Lower Rated Bond Yields Compress As HNIs Get Their Hands Dirty

As of October, the spread over five-year BBB rated corporate bonds have tightened approximately by 25-50 basis points, against AAA rated papers of the same maturity that have squeezed by 5-6 bps, according to National Securities Depository Ltd. data.

The Reserve Bank of India is also said to have been making enquiries in the market about this change in investment behaviour, a person in the know said.

The spread is squeezing in the BBB rated segment rather than in the AAA segment. The RBI is also doing a study and has been talking to market participants about the same, the person said.

An email sent to the RBI seeking a comment on the matter remained unanswered at the time of filing this story.

This has come as RBI Governor Shaktikanta Das on Wednesday warned the non-banking financial sector against imprudent growth, unfair business practices and usurious interest rates charged by certain outliers.

"The consequent high cost and indebtedness could pose financial stability risks if not addressed by these NBFCs in time," he said while announcing the monetary policy. The RBI is closely monitoring these areas of concerns and will not hesitate to take appropriate action, if necessary, Das said.

These warning signs may change the way how investors perceive the bonds issued by NBFCs, micro financial institutions and housing finance companies and their fundraising plans, experts said.

On Wednesday, yield on the 10-year benchmark government bond declined by 4 bps and that of corresponding corporate bonds fell by 2-3 bps, after the Monetary Policy Committee changed its stance to 'neutral' from 'withdrawal of accommodation'. This paves the way for potential rate cuts in the future.

With family offices and high net worth individuals becoming big participants in the bond market, access to capital is becoming easier and that's why spreads are narrowing, a senior debt capital market head at a brokerage firm said.

This is below 'AA-' segment where institutional participation is restricted, the DCM head said.

Typically, the pricing on AAA rated corporate bonds is derived from the benchmark government bond, which is then followed by AA, A and BBB rated papers.

The ratings of these bonds are based on their creditworthiness and the issuer’s ability to meet financial obligations. In a nutshell, higher the rating, lower the chance of a default.

Ideally, if rates on AAA rated papers are compressed by 5 bps on year, then those of lower rated companies are supposed to narrow by 1-2 bps, as pricing is derived based on the highest-rated investment-grade bonds.

The cost of borrowing of BBB rated issuers, including EarlySalary Services, Manba Finance, Bhanix Finance and Investment, Kinara Capital and SATYA MicroCapital Ltd., are in the range of 10.28% to as high as 15%.

However, a fall in the overall yield curve, unattractive returns on AAA rated bonds and robust liquidity conditions has made HNIs, family offices and alternative investment funds more comfortable towards BBB rated papers.

Yields on the 10-year benchmark government bond has fallen to 6.77% as of Wednesday, from 7.38% a year ago, according to data available on the Clearing Corporation of India. This is against the AAA rated corporate bonds issued by benchmark National Bank for Agriculture and Rural Development that have decreased by around 50 bps to 7.20-7.25%.

"On a risk adjusted basis, returns on corporate bonds look fairly attractive because g-sec yields have gone down. While there is some compression in corporate bonds spreads, the yields look attractive," said Anil Gupta, senior vice president and co group head financial sector ratings at ICRA.

"Moreover when you look at a 91-day Treasury bill which is at 6.43% or 10-year government bond at 6.75% levels, the term premium is also limited," he said.

The lower carry in government bonds, AAA and AA+ rated corporate bonds has made lower credits more attractive to yield chasing investors.

Confidence in the Indian economy becoming stronger, rise in more issuer upgrades than downgrades, sound balance sheets, earnings results and the inclusion of Indian government bonds in foreign indices has turned investors more comfortable towards lower credits.

The proportion of rating upgrades to downgrades increased to 2.75 times in the first half of the current financial year from 1.79 times in the second half of last year, CRISIL Ratings said in a report last week.

The emergence of alternative investment funds and the sale of credit funds to HNIs through these AIFs is also said to have been another factor for the compression in lower credit spreads, experts said.

"The underlying reason is that the pool of capital size is moving away from debt mutual funds to AIFs after the removal of taxation of debt mutual funds," said Anshul Gupta, co-founder and chief investment officer of Wint Wealth—a platform for fixed income investment products.

"Everyone wants good post tax return on their fixed income portfolio. Debt mutual funds or fixed deposits wont give it, so you need to chase a certain amount of credit risk."

Further, distributors and advisors are also said to have been pushing for products that offer higher commission such as AIFs as compared to mutual funds where there is enough investor awareness.

In 2023, the finance ministry had scrapped long-term capital gains tax and indexation benefits on income from debt mutual fund schemes, making such investments taxed at respective tax slab of the investor.

However, another section of the market believes that this cannot be the driver of rising demand for lower rated papers. This is because mutual funds, by law, cannot invest in lower credits and fungibility of such investments remains at the bare minimum.

While in the near-term, this momentum is likely to continue, analysts remain concerned that if default in borrowers of non-banking financial companies and other financial institutions take place, it may lead to risk aversion towards their papers and widening of spreads.

While the near-term trend is that the yields are declining, if there is a rise in defaults by borrowers from NBFCs, it can lead to risk aversion towards their papers, Anil Gupta said. "Such a risk aversion can increase the yields on their papers and the spreads can widen because NBFCs are the largest borrowers in the corporate bond market."