Better rated commercial entities are rapidly migrating to the bond market route for their credit needs.
Considering the shortfalls in our financial systems and the current stressed assets problem, there are multiple challenges in this trend.
What has caused the trend?
Bank interest rates are not high enough to offer a real return (accounted for inflation) to depositors.
Hence, lately, much inflow has found its way to debt instruments like “Mutual Funds” that have given better returns than banks.
However, when it comes to credit, the situation is reversed, with banks charging higher rates than the bond market rates.
Therefore naturally, companies with strong balance sheets will move from banks to bonds in order to access cheaper finance.
This leads to a situation where banks are left to lend for companies with poorer credit ratings, which reduces the quality of their credit.
Is the trend bad?
Gap between bank lending rates and bond yields is not new, but it didn’t matter in the past because restrictive rules for the bond market limited its size.
But lately, bond market volumes have been growing rapidly, and the share of banking funds the commercial sector has been dropping drastically.
Notably, while banks usually account for more than 50% of the commercial capital, the 2016-17 figures stood at a mere 38.4%, which was down from the previous year’s number of 52.3%.
This situation is unlikely to have been reversed in the current financial year, due to the capital shortage in banks.
The problem of losing their best customers is particularly acute for the weaker banks that already face issues of credit quality and interest-rate spread.
What are the risks?
Credit Crisis – Increased non-banking sources of funds is actually good, and the need to develop the bond market like elsewhere was indeed stressed for long.
But as banks are currently seeking to improve their balance sheets as a priority, the loss of good commercial consumers would strain their lending calculations.
They would hence be forced to rely on safe retail lending (for housing, cars etc…), or on working capital loans that are backed by receivables.
Consequently, due to the absence of a strong 2nd tier of non-bank financial intermediaries, small and medium sector customers would be starved of credit.
Investor Risk - The rush to bond markets puts the spotlight on the “credit rating agencies”, which influence the bond market yields with their ratings.
Typically, debt mutual funds that buy bonds manage to offer relatively attractive yields only by mixing up better rated instruments with poorer ones.
Most retail customers investing in bonds due to better yields lack awareness that better yields come bundled with greater risk.
As India’s financial systems enter into a new phase - Banks, fund managers, NBFCs, and rating agencies need to watch out for the new developments.
