Subprime storm will lift foreign-loan cost of firms

Credit default swap spreads on Indian papers soar

MUMBAI: Can a global event unrelated to Indian companies have an impact on their cost of finance? It can. The subprime home-loans crisis in the US promises just that.

The recent movement of credit spreads is a clear sign of this global interlinkage. Indeed, widening credit spreads - which indicate the rise in the cost of protection from default - has been a key indicator in the recent sharp falls in equity markets across the globe.

Says V Balakrishnan, CFO of Infosys Technologies: “It will affect all companies including Indian, as the risk premium has gone up. New loans would become expensive by 50-100 basis points.”

Risk premiums rise whenever crisis looms and investors fear default. The losses sustained by a sheaf of banks (HSBC’s subprime unit the US has racked up a staggering $8.8 billion or Rs 35,000 crore loss) and hedge funds such as those of Bear Stearns due to default by subprime borrowers in the US have set off a domino effect of risk aversion on credit spreads.

“We have to go back to September 2001 to find the same level of risk aversion,” Ulrich Katz, a Munich-based fund manager at Pacific Investment Management Co (Pimco), one of the world’s biggest fund managers, told Bloomberg on Monday.

He was referring to the subprime crisis-led angst across the globe.

A bond investor protects himself against default by the issuer using instruments such as a credit default swap (CDS).

Take, for instance, a CDS linked to a Tata Motors bond. A writer of CDS contract will agree to make good the investor’s loss of interest and principal if Tata Motors defaults on their payment. Spread is the price an investor pays to avoid this risk.

However, since the perceived risk of Tata Motors defaulting is low, the spreads were very low, too, before the subprime pandemic broke out.

N S Paramsivam, head of treasury at the Essar Group, said borrowing costs of large companies such as Vodafone have increased by 20 basis points since June.

“For Indian companies it would be at least 70 basis points. If the subprime meltdown extends further, the costs would increase anew.”

Spreads on credit default swaps linked to Indian bonds such as those of Reliance Industries, Tata Motors, State Bank of India and ICICI Bank have risen by 40 to 100 basis points once the subprime tsunami started.

But why should an event in the US affect other emerging credits? Because high-risk investors are not exposed to just one asset class.

A hedge fund holding subprime assets may also be exposed to emerging market credit default swaps, high-yielding European bond markets and other risky credits. A loss in any of these would force the fund to sell the credits across holdings to protect capital and meet redemption pressure.

This implies the cost of buying protection is moving up. Which, in turn, increases the cost of borrowing for Indian companies.

If highly traded and rated names are paying higher costs, lesser corporates will now pay much more.

This can go 200 to 300 basis points higher if risk appetite decreases considerably, said analysts.

“The flip side to this is, rising rates abroad make local finance look cheaper, comparatively,” said K Chandrashekhar, treasurer at auto major Mahindra & Mahindra.

For companies eyeing foreign loans, not only are the costs higher and the appetite among buyers low; at current levels, the risk of rupee depreciation is high, too.

‘Subprime’ is a reference to people with poor loan repayment history or capacity.