Credit spreads, as defined by the difference between corporate bonds and government bonds with similar maturity, have fallen sharply over the last four months.
Five- and ten-year AAA credit spreads have come off by 30 basis points (bps) and 35 bps since June and are currently trading at levels of 58 bps each. Credit spreads have come off on the back of corporate bond yields falling faster than government bond yields. Five and ten year AAA corporate bond yields have come off from levels of 9.35% to levels of 8.95% over the last four months, while five- and ten-year government bond yields have hardly moved over the same period.
The fall in corporate bond yields reflects the market sentiment on interest rates and liquidity.
The bond market expects the Reserve Bank of India to cut repo rates in its policy review in October and that expectation is feeding into a search for higher yields.
The bond market also expects system liquidity, as measured by bids or repo in the liquidity adjustment facility (LAF) auction of the RBI, to ease going forward, and that positive outlook on liquidity is helping corporate bond yields.
The reason the positive outlook on interest rates and liquidity is not feeding into lower government bond yields but is reflecting in lower corporate bond yields is the continuous supply of government bonds. The government is borrowing around `13,000 crore on a weekly basis and this weekly supply is keeping bond yields flat despite expectations of rate cuts. Corporate bond issuances are not as heavy as government bond issuances and the market is choosing to execute its interest rate views in the corporate bond market, leading to lower credit spreads.
The question is, will credit spreads rise from lows, stay flat at lower levels or go down further? The answer to this lies in the behaviour of government bond yields.
A rally in government bonds yields from 8.15% levels on the five- and ten-year government bonds will tend to push up credit spreads as the market looks to build positions in the more liquid government bond market to take part in the rally.
Corporate bond yields will fall much slower than government bond yields in the event of a government bond rally leading to rise in credit spreads.
Credit spreads could stay flat at levels of 58 bps if the outlook for government bonds is stable or even marginally negative. Markets will try and take advantage of higher yields offered by corporate bonds if the expectations are that five- and ten-year government bond yields will move in a narrow range around levels of 8.15%.
Liquidity could take down credit spreads from current levels of 58 bps. Mutual funds are seeing strong inflows into their income and dynamic bond funds and these funds invest in corporate bonds of five and ten year maturities. Inflows into income and dynamic bond funds have taken up fund sizes by ten times and above for many fund houses and this money is flowing into corporate bonds as the funds rush to invest money into falling yields. High liquidity flowing into these funds could push down credit spreads further as corporate bond yields fall on heavy demand.
The scenario of credit spreads rising on the back of falling government bond yields looks more likely at present. The conditions for government bond rally are positive with rate cut expectations gaining ground on the back of government reforms and the government maintaining its scheduled borrowing for fiscal 2012-13. The fact that credit spreads rallied much ahead of a broad interest rate rally indicates that credit markets are front running a government bond rally.
Investors too will hesitate to blindly buy corporate bonds at low spreads as liquidity in the market is not as good as liquidity in the government bond or even the state development loans, or SDL, market.
Five and ten year corporate bonds at levels of 8.95% are almost on par with yields on state government debt.
SDLs will be favoured by investors such as insurance companies, provident funds and banks as SDLs qualify for statutory liquidity ratio and are seen as more liquid than corporate bonds.
Parthasarathy is the editor of www.investorsareidiots.com, a website for investors.