India Economy

Going down the credit curve makes sense

Nitin Singh | Updated on March 25, 2018

With the credit cycle close to an inflection point, opportunities in credits are opening

Fixed income markets in India have turned volatile since July 2017 as CPI inflation bottomed out and rose by nearly 375 basis points from the low, turning the RBI cautious on further policy rate reductions. Additionally, fiscal slippage, rising trade deficit, higher crude prices and uptick in US treasury yields have resulted in yields rising across the curve for both government and corporate bonds.

However, corporate bonds have outperformed government bonds as the growth cycle turned up. GDP growth rose to 7.2 per cent in the quarter ended December 2017 from 5.7 per cent in the quarter ended June 2017 and credit growth moved back into double digits.

With the credit cycle close to an inflection point, opportunities in credits are opening. We see merits in going down the curve on expectations of swifter resolution of bad loans, deepening of the credit market, low corporate default risk, improving credit cycle and attractive valuations.

Merits of going down

Firstly, the credit recovery and resolution mechanism is in place. The single biggest step toward this has been the implementation of the bankruptcy law or Insolvency and Bankruptcy Code (IBC), 2016. The new law aims to provide creditors a time-bound framework for resolution of stressed assets.

Since its implementation, we have seen many cases (approximately 40 per cent of total gross non-performing loans) coming up for resolution. Another step has been the recent RBI guidelines on removal of existing loan restructuring mechanisms and the 180-day time line for banks to agree on a resolution plan. This should result in quicker recognition of bad loans.

Secondly, credit market deepening is picking up pace. Steps taken by the regulators have resulted in a larger quantum of borrowing shifting to the corporate bond market, with incremental banking sector credit reducing over the last few years.

Two key FY19 Budget proposals will quicken the process — lowering the credit rating for the investment grade from AA to A and enabling insurance and pension funds to tap into the lower rated market.

Besides, the proposal for large corporates allocating 25 per cent of their funding requirements towards capital markets will further deepen the credit market by bringing greater liquidity.

Thirdly, default risk of Indian corporates is low. Among market participants, a popular misconception exists that corporates entail a high ‘default’ risk. However, data indicates the opposite. According to credit default data for long-term ratings of issuers, compiled by CRISIL for its entire universe of rated issuers from 1988 to 2016, AAA rated corporates have never ever defaulted in its history. The risk of default is 0.04 per cent for AA rated corporates and only 0.5 per cent for A rated corporates. AAA rated corporates hold their rating around 97 per cent of all times, while 93 per cent of AA rated corporates and 88 per cent of A rated corporates.

Fourthly, with growth recovering and global macro cycle supportive, the credit cycle is turning. Data from CRISIL is indicating not only more upgrades than downgrades for investment grade credit but also improvement in debt weighted credit ratio.

Fifthly, credit spreads are attractive. The search for yield and banking sector’s rising bad loans led to faster disintermediation of RBI’s policy rates in the corporate bond market over the last three years. However, this was limited only to AAA and AA rated corporates, leading to thinning of credit spread for them. Lower rated corporates (below AA) yields has remained high with credit spreads much higher than average, making them relatively more attractive. Investment opportunities are better in credit than government bonds on worsening supply-demand dynamics for government bonds amid rising US treasury yields.

Be selective and gradual

However, investors need to be selective as credit risk is still elevated, since we are yet to see the peak in bad loans and stress exists in some sectors/segments. Investors could look at gradually building exposures to credits over the next three quarters as the elevated credit risk moderates. Investors with a time horizon of three years could look at credit opportunities and accrual funds focussing on a judicious mix of credit quality when targeting a higher yield to maturity.

The writer is MD & Head, Standard Chartered Wealth Management, India

Published on March 25, 2018

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