The recent spike in bond market yields has become a matter of concern for institutional bond investors.
The recent spike in bond market yields has become a matter of concern for institutional bond investors. Banks, being the largest holders of bonds, are most affected. The direct impact on the marked-to-market prices of bank portfolios is obvious. Since the information on rising bond yields has been widely reported and analysed in public domain, it may be safe to believe that bank stock prices are already reflecting the same. There may be a further small reaction, once banks report their current results, for psychological reasons.
There is, however, an elephant in the room, i.e. an adverse impact on resolution of NPAs, which does not seem to have been adequately discounted. The impact of rising bond yields on the parameters of the insolvency resolution process (IRP) is likely to be significant.
The restructuring or sale of corporate debt (mostly loans) by banks involves assessment of the amount of write-off on the book value of debt paper held by banks. This process can be complex. However, at the core, it involves the projection of future receipts from the paper and discounting of such future receipts at an appropriate discount rate.
Banks, through IRP, have been trying to improve the probability and amount of future receipts from debt papers. While it involves some quantitative and qualitative estimates, the final estimate in each case will be based on the views of banks and their agencies in the process. The views of banks and the debtors or bidders, as the case may be, will have a bearing on the final estimates of future receipts.
The other important variable set—the discount rates for future receipts—is not a matter of negotiation between the parties. The discount rate for future cash flows is a systemic rate, based purely on the tenor and the credit rating of the same. The appropriate discount rate should be determined by the market and not by the transacting counter-parties.
In reality, there is hardly any liquid market for corporate bonds beyond the top few credit ratings and for short tenors. In practice, a model-based (or extrapolated) discount rate is used by banks for discounting future receipts. This is where the mispricing risk lies and can become significant when bond markets are either volatile or deteriorating. The risk is multiplied when the market is both volatile and deteriorating. It is understood that present value of a loan, based on a restructuring or bidding proposal, will decline with a rise in bond market yield, and the correspondingly higher discount rate.
The question is: Are valuation models for loans under the insolvency process being frozen, as submitted by bidders, or being recalibrated based on rising bond yields? It is important for banks, as they would be bearing the loss on account of difference between the quoted valuation and marked-to-market valuation, as bond yields rise. A likely counter to this proposition is that loans are not marked-to-market in any case. While that was the past norm, it would not hold true now in view of revised accounting norms. In any case, a risk-based valuation approach would demand a revision in valuation in case of any significant change in the discount rate.
The negotiation between banks and counter-parties is private in nature. So it cannot be commented whether the aforementioned issue is being looked at by banks. But based on public discussions, the impact of rising bond yields on residual values of NPAs doesn’t seem to have got adequate attention from policy commentators/investment analysts.
For almost all large corporate debtors, owing over Rs 3 lakh crore of nominal outstanding debt to banks, the resolution process is under way. While proposals for restructuring of debt have been submitted and are being analysed for a few cases, the outcome is pending in most cases. The process may get elongated or the haircuts for banks may get deepened. The 10-year bond yield has rose by 50bps in last two months.
For a 50bps rise in yield, a typical 10-year loan will lose 5% of value. If one considers the impact of an 8x leverage, typical for a bank, the incremental loss in value for shareholders in banks holding NPAs, just on account of a hike in discount rate, would be 40%. Depending on the extent of NPAs on a bank’s balance sheet, the loss would accordingly be borne by shareholders. Considering the impact of market risk in addition to the credit risk on the valuation of NPAs, the provision of 50% mandated by RBI appears to be justified.
Shareholders of banks as well as policy-makers putting in their best efforts for a smooth IRP have a common reason to be concerned—a sharp rise in bond yields.
By Hemant Manuj, Associate professor, Finance, SP Jain Institute of Management & Research