A fickle corporate bond market is undermining monetary policy transmission

Highlights

• RBI policy rate hikes have seen efficient transmission in money market rates


• Loan rates have risen commensurate with policy rate hikes but pockets of mispricing show up


• Corporate bond spreads have been underpricing credit risk, showing lack of transmission


• RBI’s policy efficacy hinges on resolving bond market’s idiosyncratic transmission trend

In recent times, the Reserve Bank of India (RBI) has taken pride, and deservedly, in a more efficient transmission of its policy rate actions on to market interest rates. Analysts too have noted that the cumulative 250 basis points hike in the repo rate since May 2022 has trickled down almost completely to bank loan rates, money market rates and even bond yields.

Indeed, money market rates such as commercial paper rates and treasury bill yields climbed by more than 300 bps during this period and the overnight call money rate has hugged the repo rate most times. Banks have hiked lending rates consistently and nominal loan rates are at, if not above, pre-pandemic levels with the weighted average lending rate having risen by 103 bps.

But this seemingly efficient transmission in loan rates cloaks pockets of mispricing, a problem now serious enough for analysts to consider the possibility of asymmetric transmission of policy rates. Bankers have been warning about instances of mispricing of credit risk in the loan market for more than six months now. Kotak Mahindra Bank Ltd was one of the first to flag off irrational pricing in wholesale loans. Analysts such as A.S.V Krishnan of HDFC Securities pointed to mispricing even in retail loans. In an interview with Moneycontrol, Krishnan pointed out that even retail loans are underpricing risk due to aggressive lending by banks.

The bond market, though, has been more upfront about mispricing. Government bond yields have climbed roughly 20 bps across the curve and corporate bond yields too have remained benign.

State Bank of India’s economic research wing has flagged this mispricing in the bond market in a report. The report points to many instances in the corporate bond market where the spreads have reduced despite the sharp increase in policy rates and tightening of liquidity. For instance, the spread that investors get when buying 3-year AAA-rated corporate bond has reduced by 31 bps despite policy rates moving northward. “The average spread of a AAA 10-year paper that was 117 bps in pre pandemic levels over similar tenor G-Sec is now only 44 bps,” the report said.

For corporate bonds rated lower than AAA, the transmission has been even more uneven. A handful of companies have been able to borrow at aggressive yields while most have had to contend with a sharp increase in spreads.

One reason for mispricing has been surplus liquidity and the RBI’s move to levy 10 percent incremental cash reserve ratio (CRR) on banks was based on this view. However, despite banking sector liquidity now near deficit, corporate bond yields haven’t climbed much.

What explains this idiosyncratic behaviour in corporate bonds?

If changes in the quantity of money aren’t increasing its price, then in all probability the supply of paper is moving the needle. To be sure, the merger of HDFC Ltd with HDFC Bank resulted in a vacuum in bond supply as the former was one of the largest issuers of bonds. The shortfall has led to investors pursuing other issuers and a resultant fall in bond yields. This shortfall is also behind the fact that the incremental CRR hike didn’t impact the corporate bond market.

That said, bond investors are wary of credit risk because they have witnessed instances of losses in the past ever since IL&FS collapsed. Given the lack of protection due to an illiquid swaps market, credit risk accidents have hurt investors badly. Settling for inadequate credit risk pricing seems hara-kiri in the wake of past accidents.

Are investors and bankers exuberant without the conditions that warrant them? Are beefed up corporate balance sheets with good profitability luring investors into locking in funds for a long period of time that has the risk of a downcycle?

These are questions that the RBI needs to find answers to quickly as the efficacy of its monetary policy depends on them. For now, corporate bond investors are willingly indulging in underpriced credit risk, the effects of which may not be visible immediately.