Easy Liquidity Pulls Down Short-Term Corporate Bond Yields To Multi-Year Lows

Data from the Bloomberg Intelligence Banking Liquidity Index shows that the system is currently running a surplus of over Rs 2.8 lakh crore. The system has seen surplus liquidity for most of this year and this surplus has widened in the last two months. While the RBI’s preferred stance is to maintain liquidity at close to neutral, the central bank has allowed surplus liquidity conditions to persist due to weakness in the economy and poor transmission of lower interest rates.

On Monday, the central bank moved to pull out some liquidity from the system by accepting Rs 25,000 crore via a 42-day variable-rate reverse repo operation. While repo operations are used to infuse liquidity, reverse repos absorb surplus liquidity.

Easier liquidity conditions have brought some relief to the corporate bond markets.

Yields on AAA-rated and AA-rated corporate bonds have fallen sharply since last Thursday. The average yield on AAA-rated corporate bonds for a three-year duration has fallen below 7 percent for the first time since April 2009. At present, it stands at 6.8 percent.

Whereas for AA-rated corporate three-year bonds, coupon rates have fallen to 7.52 percent, the lowest since May 2010, data from Bloomberg shows.

To be sure, the gap between the RBI’s benchmark repo rate of 5.15 percent and corporate borrowing rates, known broadly as the credit spread, remains wide. Equally, the term premium, which borrowers pay to pick-up long term funds as compared to the overnight borrowing rate, remains high.

The default by the Infrastructure Leasing and Financial Services group in September 2018, led to a surge in corporate borrowing costs as investors turned risk-averse. Borrowing costs remained high even after India’s Monetary Policy Committee cut interest rates, as investors continued to demand a hefty premium for parking funds in corporate debt.

Consistently surplus liquidity conditions have now started to bring down costs, albeit selectively.

According to Lakshmi Iyer, chief investment officer - debt and head of products, Kotak Asset Management Company, there are multiple reasons for the fall in corporate bond yields, especially for short-term borrowings.

The first, she said, is the comfortable liquidity in the system. The second is that there are fewer issuers today than last year who meet investors’ requirements, the third reason is that much of the fund flow towards mutual funds is in the short- and medium-term funds, and fourth, most of the corporate bonds belong to high-rated firms.

“Also, in case of the government bonds, there is concern over the supply of government securities given uncertainty surrounding the fiscal deficit,” she said, adding that if the rate cutting cycle continues and liquidity remains in surplus, short-term bonds will benefit.

Madhavi Arora of Edelweiss said the decline in bond yields is mostly in the short-term three-year bond segment. It is largely a liquidity play, Arora said referring to the prevailing surplus liquidity conditions. She added that supply in this segment has also been limited.

While the absolute yields for AAA three-year bonds have reduced dramatically, the credit spreads for each issuer are still elevated at around 50 to 60 basis points, compared to historical lows of 20 to 40 basis points, said Dwijendra Srivastava, chief investment officer - debt at Sundaram Mutual Fund.

He added that investors are still more worried about the return of capital as opposed to the return on capital and therefore, they are looking at AAA-corporate bonds or government-backed bonds issued by public sector undertakings.

“With several government entities issuing bonds and others planning to come out with large issuances in the coming months, there is an additional supply of bonds in the market across tenures. Investors are happy to pick-up these bonds because of their relative safety and would rather invest in 1-3 year paper rather than longer term bonds due to any interest rate risks and credit risks that could emerge over time,” Shrivastava said.

While most of the fall in rates has been seen across shorter tenures, Iyer of Kotak said that this could eventually help bring down rates across the curve. “There will be a lag effect for rates on corporate bonds that have a 5 to 10-year tenure to catch up with the compression in the shorter-end of the curve,” she said.

The yields on the AAA- and AA-rated five-year corporate bonds stood at 7.23 percent and 7.92 percent, respectively, which is the lowest level since September 2017.

Ajay Manglunia, managing director and head of institutional fixed income at JM Financial said that the lower rates for AAA-rated corporate borrowers are also driven by scarcity of issuances from non-financial firms in this segment. “Overall in the AAA-rated bucket there is a scarcity of non financial issuers. With the ongoing slowdown, there are some AAA-rated players that have also reduced the frequency of  bond issuances, which investors are keen to buy in order to reduce the sector-concentration risk,” he explained.

Manglunia added that short-term corporate borrowing rates are now fairly low and attractive for issuers from a cost of capital perspective.