Bond Yields

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Macroeconomic research Why Bond Yields are likely Headed Up Including The not-so-known factor in determining Interest Rates It is our case that the trend of yields firming up that has been seen in the last few days will continue for the next few months at least… and simply put, that’s bad news for Indian banking stocks…PSU Banks, anyway October 11, 2006 Research Contact: Associate Director, Research: Hitesh Kuvelkar Sales Offices:

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IMPORTANT DISCLOSURES CAN BE FOUND AT THE END OF THIS REPORT.

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The Short Story Before plunging into macroeconomic factors, correlation, regression co-efficients et al, for forecasting interest rates & yields, let’s first point out why this is not another not-immediately-usable macroeconomic report. In short, you should care about the direction of yields. First, for the banking sector, this is the most important determinant, not just of profits & margins (particularly via the investment portfolio), but also of stock prices. In fact, the stock market has figured out pretty much a one-to-one correlation between yields and banking First, for the banking sector, this is the most stock prices. As illustration, the banking important determinant, not just of profits & margins sector has been a laggard in the market (particularly via the investment portfolio), but also of since the middle of 2005…but the stock prices. In fact, the stock market has figured out moment the 10-year G-sec yield topped pretty much a one-to-one correlation between yields out on 17th July 2006, the Banking and banking stock prices. As illustration, the indices & stocks started moving up in banking sector has been a laggard in the market exact tandem. The correlation was eerie. since the middle of 2005…but the moment the 10It is our case that the trend of yields year G-sec yield topped out on 17th July 2006, the firming up that has been seen in the last Banking indices & stocks started moving up in exact tandem. The correlation was eerie. It is our case that few days will continue for the next few the trend of yields firming up that has been seen in months at least …and simply put, that’s the last few days will continue for the next few bad news for the banking stocks, months at least …and simply put, that’s bad news for especially the PSU banks. the banking stocks, especially the PSU banks.

Movement of 10 Yr G Sec Yield and BANK NIFTY 8.5 5250

8.3 8.0

4750

7.8 4250 7.5 7.3

3750

7.0 3250 6.8

Yie ld on 10 Yr Gse c bond (%) (LHS)

Source: FG Research, Bloomberg

1

Bank Nifty Inde x (RHS)

Oct-06

Sep-06

Sep-06

Aug-06

Jul-06

Aug-06

Jul-06

Jul-06

Jun-06

Jun-06

May-06

May-06

Apr-06

Apr-06

Mar-06

Feb-06

Mar-06

Feb-06

Jan-06

Jan-06

2750 Jan-06

6.5

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One more point: over the last few days, the heads of various banks have been all over the press extolling the virtues of easy money and why the good times of Q2 will continue into the rest of the years. Would’ve been very heartening, except that merely a few months, even weeks ago, the same persons and banks foresaw interest rates continuing to harden. To give only one example, the Chairman of one of our largest banks gave these statements just a few weeks apart “Interest rates were unlikely to see any further rise in the next three to six months”. “Keeping in mind the international interest rate scenario, we may see some softening in the near future.” (“Lower interest rates on the horizon” Financial Express 27th September 2006) “Interest rates are unlikely to soften in the short to medium term”. (“XYZ Bank board to meet on Aug 12 in Bhopal” The Hindu 9th August 2006) Both statements were made by the same senior banker a few weeks apart. The only reason we haven’t named the bank, is because similar statements can be dug out for most large banks’ CEOs. As we’ve said in another recent report, the truth is that most managements tend to extrapolate the immediate As we’ve said in another recent past and often don’t have a very good crystal ball for the report, the truth is that most variables in their industries. We hope we can give a managements tend to extrapolate better perspective and forecast. the immediate past and often don’t have a very good crystal ball for the variables in their industries.

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The Way ahead During the last few weeks, there has been frenzy in the bond market due to oil prices (the most important determinant of interest rates) retracing to normal levels after touching a high of USD 78.5 per barrel in September 2006. While inflationary concerns arising out of rising oil prices do impact the interest rate movement in India and any fall in oil prices will lower inflationary concerns, we think that there are other equally important determinants of the interest rate trend, such as the Our models show a rising trend in pace and level of credit growth, the competing yields. The biggest reason is for the demand of funds between public and private sector first time this decade, we will see over and government borrowing programs. Once these are several quarters - from the second factored in, our models show a rising trend in yields. half of FY07 onto FY08- a high The biggest reason is for the first time this decade, we demand for funds from both the will see over several quarters - from the second half government, as well as private of FY07 onto FY08- a high demand for funds from borrowers. This is what will keep both the government, as well as private borrowers. yields high. This is what will keep yields high.

