Signs of a maturing bond market

How worried should one be about the bond market? In a financial market that is constrained for capacity, the bond market was expected to step into the space vacated by the slow growth of government-owned banks. Further, given the economic necessity of longer-term funding, particularly for building physical infrastructure, where banks with their five-year loans were found to be inappropriate, it is expected to be a critical part of the desired financial architecture. However, with several defaults in the last nine months, some of them of the highest rated ‘AAA’ bonds, and a clear decline in risk appetite, as visible in the higher interest rates, concerns have emerged on whether the bond market will be able to play the role.

Counter-intuitive as it may seem, the stress of the last few quarters may in fact be a necessary period of consolidation and maturation after a period of rapid growth. It still has a long way to go in terms of potential growth in size and complexity, but the recent stress is driving some essential qualitative changes in the market.

I recall that in a panel discussion I was part of a few years ago, the head of corporate credit of a large bank was sceptical about the disintermediation trend (where financial savings go through bond mutual funds instead of through banks), arguing that the bond market, which was growing rapidly, would shut down at the first sign of default. Many were concerned that a default that forced losses on to bond mutual fund (MF) unit holders would trigger a flood of redemptions, and a relatively illiquid bond market would not be able to deal with it. However, in the last nine months, several large entities have defaulted, including two that each had more than a trillion rupees of liabilities, but the market is still functioning.

Assets under management (AUM) of bond MFs had started to decline from December 2017 onwards, as a surprise change in stance from the Monetary Policy Committee (MPC), some seemingly ill-advised bond-issuance related announcements from the government, and a subsequent buyers’ strike by treasury departments of banks pushed up bond yields sharply. Bond MF AUMs fell from Rs 8.7 trillion in November 2017 to Rs 7.2 trillion in September 2018. Interestingly, despite the bond defaults that started after that, the AUMs since then have remained unchanged, and net redemptions have been only Rs 300 billion. This is a remarkable stress test that the market has gone through, one that should hold it in good stead in future credit cycles.

illustration: Binay Sinha

Equally importantly, bond MFs have been forced to improve their credit evaluation capabilities and credit ratings are starting to become more appropriate. Funds that were overly reliant on ratings for their investments have had to book losses and investors are beginning to become more discerning about MFs. Bond MF holders as well as wealth advisors have also become more used to defaults, and screening of bond holdings of a fund is much more common-place than it was a year back. Fixed maturity plans were once considered an alternative to fixed deposits, but they no longer are.

Further, rating agencies, which have taken a significant hit to their credibility, are now steadily downgrading ratings, prodded along by a pro-cyclical tightening of regulations, reducing the preponderance of the ‘AAA’ (highest possible) classification. As a credit fund manager recently explained to us, this may not necessarily affect bond yields, as the bond market was pricing in the risk anyway: An ‘AAA’ rated bond yielding 9 per cent a year most likely meant that it was not ‘AAA’ in the first place.

Currently, risk aversion appears to be quite extreme, with bond markets choosing to fund only a handful of companies that are universally considered “safe”. Loans to some other firms with a slightly higher risk have been priced sharply upwards, and firms which the market does not trust at all are getting no funding. Trading in riskier bonds has become so illiquid that their pricing could be suspect. However, this is a cyclical trend visible in all markets (like the price-to-earnings ratios in equity markets, which swing from reflecting extreme optimism to extreme pessimism), and one that should reverse once the defaults are out of the way.

Developments in the last three quarters have also impacted the behaviour of borrowers. Erstwhile “marquee” corporate groups have been forced to sell assets to protect their credit-worthiness, and work hard to retain control of their companies. The positive effects of the resultant impact on quality of borrowing and more efficient capital allocation should be visible in the next cycle.

Encouraging as the longer-term impact of these stresses may be, there are two concerns that have emerged. The first is the drag on growth: The markets naturally reviving from these disruptions, while perhaps healthier from a longer-term perspective, could take much longer than may be necessary. For example, some of the entities that the bond market refuses to fund are now on the path to default. However, till they have defaulted, some of the non-MF holders may not feel the pain, and the impact of their reaction will not be visible. This lag of several months appears unnecessary. Similarly, the ratings deflation, in particular a drop in the number of ‘AAA’ issuers, is likely to reduce the quantum that pension and insurance funds can buy. An Asset quality review that many (including this writer) have recommended on the other hand would accelerate the denouement, and bring forward the recovery.

Secondly, the prevailing monetary tightness, while exacerbated by current problems in non-banking finance companies, is also a reflection of a drop in the money-multiplier. This is the ratio of the broad money available in the economy (M3) to the base money injected by the Reserve Bank India (M0). Banks create money when they lend: If M3 in the system is Rs 100, and a bank gives a Rs 5 loan, M3 immediately becomes Rs 105. Non-banking entities, on the other hand, do not create money when they lend. Thus, if the share of non-banks in the market is to rise, the money-multiplier would naturally shrink. To keep overall money supply growing at a healthy pace, the central bank may have to inject more base money than it would in a largely bank-funded market. This policy recalibration may also be necessary to revive the economy.

The writer is co-head of Asia Pacific Strategy and India Strategy for Credit Suisse

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