Mumbai: Bonds of HDFC are yielding about 40 basis points lower than outstanding debt at government-owned Rural Electrification Corporation (RECNSE 1.93 %), upending the maxim that sovereign-backed loans are safer than paper issued by private-sector borrowers.
This is an unintended consequence of the proposed merger between REC and another state-run entity Power Finance Corporation (PFC), triggering arbitrage trades and distortion in market rates, multiple market sources told ET.
The 10-year REC bonds are yielding 8.60-8.65 per cent, while similar maturity HDFC debt securities are fetching 8.10-8.25 per cent, dealers said.
“Individual exposure limits are stretched for investors,” said Vijay Sharma, head of fixed income, PNB GILT. “This is an unintended consequence of the PFC-REC merger. For the market participants, this widening yield spread is not necessarily a credit call, but it’s more due to exposure norms. This is for the first time that both the government-backed companies are yielding higher than top-rated private company.” Insurers and pension funds have largely invested in bonds of REC and PFC. Every investor is mandated to be compliant with single group exposure limits.
For debt investments, mutual funds are supposed to invest up to 10 per cent of their total assets, which could be extended by another 2 per cent with individual board approval.
If two groups merge, immediate offloading of securities is needed to halve their exposure.
“The merger of two entities, both of which have high outstanding bonds, has created an unanticipated problem,” said Shailendra Jhingan, MD, ICICI Securities Primary Dealership. “The two entities are subject to group exposure limits, resulting in limits being unavailable for further issuance from investors.”
While some existing investors would be forced to sell, arbitragers would be buying these bonds. They seek to gain from a wide differential between REC/PFC and the likes of National Highways Authority of India (NHAI), National Bank for Agriculture and Rural Development (NABARD), Indian Railways Finance Corporation (IRFC), where bonds are yielding 7.75-7.85 per cent.
Typically, the yield gap between those two sets of top-rated sovereign companies remains at 10-15 basis points instead of 85-90 bps now.
“The merger between REC and PFC has apparently triggered concerns among a section of investors who believe a rating downgrade is likely,” said Vikram Dalal, managing director at Synergee Capital. “Investor risk perception has changed in the past eight months.”
In March, PFC paid Rs 14,500 crore to the government to buy out its stake in REC. The proposed merger process is likely to reduce sovereign holdings in the combined entity even as the fund outgo would increase overall borrowing levels.
Speculation is rife that it might take away government’s majority control, although nothing is finanlised yet. REC/PFC secondary market yields are suggesting rates akin to AA+ rated bonds, said a fund manager, citing changing investor risk perception across rating grades. Moreover, both entities issued government serviced bonds in addition to their yearly borrowings.