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The known factors Credit growth and yield The Scheduled Commercial Banks (SCBs) in India have delivered a stellar performance over the last few years, as far as credit disbursal is concerned. During the last twenty-four months (from October During the last twenty-four months 2004-September 2006), credit grew at an average of (from October 2004-September 31.5% M-o-M, as compared to a much modest M-o-M 2006), credit grew at an average of growth of 18.5% from October 1999-September 2004). 31.5% M-o-M, as compared to a The correlation between yields and credit growth is also much modest M-o-M growth of improving…just as we’d predicted last year. Of course, 18.5% from October 1999the data points are few for the last correlation. September 2004). The correlation between yields and credit growth is also improving…just as we’d predicted last year.

Positive relationship between yields and credit growth improves…finally Correlation between change in 10 yr G sec yield and change in Corporate Credit by SCBs (M-o-M change) From Dec 1998 to Sep 2005

21%

From Dec 1998 to Sep 2006

23%

From Sep 2005 to Sep 2006

30%

The key issue here is what does such rapid growth in credit mean for the interest rates? Although the correlation between credit disbursed and yields on 10 yr G Sec does not produce a significant relationship, the relationship has improved on the back of the two important factors, viz., demand side factor - strong corporate demand during the last few months and tight liquidity - and supply side factor – SCBs are facing a resource crunch, which ultimately impacts the pricing of loan and the interest rate movement. And this is exactly what we had mentioned a year ago in our report on interest rates:

Quote: A statistical regression exercise does not show a clear relationship of interest rates with money supply & government borrowings. To our mind a major reason for this is that a consistent data series for these variables was available only from FY99. However, the next few years thereafter were characterized by excess liquidity where the upward pressure on interest rates due to either tighter money supply or the ‘crowding out’ of private borrowings due to excess government borrowings could not become visible as both these would’ve required a supply constraint to operate in face of adequate demand. Whereas, in this period it was, by and large, demand which was the constraint. Essentially, in the first few years of this decade, liquidity was in excess relative 4

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to the corporate demand for funds. Hence, crowding out was not visible. … However, this trend has changed as the demand for funds from the corporate world & households has picked up. …In our view, the lack of apparent correlation of yields with Money Supply & Government Borrowings has been due to the excess liquidity and/or lack of corporate demand in the period (FY99) for which consistent data is available. This relationship is clearly undergoing a change in the last 12-18 months, as demand for funds has picked up.

Unquote: (From First Global’s “Where are interest rates headed...and why it should concern you (India Macro Research)” dated September 26, 2005)

Outstanding credit by SCBs and growth on M-o-M basis 18,000

40

16,000

35

14,000

30

12,000

25

10,000 20 8,000 15

6,000 4,000

10

2,000

5

0 12/31/98

0 3/31/00

6/29/01

9/30/02

Corporate Credit (Rs bn) (LHS)

12/31/03

3/31/05

6/30/06

M-oM Growth(%) (RHS)

Source: FG Research, Bloomberg

Money supply and yield While money supply, as widely denoted by M3, grew at a modest rate of 15.2% M-o-M (from October 1999-September 2004), the growth of M3 has further improved to 16% over the last 24 months M-o-M (from October 2004-September 2006) and even higher to 18% M-o-M during the last twelve months (from October 2005-September 2006). With a credit growth of more than 30% M-oM, this was bound to happen. And the next thing as an outcome of the same “credit growth-money supply cycle”, which we see to happen, is rise in inflation that again may propel interest rates to rise. However, statistically speaking, the correlation between M3 and the change in the 10-year G Sec yield has worsened during the last few years. Correlation between change in 10 yr G sec yield and change in money supply (M3) (M-o-M change) From Dec 1998 to Sep 2005

15%

From Dec 1998 to Sep 2006

13%

From Sep 2005 to Sep 2006

0%

5

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Money Supply (M3) and M3 growth in the system 35,000

25

30,000 20 25,000 20,000

15

15,000

10

10,000 5 5,000 0 12/31/98

0 3/31/00

6/29/01

9/30/02

Money Supply (M3) (Rs bn)(LHS)

12/31/03

3/31/05

6/30/06

M-o-M grwoth (%) (RHS)

