Indian LCY corporate bonds present an opportunity

l Global Research l
Credit Alert | 19 September 2014
Indian LCY corporate bonds present an opportunity
 Indian USD bonds have tightened substantially and do not offer relative value at current levels
 We think Indian LCY corporate bonds offer better value even on a fully hedged basis
 Given the flat yield curves in India, we prefer the 3Y-5Y sector in the Indian LCY space
Summary
Indian US dollar (USD) bonds have had a strong run YTD and have been one of the
best-performing categories in Asia ex-Japan (AXJ) in terms of spread tightening. We
think Indian USD credit spreads are fair at current levels compared to peers both in
Asia and the broader emerging markets, and are unlikely to outperform substantially
unless there is a material improvement in India’s fundamental metrics and rating
agencies’ views.
Shankar Narayanaswamy +65 6596 8249
[email protected]
FICC Research
Standard Chartered Bank, Singapore Branch
Sandeep Tharian +44 20 7885 5171
[email protected]
FICC Research
Standard Chartered Bank
Nagaraj Kulkarni +65 6596 6738
On the other hand, Indian government bonds (IGBs) and local-currency (LCY)
corporate bonds yields have been treading water this year, despite the improvement
in investor sentiment and strong inflows to the Indian rupee (INR) bond space, and
offer value in the short to medium term, in our view.
[email protected]
FICC Research
Standard Chartered Bank, Singapore Branch
Divya Devesh +65 6596 8608
[email protected]
FICC Research
Standard Chartered Bank, Singapore Branch
IGBs have been the first port of call for international investor involvement in the
Indian LCY space. Investments in IGBs have increased substantially and have
almost reached the quota limit. We therefore think INR corporate bonds are a good
alternative given the larger quota still available in the space. We prefer the stronger
quasi-sovereign names (rated AAA locally) that give a 50-100bps pick-up over
government bonds of similar tenor.
INR corporate bonds look attractive whether hedged or unhedged
For benchmark quasi-sovereign names, fully hedged LCY bonds in the 2Y-5Y bucket
offer a spread pick-up of 20-80bps over USD bonds of similar tenor. We use nondeliverable cross-currency swap (ND CCS) for hedging INR cash flows. This is after
adjusting for 5% withholding tax on the INR corporate bonds. On a hedged-basis, 5Y
bonds offer a higher pick-up than shorter-dated bonds, over similar USD credits given
the lower swap costs. That said, hedged trades need to be packaged, which makes
them less liquid than outright buying INR corporate bonds.
We prefer investing in INR corporate bonds on an unhedged basis given our Neutral
view on Indian rates and our Overweight recommendation on the INR in the medium
term. We recommend buying quasi-sovereign credits in 2Y-3Y space that offer strong
carry returns. For example, an unhedged investment in a 2Y INR corporate bond
offers an 8.50% return in INR terms after withholding tax, versus a yield of c.2.0%
offered by the 2Y USD bond issued by a similar quasi-sovereign issuer. Thus, to the
extent that FX stays flat or appreciates from current levels, the investor makes higher
returns in USD terms relative to the USD bond.
Important disclosures can be found in the Disclosures Appendix
All rights reserved. Standard Chartered Bank 2014
research.standardchartered.com
Credit Alert
Indian USD credit spreads – Where next?
Tightening credit spreads leave little room for error
India has been one of the bestperforming markets in AXJ credit
YTD
Indian credit spreads have
tightened considerably after the
election results
Credit spreads in India – across both banks and corporates – have tightened
considerably since the National Democratic Alliance’s (NDA’s) victory at the July
elections. India, which was among the ‘fragile five’ just a year ago, has transformed
to become one of the positive stories not only in Asia but also among the broader
emerging markets. Many emerging-market (EM) investors now consider India to be
more of a core holding that generates decent carry than the quick tactical position it
used to be. While Indian spreads have tightened considerably – and are at their alltime tight levels – momentum remains strong and should continue to be supportive of
spreads. That said, Indian credit spreads are unlikely to outperform their EM peers in
the near term. However, downside risks have abated as well, and we do not expect
India to underperform the rest of Asia in a broad market sell-off like it did in May
2013. We had an Overweight recommendation on India since February 2014, which
we cut to Neutral in June 2014. Given the current tight spread levels in the USD
space, we take a look at the INR corporate bond space to assess how to position and
identify pockets of value, if any.
