bonds: Credit spreads for lower-rated cos rising; higher rates could hit retail equity flows: Nomura

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NEW DELHI – Supportive liquidity conditions in the banking system amid the Covid-19 pandemic have benefited highly rated corporate borrowers, but the credit spreads between benchmark yields and lower-rated borrowers have continued to rise throughout 2021, Nomura wrote.

“While the fiscal deficit inched up during the pandemic in 2021, most large corporates benefited from market share gains, better pricing and lower costs, which led to improved profitability and cash flows. The credit spread for low credit rating borrowers, however, continued to rise through 2021,” the foreign firm wrote.

The Reserve Bank of India, which maintained surplus liquidity conditions in the banking system even before the pandemic struck the country, significantly stepped up its fund infusions after 2020, with the current liquidity surplus estimated at around Rs 7 lakh crore.

Strong overseas inflows and a favourable trade balance also added to the liquidity in 2021, Nomura said, adding that the lending rates between scheduled commercial banks had registered a decline over the past couple of years.

Consequently, the cost of funds for larger and higher-rated companies declined, with the spread between AAA corporate bonds and government securities dropping to multi-year lows.

Going ahead, however, market interest rates are likely to harden as global central banks are moving towards tightening the liquidity spigot. Elevated domestic fiscal deficits are also likely to exert upward pressure on government bond yields.

The government is aiming for a fiscal deficit target of 6.8 per cent of GDP in the current financial year.

Nomura expects the 10-year government bond to rise to 6.75 per cent by the end of 2022 and then to 7 per cent by 2023.

Even as spreads between government bond yields and highly-rated corporate bonds may remain benign, a rise in sovereign debt yields is likely to lead to a rise in corporate borrowing costs in absolute terms as gilt yields are the pricing benchmark for debt issued by companies.

The 10-year benchmark bond yield closed at 6.59 per cent on Friday.

While the possible inclusion of Indian government bonds in global bond indices, a step that could bring in around $30-45 billion of overseas flows in a year, may prevent bond yields from shooting up, a widening trade deficit is likely to keep the bias on the upside.

“Our economics team forecast a basic BoP deficit of $19.5 billion in FY23, reversing from the surplus registered over the past three years,” Nomura wrote.

According to the foreign firm, a prolonged stretch of sub-par returns in equity and rising interest rates could adversely impact retail flows in the Indian market. Also, particularly have a detrimental impact on the mid-cap and small-cap segment.

While advance central banks’ move away from balance sheet expansion has led to foreign institutional investors paring down exposure to Indian equities in the last few months of 2021, robust buying support from domestic players, especially retail investors, has propped up benchmark equity indices.

“FY22 YTD, FIIs are net sellers of $3.65 billion in the equity market. We note that the FII participation in primary markets has remained strong, although there has been sell-off in the secondary market,” Nomura wrote.

The firm picked out banks and IT services as the two sectors which witnessed the greatest degree of FII selling in the current financial year so far. The banking sector was among the largest recipients of overseas inflows in the previous financial year.

The picture on IT services is a little different. The sector saw very limited FII inflows in the previous financial year and a fair degree of selling pressure in the current fiscal.

“The relative underperformance of financials and outperformance of IT services led to a decline in FII ownership of Indian equities, from the peak of 20.1% in Feb 2021 to 18.4% as of 15 December 2021, the lowest since August 2013,” Nomura wrote.

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