bonds: credit spreads for lower-rated cos up; higher rates could affect retail stock flows: Nomura

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

“As the budget deficit widened during the pandemic in 2021, most large companies benefited from market share gains, better pricing and lower costs, leading to improved profitability and cash flow. The credit spread for low-credit borrowers, however, continued to increase through 2021,” the foreign company wrote.

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

Strong overseas inflows and a favorable trade balance have also added to liquidity in 2021, Nomura said, adding that lending rates among regular commercial banks have seen a decline over the past two years.

As a result, the cost of funds for larger, better-rated companies has fallen, with the spread between AAA corporate bonds and government securities falling to multi-year lows.

Going forward, however, market interest rates are expected to tighten as global central banks move towards a tightening of the liquidity tap. High domestic budget deficits are also likely to put upward pressure on government bond yields.

The government is aiming for a budget deficit target of 6.8% of GDP for the current fiscal year.

Nomura expects 10-year government bonds to rise to 6.75% by the end of 2022, then 7% by 2023.

While spreads between government bond yields and investment grade corporate bonds may remain benign, a rise in sovereign debt yields is likely to drive up corporate borrowing costs in absolute terms, as yields gilts are the price benchmark for debt issued by companies.

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

While the eventual inclusion of Indian government bonds in global bond indices, a step that could bring about $30 billion to $45 billion in outflows a year, may keep bond yields from soaring, a growing trade deficit is likely to keep the bias on the upside.

“Our economics team has projected a basic BoP deficit of $19.5 billion in FY23, down from the surplus recorded in the past three years,” Nomura wrote.

According to the foreign firm, a long period of below-average stock returns and rising interest rates could negatively impact retail flows in the Indian market. In addition, having a particularly detrimental impact on the mid cap and small cap segment.

While central banks’ early exit from balance sheet expansion led foreign institutional investors to reduce their exposure to Indian equities in the final months of 2021, strong buying support from domestic players, particularly retail investors, supported benchmark equity indices.

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

The company singled out banking and IT services as the two sectors that have seen the most FII sales so far in the current fiscal year. The banking sector was one of the main recipients of foreign flows during the previous year.

The table of IT services is a little different. The sector has seen very limited FII inflows in the past fiscal year and fairly strong selling pressure in the current fiscal year.

“The relative underperformance of Financial Services and outperformance of IT Services caused FII ownership of Indian equities to decline from a high of 20.1% in February 2021 to 18.4% as of December 15, 2021, the most low since August 2013,” Nomura wrote.

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