LCY bonds are an interesting alternative
With IGB quotas almost full, we may
see increased investor focus on INR
corporate bonds
Indian LCY corporate bonds offer an attractive opportunity both on a hedged and an
unhedged basis. After the positive election outcome in mid-May, international fixedincome investors have increased their allocations to Indian LCY debt substantially. In
addition to the decisive election mandate, macro fundamentals are improving. The
central bank is determined to tame inflation and has also been accumulating FX
reserves. The bulk of the inflow to the INR bond space has gone to the government
bond/rates markets. IGBs have received INR 624.6bn (c.USD 10.3bn) of inflows
since 16 May, while inflows to LCY corporate bonds have been c.INR 197.6bn (USD
3.3bn). Given the strong inflow to the IGB space, investors are close to reaching the
current quota for foreign IGB debt holdings (capped at USD 30bn and 99% utilised at
present). However, the quota for LCY corporate bonds is substantially higher, at USD
51bn, of which USD 22bn is still available. As a further increase in the government’s
bond quota is uncertain and may not be forthcoming soon, we expect investors to
focus more on LCY corporate bonds.
We believe gaining exposure to India via LCY corporate bonds is an attractive
proposition for several reasons. First, unlike for IGBs, foreign investors can buy LCY
corporate bonds without any residual maturity restrictions (for IGBs, it is minimum of
Figure 1: India has outperformed in AXJ credit
Figure 2: Indian 3Y-5Y corporate bonds offer attractive value
YTD spread tightening in major AXJ geographies (bps)
INR corporate and GB yield curve (%)
Philippines
9.5%
AAA-PSU
yield curve
Hong Kong
Thailand
China
9.0%
Singapore
Malaysia
Korea
8.5%
IGB yield
curve
Indonesia
India
Composite
-100 -90
-80
-70
-60
-50
-40
Source: Bloomberg, Standard Chartered Research
19 September 2014
-30
-20
-10
0
8.0%
1Y
2Y
3Y
4Y
5Y
6Y7Y
8Y
9Y 10Y
Source: Bloomberg, Reuters, Standard Chartered Research
2
Credit Alert
three years). Second, of all the regional (ASEAN) LCY corporate bond markets,
secondary-market liquidity is better in India. Finally, investors may initially focus on
names that already have USD bonds outstanding or other strong sovereign-linked
names that are easier to research and take a view on. Investors also have a choice
of actively managing FX risk or hedging it.
LCY bonds on a hedged basis offer a modest pick-up
INR LCY credits on a hedged basis
offer a modest pick-up over USD
bonds of similar duration on a fully
hedged basis
Investing in INR LCY bonds on a hedged basis has been unattractive in recent years
because of (1) high hedging costs and (2) elevated credit spreads on USD bonds
issued by Indian issuers given the sovereign-rating pressure that existed at the time.
With Indian USD credit spreads tightening sharply and LCY bond yields treading
water, the equation has changed substantially (see Figures 2 and 3). Investments in
INR bonds are now offering a 20-80bps pick-up on a fully hedged basis, depending
on the name and tenor.
