Budget move to go lower down the ratings scale will deepen bond market

In his Budget speech, the Finance Minister indicated that the government would work with various regulators to allow increased investment in relatively lower-rated ‘A’ grade bonds.

This signals the government’s intent to deepen the corporate bond market in the country. Other measures towards this goals include urging SEBI to mandate large corporates to meet about one-fourth of their financing needs from the bond market.

Currently, though corporate bonds rated ‘BBB’ or equivalent are considered investment grade, most regulators in India have set a minimum of ‘AA’ rating for bonds to be eligible for investment. Therefore, the Indian corporate bond market is currently skewed towards high-rated debt instruments (AA and AAA).

The government thinks it is time for regulators to move lower from ‘AA’ to ‘A’ grade ratings. Relaxing the restriction could help entities such as the EPFO, pension funds, insurance companies, mutual funds and banks while improving the demand for these lower-rated bonds.

Most market specialists BusinessLine spoke to welcomed the move — indicating that higher spreads justify the risk of investing in ‘A’ rated bonds. But some highlight the need to safeguard retail investors.

Big market potential

Anil Gupta, Sector Head- Financial Sector Rating, ICRA, says, “Regulatory easing to allow investments up to ‘A’ rated issuers will significantly deepen the bond market. More than 89 per cent of debt issuance during first nine months of this fiscal in value terms was by issuers rated either ‘AAA’ (60 per cent) or ‘AA’ (29 per cent). Issuers rated in the ‘A’ category accounted for just 4 per cent.”

Ravi Saraogi, Head – Investor Relations and Products at IFMR Investments, says, “The current outstanding stock of corporate bonds in India is estimated at ₹25 trillion, of which lower-rated bonds (below AA) are estimated to have an outstanding of ₹3.75 trillion. By only marginally increasing the limit for lower-rated bonds, we can add about ₹1.2 trillion to the demand for such bonds.”

Risky, but worthwhile

A bond with a lower rating usually gives higher yields. Also, default rates may not be all that bad, say experts.

Says Anil Gupta, “Generally, yields on ‘A’ rated papers are higher by 2-2.25 per cent in relation to ‘AAA’ rated papers and 1.75-2.0 per cent higher compared to ‘AA’ rated papers. Even assuming higher credit risk in the lower-rated category, the risk-adjusted returns are expected to be higher with adequate diversification across various issuers.” Kumaresh Ramakrishanan, Head - Fixed Income, DHFL Pramerica MF, says, “According to a study by CRISIL, the average default rates over 1-, 2- and 3-year periods for securities with a starting rating of ‘A’ stand at 0.51 per cent, 2.07 per cent and 4.25 per cent, respectively. However, the credit spreads for ‘A’ issuers (at 250 bps) vis-a-vis AAA issuers compensates for the higher risk.”

But some aren’t sure if the risk is worth taking. Arvind Chari, Head of Fixed Income and Alternatives, Quantum Advisors, says, “Mandating this for insurance companies is fine. But the end-investor in pension funds, NPS and EPFO has not signed up to absorb that risk.”

Liquidity in such bonds could also be an issue, Chari says. “If there are credit/liquidity problems like the ones we faced in 2008 or 2013, it would become a bigger issue.”

Rajeev Thakkar, CIO and Director, PPFAS Mutual Fund says, “I do not see institutions investing in lower-rated bonds soon as the corporate bond market in India is not very liquid beyond the highest-rated corporates and PSUs. Resolution of default cases also takes long with very limited recovery..”

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