Corporate bonds: How long can low spreads between G-Sec and corporate bonds sustain?


Indian bond yields hardened last month, as RBI refrained from cutting policy rates due to higher CPI inflation readings. Even though this was on the expected lines, markets were disappointed, as they has some expectations, like an increase in the held-to-maturity (HTM) limits for banks, the calendar of open market operations (OMO) and Operation Twist. In the minutes of the monetary policy meeting, views of MPC members indicated a reluctance to cut rates due to CPI inflation readings going above the 6% level for last six months.

The hardening of yields was pronounced in the most liquid segment of the debt market: Government Securities. We saw the yields of 5-year G-Sec move up 60 basis points and 10-year yields go up 40 basis points in last one month. The above 10-year G-sec yields moved up by 30-35 basis points. However, the spike in yields on the short end of AAA-rated PSU bonds was lower, with five-year yields moving up by 40 basis points. The spread, which was 45- 50 basis points pre-policy, narrowed to 20 to 25 basis points in last one month.

Corporate bond yields have outperformed those of government securities by a decent margin over the past five months after the introduction of TLTRO (targeted long-term repo operation) by RBI. The total target long-term repo auction stood at Rs 1.12 lakh crore. This amount had to be deployed in the corporate bond market, out of which at least 50 % was to be purchased in the secondary markets. This was done to create liquidity in the secondary markets for corporate bonds.

The supply of corporate bonds was around Rs 2.6 lakh crore, out of which majority was in the short end of the yield curve of up to five years. Mutual funds, banks and insurance companies turned major buyers in the market for these papers as it was in line with their requirements. Mutual funds received Rs 1.20 lakh crore from April onwards, which was predominantly invested in AAA-rated papers.

The corporate bond-to-G-Sec spreads compressing as banks and mutual funds competed to deploy the money into these papers. The spread reduced from 120 basis points to 20-30 basis points up to the five-year segment. Banking system liquidity is in excess of Rs 6 lakh crore and the Indian economy is expected to remain weak for the next 2/3 years due to after-effect of the Covid pandemic. This situation is expected to force RBI to maintain an accommodative monetary policy stance.

Corporate bond rates are still attractive for companies to borrow even when yields have moved up by 30-40 basis points in different segments of the yield curve. The minimum MCLR rates that banks are charging is above the 7 per cent level, and these rates are not expected to come down materially from these levels. Companies still have an interest rate differential of 100 to 175 basis points over banks’ MCLR rates. Corporates are expected to borrow more in the debt market due to this arbitrage and lower their borrowing costs.

After the August 6, 2020 monetary policy meeting, RBI has given conflicting signals to the markets. The bond market is accustomed to RBI’s intervention in the bond market, when the 10-year yields trade in the 5.90-6% band. Without RBI’s support, Rs 20 lakh of central government borrowing will not be possible this financial year. RBI devolved the 10-year below 6 per cent in the primary auction, after the monetary policy. This was taken as a signal and the market stabilised after the monetary policy. However, the minutes of RBI policy indicated the discomfort of monetary policy members with high CPI inflation. This led to higher yields in the primary auctions and triggered the subsequent selling, as RBI delayed doing Operation Twist even when the 10-year yields traded above 6.20% levels. Some traders who have shorted the market, started calling for the 10-year yield moving to 7% level, where the demand-supply of government securities could match.

RBI started intervening in the bond market through Operation Twist for Rs 20,000 crore, and it is expected that the central bank will follow through with these operations till 10-year yield comes towards 6 per cent level.

In this scenario, government securities are expected to perform well going forward and the spread between G-Sec and corporate bonds which is around 30 basis points now is expected to widen.

The industrial capacity utilization was at 69.3 per cent in February and our India economic growth rate for last year came in at 4.2 per cent, below the potential growth rate of 6.5 – 7 per cent. Even though fuel inflation is expected to remain at elevated levels due to excise duty increase, food inflation is likely to moderate in the coming months due to good monsoon rains. The phase-wise lifting of lockdown restrictions should lead to higher supply of goods which should take care of demand for essentials food items. Higher rates in the economy can be self-defeating and reduce the potential growth rate of the economy. We expect aggressive RBI intervention in the debt markets to stabilise government bond yield in the coming months.





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