The Hindu Business Line : ‘Bond market to gain from falling inflation, easing interest rates’

The corporate bond market has been the worst hit due to a direct fallout of the global credit crisis.— Mr B. Prasanna, MD and CEO, ICICI Securities Primary Dealership Ltd

Mr B. Prasanna, MD and CEO, ICICI Securities Primary Dealership Ltd

Priya Nair
Remya Nair

Mumbai, Dec. 25 The current year has been an eventful one for the bond market. While rising interest rates pushed bond yields up, the volatility in the equity markets saw investors turning to the debt market as a safe investment option. With interest rates poised to ease and inflationary pressures receding, the bond market stands to gain, says Mr B. Prasanna, MD and CEO, ICICI Securities Primary Dealership Ltd. In an interview with Business Line, Mr Prasanna talks about his outlook for the bond market in 2009.

How do you think the current year has been for the money markets given the developments in terms of interest rate movements?

The current year has been quite challenging and unprecedented as far as money markets are concerned. The volatility during the year can be seen from the intra-year (to date) movement in the 10-year benchmark which has traded in a 5.40-9.46 per cent range. Considering that benchmark peaked in July, the pace at which yields have dropped has been unprecedented. The benchmark was still ruling at 8 per cent plus in early October and 7 per cent plus at the beginning of December.

Similarly, the turnaround in monetary policy has also been quite rapid. The last hike in repo rate (taking it to 9 per cent) happened on July 30 and by October 20 RBI had started the easing cycle. The turnaround in bond market sentiment didn’t come about smoothly and was preceded by extremely tight liquidity conditions, sharp depreciation in the currency and freezing up of the short-end corporate bond market. This episode (starting mid-September) has also highlighted the high correlation between global and domestic financial markets. While it initially appeared that India would be spared the worst of the US credit crisis, the contagion in global equity and financial markets after the Lehman Brothers bankruptcy led to tightening of financial conditions in India and intensified the slowdown which was already in train.

Has the higher limit for FIIs added to the volatility in the debt market?

The higher limit has not had such an impact as the total limit is still small compared to the size of bond market and domestic investors.

The limit in Government bonds has increased from $3.2 billion to $5 billion which has been utilised fully, while the corporate bond limit has increased from $1.5 billion to $6 billion where the limits are still unutilised.

FIIs typically used to have access to unlimited funds at Libor in the international markets, which helped them to fund emerging market debt at attractive spreads. However, the credit crisis has made the funding cost costlier for these FIIs at 150 to 300 bps over Libor and hence has made these debt investments relatively unattractive.

Also, the CDS spreads of Indian entities are at much higher levels abroad, and theoretically an FII can create a synthetic credit asset abroad through CDS at much higher yields. These have resulted in slower utilisation of limits domestically.

How has the corporate bond market been growing? What do you think are the prospects for it next year?

The corporate bond market has been the worst hit amongst all markets in India due to a direct fall out of the global credit crisis. AAA corporate spreads (which peaked out at 450 bps in October over comparable sovereign yields) was at a multi-year high and was a direct casualty of the lending crisis. There are a couple of reasons as to why the credit spread blew out.

First was the suddenness of the global crisis after Lehman Bros and the fear that more firms might go bankrupt. The second was the lack of liquidity for lending products.

These factors resulted in the CDS spreads of leading Indian corporates and banks also going haywire more due to the general trend rather than fears of bankruptcies.

The RBI actions of rate cuts and promise of abundant liquidity have been directed at bringing down these corporate spreads. While lending rates have been slower in coming down, the corporate bond yields in the secondary market have been quick to react in the last couple of weeks. They have fallen to around 300 to 310 bps.

The loan rates are not falling due to following factors — the sudden fall in inventory values (due to the fall in commodity prices and lengthening of the working capital cycle due to the slowdown.

This correction process is expected to last for one quarter after which the companies will start benefiting from lower cost of raw materials. Banks will start lending once that correction happens and you can expect PLRs to fall further followed by corporate yields and spreads.

The higher loan rates encourage companies to come to the bond market to raise funds rather than going to the bank. The situation was different for the past three-four years when banks aggressively priced their loans and prevented these corporates from coming to the bond market. Also, corporates are unable to raise funds from abroad through the ECB window and this too has led to an increase in the supply of corporate bonds.

What is your opinion about primary dealers (PDs) being allowed to diversify into other business?

PDs were set up as specialists in fixed income products with the responsibility of underwriting government auctions as well as to improve liquidity in the government bond market. There is no doubt that this system has been a hugely successful one. However, from the industry point of view, lack of ability to short interest rates as well as to participate in currency and commodity markets has been a huge setback. Going forward, introduction of exchange traded interest rate futures is expected to help PDs perform even during adverse interest rate movements provided there are no restrictions in accessing the market.

Also, PDs are probably the only investor segment in the country which are not allowed in currency futures. PDs by virtue of their vast expertise in interest rate markets and sound understanding of the linkages between foreign currency and interest rate markets are ideally positioned to lend their informed judgment to deepening of the currency futures market and superior price discovery.

Similarly, commodity markets such as oil and bullion offer an ideal diversification tool for interest rate and currency traders. Normally, bond prices are inversely related to price shocks on commodities such as oil etc which offer ideal hedging opportunities.

What is the outlook for the next year given that we are entering a softening rate scenario? Will the bond market continue to benefit from the volatility in the equities market?

The outlook for next year is one of slowing growth, falling inflation and more rate cuts by RBI. Sentiment in bond market will continue to be bullish as long as global outlook remains weak and fear of deflation in US and other advanced economies persist.

The US has been officially declared to be in recession from December 2007. The length of the current contractionary period is said to be the longest, post the great depression.

Intensification of the slowdown is at an all-time high in other key global economies as well. Bank of England is expected to cut rates by 150 to 200 basis points from the current 2 per cent while European Central Bank could cut by 100 to 150 basis points from 2.5 per cent. Bank of Japan has already cut rates close to zero per cent and so has the US Federal Reserve. So, globally the story is of fighting deflation with quantitative easing in addition to reduction in interest rates.

In India, inflation has come down from its highs and could ease around 2 per cent in March. If crude stays around $35-40, further cut in domestic administered oil prices could bring inflation down even further.

All of these factors would give the RBI more headroom to cut rates. I expect the reverse repo-repo corridor to go to 4-5 per cent by April and probably 4.5 - 5.5 per cent in the immediate future as the focus seems to have clearly tilted towards encouraging growth rather than fighting inflation.

With outlook for equities uncertain, bond market may also benefit from more inflows into fixed income funds which in turn will fuel a further fall in yields.

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