5Y INR LCY corporate paper is
attractive on a hedged basis
We consider some comparable pairs in Figure 4 to highlight the pick-up. We analyse
post-withholding tax yields on exposure to INR bonds issued by quasi-sovereign
credits on a fully hedged basis (hedged through ND-CCS fixed to fixed) and compare
those to yields on USD bonds issued by similar Indian credits. The 2Y-5Y maturities
in the LCY corporate space offer value on a fully hedged basis. For example,
investors can buy the 5Y India EXIM LCY bond yielding 9.15%, net of the 5%
withholding tax – the investor will receive an 8.70% yield in LCY terms. In case the
investor opts to hedge the LCY receivables fully with ND-CCS, the hedge will
currently cost 4.63%. Thus, the investor locks in a carry of 4.07% USD return. In this
example, we assume that the investor will hedge FX risk via ND-CCS, which is easily
accessible. The 4.07% effective yield in USD terms on the LCY corporate bond offers
an attractive 69bps pick-up over a similar USD-denominated bond (EXIMBK 19) that
offers a yield of 3.38% currently.
The pick-up on a fully hedged basis makes the space interesting given the current
low-yield environment. The pick-up is especially interesting in the 5Y space given the
lower hedge costs. While there are challenges and costs involved in accessing
onshore markets, we believe access will likely get easier and cheaper in the future.
For details, see Rates Alert, 7 October 2013, ‘India – Foreign portfolio investors’
access simplified’.
Figure 3: INR credits swapped to USD offer value*
Figure 4: INR credits swapped to USD offer value*
LCY 5Y swapped to USD, vs. BOBIN 19 (ASW bps)
LCY 3Y swapped to USD, vs. INRCIN 17 (ASW bps)
350
BOBIN 19
300
250
LCY 5Y
swapped
150
350
100
300
50
200
250
200
200
INRCIN 17
150
100
LCY 3Y
swapped
Differential
(RHS)
0
150
100
Differential
(RHS)
-50
-100
50
0
Jan-14
Mar-14
May-14
Jul-14
-150
Sep-14
* LCY spread does not factor in withholding tax; Source: Standard Chartered Research
19 September 2014
50
150
0
100
-50
50
-100
0
Jan-14
-150
Mar-14
May-14
Jul-14
Sep-14
* LCY spread does not factor in withholding tax; Source: Standard Chartered Research
3
Credit Alert
INR LCY bonds on an unhedged basis are more attractive
The strong carry in LCY bonds and
our view of INR appreciation in the
medium term make unhedged LCY
investments more attractive
While investment in INR corporate bonds offers value on a hedged basis, the bond
investment packaged with a hedge makes it less liquid, which could deter some
investors. We prefer investing in INR corporate bonds on an unhedged basis. INR
corporate bonds offer strong carry, with even 1Y paper yielding c.9%. We have a
Neutral view on INR rates in the near term and expect IGB yields to remain rangebound in the near term. We have an Overweight FX weighting on the INR for both the
short and medium term. We therefore expect strong returns in the next 1Y-3Y on an
unhedged basis. For example, an unhedged investment in the 2Y REC bond offers
an 8.50% return in INR terms after withholding tax, versus the 1.93% yield offered by
the 2Y USD bond by the same issuer – the RECLIN 16. Thus, to the extent that FX
stays flat or appreciates from its current level, the investor makes substantially higher
returns in USD terms.
The short end offers better value, as INR yield curves are flat
Flat yield curves make going down
the duration curve in INR LCY
credits unattractive
LCY curves in both the Indian sovereign and corporate space are flat, much flatter
than the USD curve for Indian credits. Thus, it makes sense to invest in the short end
of the curve when investing unhedged. 2Y INR corporate paper seems attractive on
an unhedged basis. The 5Y seems to be the sweet spot for buying INR corporate
bonds both on a hedged and an unhedged basis given the lower swap costs for 5Y.
Moreover, swapping INR corporate bonds to USD is practical only up to five years.
Beyond that, the swap markets are not very active in INR, and longer-tenor bonds
cannot be fully hedged, although investors may partially hedge with a 5Y swap. In
any case, longer dates do not offer any pick-up in yield, making it unattractive to
invest in, unless the investor expects yields to fall substantially. It will also make the
structure substantially more illiquid.
