Most retail customers rushing with their money to the bond market are less than fully aware that better yields come bundled with greater risk.
The Reserve Bank has given occasional voice to the concern that bank interest rates are not high enough to offer savers a return over and above the rate of inflation (i.e., a ‘real’ rate of return). This and the collapse of the housing market have led in recent times to more money flowing into mutual funds than ever before; much of the inflow has found its way to debt instruments that have given better returns than banks. However, when it comes to credit, the situation is reversed: The banks charge higher rates because they have to cover large operational costs.
For instance, State Bank of India’s best rate for a three-year loan is 8.1 per cent, whereas the comparable yield on the highest-rated bonds is just above seven per cent. Naturally, companies with strong balance sheets will move from banks to bonds in order to access cheaper finance. That will leave the banks with having to lend more to companies that can’t get good credit ratings — which is another way of saying that the quality of bank credit will suffer. Given the already high level of stressed banking assets, this presents a renewed challenge.
The development of non-bank sources of funds is not a bad thing. Indeed, it has been a point of criticism for many years that the country’s financial system is unusually bank-centric, and that the bond market needs to be developed — as in the developed financial markets elsewhere. If they lose their best commercial customers, banks seeking to improve their balance sheets would be forced to focus on relatively safe retail lending (for housing, cars, and the like), or on working capital loans that are backed by receivables. The problem in India is that in the absence of a strong second tier of financial intermediaries — non-banking financial companies (NBFCs) that can operate more flexibly than banks — customers in the small and medium sector would find their credit needs not being met.
The new situation puts the spotlight on another set of players: the credit rating agencies. It is their rating of corporate bonds that influences bond yields. Typically, debt mutual funds, which buy bonds, manage to offer relatively attractive yields only by mixing the better-rated paper with other instruments that have poorer ratings. Given the way salesmen anywhere function, the precise nature of this mix may or may not be fully disclosed to customers, or fully understood. That makes it even more critical that the rating exercise is of the highest quality; after all, rating failure was one of the main causes of the western financial meltdown of 2008.
In India too, there have been cases of companies with reassuringly good ratings going belly up at startling speed. While these have been only a few so far, the fact is that most retail customers rushing with their money to the bond market are less than fully aware that the better yields come bundled with greater risk. Banks, fund managers, NBFCs, rating agencies, those buying into debt funds — all of them will have to watch their step as India’s financial system enters a new phase
By Special Arrangement with Business Standard