Realty, health pose risks to bond market, says McKinsey Global Institute

Corporate bonds in India are at lower risk than in other emerging economies, but two sectors, real estate and health care, are at greater risk than average, a recent discussion paper from McKinsey Global Institute has flagged.

About 18 per cent of outstanding corporate bonds in India were at default risk in 2016, it said. 

In comparison, the situation in India is better than in other emerging economies: The share of risky corporate bonds in both China and Brazil is 24 per cent. In advanced economies like the US and Canada, less than 7 per cent bonds are at risk.

However, the report also demonstrates a well-known fact: That the size of the corporate bond market in India is inherently small — at 4 per cent of the country’s gross domestic product. In real estate and health care, 35 per cent and 30 per cent bonds were at risk, respectively. Access to formal capital in India has still not come of age owing to a large informal sector, and the existing exposure of corporate bonds to various sectors is top-rated — meaning lower credit risk — which obviates any risk as of now, markets experts said.  

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At the same time, the paper warns that the share of risky bonds might rise from the current 18 per cent to 27 per cent if the interest rate on corporate bonds rises by 200 basis points.

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Average corporate bond yields rose to a near two-year high in May at 8.9 per cent, up from 8.4 per cent at the beginning of 2018 (50 basis points), meaning bonds are getting costlier over the year, Care Ratings said in its May 2018 corporate bond monitor report.

Corporate bonds are an important but not fully developed phenomenon in India’s debt market. Companies, or the corporate sector in India, rather prefer to raise finance through banks and equity (stocks, mutual funds). The paper, titled “Rising Corporate Debt: Peril or Promise?”, says that more than a fifth of corporate bonds in India, China and Brazil are from issuers with an interest coverage ratio below 1.5, which puts them at the risk of default.

The interest coverage ratio (ICR) can be crudely defined as the ability of a company to pay interest on its outstanding debt. It is the ratio of the EBITDA (earnings before interest, taxes, depreciation and amortisation) over interest payments of the company. A higher ICR means a less risky bond, while the risk increases as the ICR decreases.

“Even though the corporate bond market is small in India, most of the corporate bond issuers are rated either AA or AAA, which does not point to a worrisome trend,” Jitin Makkar, vice-president, Icra, told Business Standard. Care ratings puts the share of the two highest-rated bonds in exposure at more than 90 per cent. 

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Stating that from a low base the bond market can grow, he added that the growth, however, depends upon investor appetite, the regulatory environment, and rising income levels, which can support corporate growth. 

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Among sectors, more than a third of corporate bonds exposed to real estate are at risk, says the paper. Experts do not seem to buy this argument since more than two-thirds of housing is financed by non-banking financial companies (NBFCs) while about 20 per cent by banks, leaving less than 5 per cent space for corporate bonds.
 

Note: * for January-June 2017; EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization. (Source: McKinsey Global Institute)

“Of the incremental credit offtake of $20 billion a year, only about $1 billion is financed through bonds. Further, only listed companies are allowed to issue bonds, but majority of real estate activity is concentrated in the rural sector, and has limited exposure to formal finance,” Shobhit Agarwal, MD and CEO, ANAROCK Capital Advisors said.

As an indicator of the maturity of the housing market, the mortgage penetration in the US is more than 90 per cent — meaning of 100 houses sold in the US, 91 are financed through mortgaged loans. In China, the penetration is 36 per cent, while in India, it is as low as 9 per cent.
 

The situation is that it is not just the real estate market that is not receptive to corporate bonds, but is true of the entire economy at this stage, observers said.