The high-grade space offers value
Opportunities in the Indian credit markets are mainly in the highly rated (AAA/AA+)
space on the local rating scale, which roughly corresponds to BBB- to BB on the
international rating scale. The issuance space is dominated by quasi-sovereign credits,
but there is issuance from privately owned financial institutions as well. Private
corporate paper is still somewhat hard to find, as banks offer cheaper funding. A firsttime investor may prefer a (locally) AAA rated quasi-sovereign bond that offers a pickup of c.20-80bps over the USD-denominated bond on a hedged basis. Investors with a
slightly higher risk appetite may get a better pick-up by moving down the rating scale to
(locally) AA+ rated entities. However, lower-rated paper in LCY corporate bonds lacks
secondary-market liquidity and is subject to idiosyncratic risks.
Figure 5: 5Y INR LCY paper offers the best value on a swapped basis
Yield on INR LCY paper swapped to USD, vs. USD paper of similar maturity (%)
Bond yield*
(net)
8.55%
Hedge cost
Net return
1y REC
Bond yield
(gross)
9.00%
Name
USD bond yield
1.80%
BOIIN15
1.43%
Pick-up
(bps)
37
6.75%
2y REC
8.95%
8.50%
6.08%
2.42%
RECLIN 16
1.93%
49
5y REC
9.20%
8.75%
4.63%
1y EXIM
8.95%
8.50%
6.75%
4.12%
SBIIN 19
3.28%
84
1.75%
EXIMBK 15
1.13%
62
2y EXIM
8.80%
8.35%
6.08%
5y EXIM
9.15%
8.70%
4.63%
2.27%
BOBIN 16
2.03%
21
4.07%
EXIMBK 19
3.38%
69
1y PGC
8.95%
8.50%
6.75%
1.75%
SBIIN 15
1.23%
52
2y PGC
8.80%
5y PGC
9.15%
8.35%
6.08%
2.27%
INRCIN 16
1.64%
63
8.70%
4.63%
4.07%
ONGCIN 19
3.38%
69
Note: Net bond yield is after 5% WHT on an average coupon of 9%; Source: Standard Chartered Research
19 September 2014
4
Credit Alert
Regulatory and tax considerations
Eligible investors
For direct access to Indian LCY debt instruments, entities have to be registered as
foreign portfolio investors (FPIs). For access via synthetic instruments, Indian
regulations require the entities to be regulated by their respective local regulators.
Withholding tax
In April 2013, the Indian government lowered the withholding tax (WHT) on interest
payments from IGBs and corporate bonds for foreign institutional investors (FIIs).
The reduction was to 5% from 20% and was effective from 1 June 2013 to 31 May
2015. Although the government may keep this reduction in place, we highlight the
uncertainty in tax policy.
Capital gains tax
Depending on the jurisdiction, investors may need to pay capital gains tax. India has
a double-taxation agreement (DTA) with several countries, and both capital gains tax
and WHT are subject to these agreements.
Our IGB outlook is Neutral
We have a Neutral outlook on IGBs
From an LCY rates perspective, we have shifted our outlook on IGBs to Neutral from
Positive after the Reserve Bank of India’s (RBI’s) 5 August monetary policy, and expect
IGB yields to be range-bound. In the near term, the positive impact of favourable
inflation dynamics on IGBs is likely to be offset by the RBI’s more hawkish monetary
policy stance and the reductions in the statutory liquidity ratio (SLR) and the held-tomaturity (HTM) ratio. Inflation dynamics are favourable for the remainder of 2014 (see
Economic Alert, 28 July 2014, ‘India – Poor monsoon but limited inflation impact’). The
rates market had hoped that the RBI would soften its anti-inflationary stance and
possibly lower policy rates in 2014. After the 5 August monetary policy announcement,
expectations of a rate cut have been unwound. Moreover, with 50bps reductions in the
SLR and HTM ratios in June and August, expectations of further reductions are likely to
persist. We think this will dampen banks’ demand for IGBs. Banks are the largest
investors in IGBs (holding c.44% of the total outstanding). We forecast the benchmark
10Y IGB yield at 8.40% by end-December.
