any delay in payment of coupons — technically not default because of the nature of the bonds — would still be counted as default by the market. Since these banks have implicit government guarantee, such incidents dampen the credit-worthiness of the sovereign. 
But the other fixed income instruments of banks don’t have such leeway of delayed payment, or a recall option. The market has started taking a cautious view on these instruments.

While the market doesn’t really expect the banks to default, it is a risk nevertheless. In some cases, primary market deals are not taking place as investors are asking for deep discounts to face value, whereas, banks are refusing to give so citing the government guarantee. The wide bid and ask spread, therefore, is stalling fresh issuance of public sector bonds.

Shameek Ray, head of debt capital market, ICICI Securities Primary Dealership, said it is getting difficult for banks to raise money from the primary market.

“Wholesale investors may have differing views on pricing based on liquidity, rate outlook and credit perceptions and may require a higher yield than what sellers in secondary markets may be offering and, hence, there have been few trades in recent times,” Ray said.

What is compounding the issue for some of the smaller banks under PCA is that investors have started shedding the bonds as the ratings get downgraded. 

“The usual investors in bank tier-II bonds (subordinate debt) have been buy and hold investors like provident funds. But these funds have rating restrictions of not investing below AA and, hence, are no longer able to invest in the tier-II bonds of state-owned banks where the rating is now lower than AA,” said Ray. 

Many of these banks have a rating of AA- now, lower than the minimum investment grade allowed under regulations. 

Trades are limited by the low floating stock in market as there have been few tier-II issues in recent times, even when rates were far lower for banks to raise such instruments. Besides, regulatory guidelines give greater weightage to tier-1 capital (core equity and related bonds such as AT1), preventing investors to avoid taking much exposure on the subordinated debt instruments. 

A persistent OMO purchase drive by the RBI could change the situation drastically. By providing the liquidity, the RBI can drive down elevated bond yields, which will help bank treasuries recover some of their losses. The 10-year bond yields are nearing 8 per cent now, from about 6.5 per cent seven months ago. As yields rise, bond prices fall. 

Indeed, Macquarie expects the central bank “may need to conduct OMO purchase of Rs 800-1,000 billion in FY19, which will help to keep the liquidity condition near neutral levels”.

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