India’s central bank has released a draft paper suggesting lenders should issue long-term bonds and offer fixed interest rate loans of similar maturities. This will help to deepen the bond market by extending the curve for bank and corporate credit, but the universe of eligible issuers may be small.
In addition, this could result in India’s banks taking on more risk, as corporations often already struggle to repay 10-year loans. Furthermore, lenders with long-term loans on their books may run into problems in the case of a liquidity squeeze, according to commentators.
The Reserve Bank of India (RBI) released the report on January 22. In summary, the RBI is seeking to encourage banks to extend fixed-rate rather than floating-rate loans, due to concerns that both banks and borrowers may fail to manage the interest-rate risks involved in floating-rate loans.
However, a majority of banks’ liabilities are short-to-medium term deposits. Because of this, long-term fixed-rate loans create a balance sheet asset-liability mismatch.
The best way to overcome this, according to the report, is for banks to raise long-term funds by issuing bonds with a tenor of up to 30-years.
In order to encourage demand, the RBI will seek to encourage pension funds, provident funds and insurance companies, who have a natural demand for duration, to invest in the bonds. This may include changing the regulations to allow them to buy riskier assets than government securities.
This would provide two main benefits. The first is that longer-term loans would be available both for mortgages and project financing. For mortgages, this would reduce the equated monthly installment (EMI) amount on home loans and, in theory, reduce non-performing loan (NPL) levels.
For corporates, this would facilitate longer-term projects. However, some commentators believe this would result in banks incurring more, rather than less, risk.
“Infrastructure companies are not paying back their seven-to-10 year loans, so to give them a chance with a much longer-dated loan is very risky. Most of the companies that would have demand for this are sub-investment grade companies,” said one Mumbai-based bank analyst at a global bank.
She believes state-owned banks would be the most likely to issue the bonds and extend 30-year loans, but others are less certain that banks, or even borrowers, will be interested in such long-term loans.
"A 30-year bond is like quasi-equity. A client would rather do equity, unless he has a strong view on yields or duration. Even banks would prefer not to be tied to a fixed rate of interest. They may want flexibility with the ALM [asset-liability management]. So this is a good step to deepen the bond market but if long-term bonds do become popular it would more likely be in the 10 or 15-year bucket," said Arvind Narayanan, head of sales, treasury and markets, at DBS India.
A majority of long-term lending in the Indian bank market is between five and seven years. In project finance the range extends to around 12 to 13 years.
The second benefit would be to deepen the domestic bond market. This is a long-term goal for India’s central bank. If the changes suggested in this draft paper were implemented, over a period of time a corporate bond curve extend to the same length as the sovereign market, which would allow corporate credit to be priced much more effectively.
“Also if the CDS [credit default swap] market takes off, they will be able to trade in this segment as well. If there’s an active bond curve at the long end then the pricing of CDS becomes a lot clearer,” said one fixed income sales banker based in India.
Thirty-year bank bonds would likely prove attractive to long-term investors, especially if the regulators provide the pension funds and insurance companies with incentives to invest in such bonds, according to Rohit Arora, fixed income strategist at Barclays. This in turn could have a negative impact on the performance of sovereign bonds.
“If this were implemented it would be marginally bad for the government bonds as there might be a rotation away from G-Secs [government securities] into slightly higher yielding bank bonds,” he said.
“The positives are many, but do I see this as a volume buster in the market? Probably not because it will only be open to the best names. Think of Singapore, Temasek can do a 30-year, but it’s not open to everybody,” said Narayanan.
Strict guidelines surrounding the investments available to insurance companies and pension funds are unlikely to be fully relaxed, which would limit the market to a small number of high quality issuers. This would restrict liquidity at the long end of the curve, he said.
In terms of other investors such as fund managers, he doesn’t believe there would be enough appetite to lend money for thirty-years to lower quality names.
“A lot of things need to fall into place for an investor to be convinced. Whether they would have access to the [issuer’s] assets in case of bankruptcy, the legal system mechanism and corporate governance being a few. So for a 30-year bond there would be a lot of these questions,” he said.