Analysing India’s corporate bond market during Covid-19

As the Covid-19 pandemic unfolds, several countries have taken extraordinary steps to deal with the crisis. Central banks have resorted to the use of unconventional monetary policy tools in order to ensure adequate system level liquidity. Starting with the long-term repo operations (LTRO), the Reserve Bank of India (RBI) has moved quite swiftly towards targeted liquidity provision, called the targeted long-term repo operations (TLTRO). The idea is to push money via banks at the current repo rate to the “sectors and entities experiencing liquidity constraints and/or hindrances to market access”.

Towards this objective, the RBI recently opened the TLTRO 2.0 window. As per the RBI, the “funds availed under TLTRO 2.0 shall be deployed in investment grade bonds, commercial paper (CPs) and non-convertible debentures (NCDs) of Non-Banking Financial Companies (NBFCs)”. Out of the maximum ₹50,000 crore available through this window, the RBI conducted the first tranche of TLTRO on April 23, 2020. However, it received lukewarm response from the market — a total bids of ₹12,850 crore was received with a bid cover ratio of 0.5.

Further, the RBI opened another special liquidity facility for mutual funds for ₹50,000 crore to ease their liquidity pressures. This scheme was meant for “ extending loans, and undertaking outright purchase of and/or repos against the collateral of investment grade corporate bonds, commercial papers (CPs), debentures and certificates of Deposit (CDs) held by MFs.” As per the RBI’s press release on Money Market Operations, only ₹2,430 crore was injected through this window.

Why is the market not more enthused about availing reasonably cheap money to lend to these targeted sectors? Let us examine this issue from the corporate bond market angle, post demonetisation.

Financial downfall

The demonetisation of over 85 per cent of currency notes in November 2016 led to a huge influx of liquidity in the banking system. As a consequence, corporate bond yields plummeted to a historic low at around 7 per cent (Chart 1). This was also reflected in the yields of G-sec market. Both abundant liquidity and a benign inflation outlook retained the corporate bond yields at around the same level for some time. However, after a year, around October 2017, the bond market witnessed a sharp upturn. This happened even though the RBI had kept its policy rate unchanged.

Mainly three things contributed to this: first, the growth prospects of the Indian economy turned unfavourable. Second, headline CPI inflation crossed the RBI’s comfort zone of 4 per cent, and its outlook remained pessimistic. Finally, and most importantly, the government stepped up its borrowing programme and there was possibility of a fiscal slippage against the background of poor implementation of the GST.

This episode was also marked by a sudden escalation of corporate bond spread over G-Sec yields. While the spread increase was visible across maturity buckets, this was more pronounced for the shorter maturity corporate bonds (Chart 2). The signs of macroeconomic weakness and corporate default risk were clearly building up. The features of higher yield and excess spread continued and reached their tipping point in September 2018, when Indian bond market came under severe stress due to the default of IL&FS (an AAA-rated company). The failure of IL&FS triggered a massive liquidity crisis and subsequently increased the borrowing costs of Indian corporates. This led to a series of defaults and rating downgrades. This effect spilled over to the mutual funds which had large exposure to IL&FS, and wiped out large amount of investors’ wealth.

The matter deteriorated further when DHFL, a large NBFC, defaulted on its financial obligations towards bonds issuance and commercial paper. The cascading effect snowballed into banks which had exposure to DHFL. At the same time, CP and CD rates also started showing wider volatility and issuance dropped (Chart 3). The stress on corporate bond market continued – the yield spread across different rated bonds became highly volatile and hardened throughout the period.

The shadow banking crisis has had a long, lasting impact on the banking sector. An overhang of large NPAs, coupled with large frauds and muted macroeconomic performance during 2018-19, forced commercial banks to become excessively risk-averse. Banks were simply not lending and liquidity support to the private sector in the market was fast drying up. Delayed and inadequate recapitalisation and other churning in the banking sector created a void in the liquidity availability for Indian firms. The subsequent YES Bank moratorium also played an important role.

Liquidity measures

As the liquidity crunch was unfolding, the RBI started easing its policy rate gradually, even though the headline CPI inflation outlook was not in its comfort zone. However, the RBI’s infusion of liquidity through CRR cuts and drops in policy rate turned out to be less effective, as it did not result in entities taking higher exposure. In a practical sense, the cut in repo rate resulted in higher book profit (valuation for March quarter-end) to ensure the funding of bank mergers, propping up balance sheets and also less funding for recapitalisation of banks.

Now, juxtapose the LTRO and TLTRO operations of the RBI against the backdrop of unfolding Covid-19 crisis. The banking system is flush with abundant liquidity, including special incentives targeted towards mutual funds and corporate bond market. This may allow some temporary breathing time, but the situation looks unsustainable. If the underlying credit quality does not change, how is this process of liquidity infusion going to help? The effect of increased stress in clearly visible in the short term (Chart 4). IndusInd CD trades ng at 300 plus bps over other CDs for less than 60 days on account of uncertain cash flows. IDFC CD trades about 200 bps over other CDs. In essence, their asset quality is poor. Even the market has started considering the public sector (which accounts for the major share in CP) as risky and charging higher spread.

This is possibly getting reflected in the lukewarm response to the RBI’s special liquidity operations. In the midst of all these special efforts, commercial banks have discovered their biggest customer in the RBI — parking a huge amount of their money in the reverse repo window.

Covid shock

The Indian corporate bond market has some special characteristics. Even after several regulatory initiatives, the depth of the market has remained thin. As per an RBI research report, corporate bond comprises less than 20 per cent of GDP, as compared to over 120 per cent in the case of the US. It is dominated primarily by two types of firms — financial and infrastructure. They are in general large in size. As per CMIE Prowess data, the leverage (as measured by simple measure like debt as a percentage to total assets) of first the decile class of Indian corporates is 10 times higher than the second decile class.

Therefore, the Indian corporate bond market is essentially a shallow market with participation from large, concentrated and leveraged firms.

The Covid-19 shock to the economy is unprecedented. Almost the entire output of an economic cycle is lost due to a public health issue, and we still do know how long this slump will last. Amongst various sectors, the effect of Covid-19 on the corporate sector would probably be the worst. With cash flows suddenly drying up, corporates need liquidity support, particularly in the short run. As the potential risk of bankruptcy increases, there could be additional stress emanating from both trade credit and existing credit lines. Longer the crisis, larger would be the liquidity needs.

The Covid-19 crisis has posed significant challenges to Indian firms. The CD market is already facing stress and the CP market has dried up. Credit offtake is the biggest challenge. All through these years, banks have increased their resources for an easy target — consumer credit — instead of corporate credit. Things are different now — Covid-19 has effectively killed consumer demand, at least for a couple of quarters. Banks may face significant challenges as they have limited machinery to expedite corporate credit. The RBI has its own policy dilemma, banks are on a different plane, and consumers are somewhere else. With everything, the economy is in the third quadrant, gasping for both breath and liquidity — quite a challenging time ahead.

Nath is SVP, CCIL. Das is Professor and Chair, Misra Centre for Financial Markets and Economy, IIMA. Views are personal

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