Figure 6: The high-grade space offers variety
Credit rating
AAA
Tenor
Range of yields
1Y
8.95% (EXIM) to 9.35% (HDFC)
2Y
8.80% (EXIM) to 9.40% (LIC Housing Finance)
5Y
9.20% (PGC) to 9.40% (HDFC)
2Y
9.50% to 9.60% (Sundaram Finance, Bajaj Finance)
5Y
9.60% to 9.65% (Sundaram Finance, Bajaj Finance)
AA+
Source: Standard Chartered Research
19 September 2014
5
Credit Alert
Our FX weighting on the INR is Overweight
Our medium-term Overweight view
on the INR is predicated on an
improvement in the growth/inflation
mix
We have an Overweight FX weighting on the INR for both the short and medium
term. Key near-term positives are strong capital inflows, a high carry-to-vol ratio and
an increase in the RBI’s reserves. Since the announcement of election results, we
have witnessed total inflow of USD 20.5bn (USD 6.9bn in equities and USD 13.6 in
debt). On the back of these inflows, the RBI has also bolstered its FX reserves. As of
end-August, India’s FX reserves were USD 318bn, versus USD 293bn at end-2013.
This leaves the RBI in a relatively more comfortable position to tackle upward
pressure on USD-INR following a repricing of Fed rate-hike expectations or a
worsening of global risk appetite due to geopolitical concerns. The central bank’s FX
intervention tactics have helped crush realised spot volatility – one-month USD-INR
daily realised volatility is just 4.46%. Among all AXJ currencies YTD, the INR has
offered the highest carry-return Sharpe ratios. We believe India’s policy dynamics
have changed considerably and will likely improve the Indian growth/inflation mix in
the medium term. RBI Governor Rajan continues to focus on containing inflation,
which is likely to be positive for the INR in the long run (and will likely leave the RBI
unwilling to tolerate extended INR weakness short-term).
Figure 7: USD-INR – Medium-term forecasts
We expect the INR to appreciate in
the medium term
USD-INR
2014
2015
2016
2017
2018
58.00
59.00
58.50
58.00
58.00
Source: Standard Chartered Research
Figure 8: Improving growth-inflation mix is positive for the INR
Real GDP growth (%), inflation (yearly average, %)
7
6
5
12
Forecasts
Inflation (RHS)
10
Real GDP growth
8
4
6
3
4
2
2
1
0
0
FY12
FY13
FY14
FY15
FY16
Source: Bloomberg, Standard Chartered Research
19 September 2014
6
Credit Alert
Disclosures appendix
Recommendations structure
Issuer –
Credit outlook
Standard Chartered terminology
Impact
Positive
Improve
Stable
Remain stable
Negative
Deteriorate
Definition
We expect the fundamental credit profile of the
issuer to <Impact> over the next 12 months
Standard Chartered Research offers trade ideas with outright Buy or Sell recommendations on bonds as well as pair trade recommendations
among bonds and/or CDS. In Trading Recommendations/Ideas/Notes, the time horizon is dependent on prevailing market conditions and may
or may not include price targets.
Credit trend distribution as at 03 September 2014
Positive
Stable
Negative
Total (IB%)
Coverage total (IB %)
17 (17.6%)
220 (16.0%)
78 (26.3%)
315 (18.6%)
Additional information, including disclosures, with respect to any securities referred to herein will be available upon
request. Requests should be sent to [email protected].
19 September 2014
7
Credit Alert
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Document approved by
Document is released at
Kaushik Rudra
Head, Rates & Credit Research
02:37 GMT 19 September 2014
19 September 2014
8

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