Budget 2014 has inadvertently proved to be highly negative for credit spreads in the near term. The reclassification of debt mutual funds schemes for availing capital gains benefits is the major reason for the possibility of credit spreads shooting up in the coming days.
Corporate bond yields rose sharply post budget 2014 with one, three, five and ten year benchmark AAA bond yields rising by 20bps, 23bps, 16bps and 13bps respectively. Three, five and ten year benchmark credit spreads rose by 15bps, 4bps and 5bps respectively to close at levels of 68bps, 49bps and 32bps. Three and five year credit spreads can rise sharply if mutual funds come to sell corporate bonds at the short end of the yield curve.
Debt mutual fund schemes are classified as short term capital assets if held for a period of less than thirty six months and capital gains tax is 20% with indexation benefits. Prior to budget 2014, the holding period was twelve months to avail of capital gains tax of 10% without indexation and 20% with indexation benefits. The tax will come into effect from assessment year 2015-16, which effectively means that all redemption or transfer of units of debt funds will be taxed at base rates.
Debt mutual funds predominantly invest at the short end of the corporate bond yield curve. Assets are concentrated at the short end. AMFI (Association of Mutual Funds of India) data for June 2014 shows that of total assets of Rs 9740 billion, debt funds account for Rs 7500 billion or around 75% of total assets. Breaking down debt funds, Rs 2160 billion is in liquid funds that have an investment maturity cap of 91 days. Close ended income funds that are predominantly FMP or Fixed Maturity Plans have a total of Rs 1740 billion. Maturity of these schemes vary between three months to three years with concentration around the one year maturity bucket to avail of long term capital gains benefit before the tax change was announced.
FMPs cannot be redeemed before maturity of the scheme and can only be sold through the stock exchanges as they are listed.
Open ended income funds account for Rs 2950 billion of assets and of these around Rs 1500 billion would be in less than one year assets in the form of ultra short term funds that are positioned as quasi liquid funds for investors. The rest of Rs 1450 billion of assets are distributed amongst bond funds of short, medium and long term maturities with short and medium term funds accounting for most of the assets.
This segment could be the cause of trouble for credit spreads if investors a) redeem investments and b) investors stop investing in such funds due to adverse tax laws.
Banks are not large investors in corporate bonds while insurance companies and provident funds prefer to invest in long maturity corporate bonds. FIIs invest in short maturity corporate bonds and still have limits of around USD 30 billion that could potentially flow into credits. Mutual funds are by far the largest investors in corporate bonds in the one to five year maturity segment of the curve. Hence selling or lack of buying interest by mutual funds in corporate bonds will take up yields for issuers leading to rise in credit spreads.
Government bond yields rose by 9bps to 14bps across the curve last week as budget 2014 failed to address issues of subsidy control even though borrowing was kept at interim budget levels. Outlook for bond yields is not negative as borrowings drop in the coming weeks and a new ten year benchmark bond issuance takes up trading interest. The 8.83% 2023 bond closed at levels of 8.77% and the cut off on a 2024 bond should come in at around 8.5% levels going by SDL (State Development Loans) cut off of around 9% in last week’s auction. SDLs trade at 50bps spread over ten year benchmark government bonds.
OIS market saw one year OIS yields rising by 8bps and five year OIS yields rising by 11 bps to close at levels of 8.42% and 7.93% respectively. The five over one OIS spread flattened by 3bps to close at negative 49bps levels. OIS yields are likely to stay steady at current levels with no real driving force in the coming weeks.
Liquidity tightened last week as bank borrowing from RBI in repo and term repo auctions increased by Rs 80 billion week on week. Government surplus held with RBI is likely the cause for drop in liquidity. Outlook for liquidity is stable with RBI managing deficits through term repo auctions. RBI has schedule a 4 day term repo auction for Rs 50 billion on the 14th of July.