Source: FG Research, Bloomberg

Government borrowing and Yield For the fiscal year 2006-07, the Government of India’s gross market-borrowing programme stands at Rs.1520 bn and net market borrowing stands at Rs.1020 bn, which forms 67.10% of its budgeted borrowing. So far, the government has borrowed Rs.890 bn through twenty bond issues in H1 FY07. Hence, the remaining Rs.630 bn is the government’s planned borrowing for H2 FY07. With most of the SCBs now on the brink of their minimum SLR holding level, the government’s planned borrowing program for the H2FY07 is expected to easily sail through as banks will need those bonds to satisfy their SLR requirements...assuming the borrowings don’t exceed targets And this probably drove the decline in the 10-year G Sec yield over the last few months, along with the oil factor, which has allayed inflationary concerns in the near-term. But hang on…let us now check what could happen if SCBs are faced with both corporate credit What could happen if SCBs are faced with demand continuing into FY08 as well and the both corporate credit demand continuing into government simultaneously planning to borrow FY08 as well and the government close to Rs.1500 bn once again in FY08 (with simultaneously planning to borrow close to the government borrowing 61% of its budgeted Rs.1500 bn once again in FY08… borrowing for FY07 in H1FY07 alone and … this will become a case of the “crowding considering that oil bonds are yet to be issued, out” effect, where the government as well as we think that the government borrowing the private sector will both compete for the program for FY08 will not be lower than that in same resources of SCBs and will, therefore, FY07). And this will become a case of the result in the building of a platform for a rise “crowding out” effect, where the government as in the interest rates. well as the private sector will both compete for the same resources of SCBs and will, therefore, result in the building of a platform for a rise in the interest rates.

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If we expect deposits in the Indian banking system to grow at 14% a year for FY07 and FY08, then banks will need to buy bonds worth Rs.1500 bn in those two years in order to maintain their SLR levels. And with H1FY07 already behind us, we think that banks can still accommodate bonds well above approximately Rs.1100 bn over the next 18 months. The point here is who will dictate the terms of pricing of bond issues once the banks have adequate SLR with them? Will it be the seller of the bonds (the government) or the buyer of the bonds (banks, PDs, Foreign Institutions)? We believe that the government may initially dictate the terms, as banks (the major buyer of such issues) will need those The government may initially dictate bonds to satisfy their SLR requirements. Even so, the the terms, as banks (the major buyer of ‘crowding out’ effect will persist as private demand such issues) will need those bonds to also soars pushing up bond yields in the secondary satisfy their SLR requirements. Even so, market. Plus, unlike the low interest rate regime, the ‘ crowding out’ effect will persist as banks will try to avoid carrying any excess SLR private demand also soars pushing up portfolio, as the loan demand appears to remain bond yields in the secondary market. robust. When seen in the context of the strong credit Plus, unlike the low interest rate regime, growth prevailing in the system (loans and advances banks will try to avoid carrying any excess SLR portfolio, as the loan grew by 30% on a M-o-M basis in more than 24 demand appears to remain robust. months), banks would be better off by lending to corporate and retail credit demand, as compared to lending to the government by subscribing to its bond offerings. Hence, based on our belief that banks may not invest even a extra paise on G Sec Bonds than what is required to maintain the minimum SLR level, the government may face pressure on the demand side Banks may not invest even a extra paise on with respect to its borrowing program. Hence, we G Sec Bonds than what is required to think that the government may have to offer higher maintain the minimum SLR level, the interest rates on G Sec bonds, which will further government may face pressure on the push up the yields. demand side with respect to its borrowing program. Hence, we think that the government may have to offer higher Although government borrowing has not shown a interest rates on G Sec bonds, which will significant statistical relationship with yield over further push up the yields. the period October-1998-September 2006 (the reasons have been explained in the quote given earlier from our Sept 2005 report), the negative correlation of government borrowing with credit growth (at a negative 5.7%) lends further credence to our belief that there will be a rise in the interest rates, as both the government as well as the private sector will compete for the resources lying with SCBs.

Correlation matrix for Yield on 10 Yr G Sec, Credit growth, Govt Borrowing and Money Supply Yield on 10Y G Sec Credit Growth Govt Borr Money Supply (M3)

Yield on 10Y G Sec 1 0.230 0.035 0.127

7

Credit Growth

Govt Borr

Money Supply (M3)

1 -0.057 0.347

1 0.195

1

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Term structure of interest rates With the RBI beginning to raise its reverse repo rate since the last quarter of CY04, the yield curve has continued to rise to its current level. The yield on 10-year G Sec, which hit rock bottom during the first quarter of CY04, has begun to move upwards since then. And it is not just the 10-year G Sec, but the yield curve (plot of yields of G Sec of different maturities) that is itself moving up (please refer to the graph below).

Upward sloping yield curve of G Secs as at the end of different end period 8.00 7.50 7.00 6.50 6.00 5.50 5.00 4.50 4.00 3M

6M

1Y

2Y

3Y

4Y

As on 30th September 2006 As on 31st March 2005

5Y

7Y

8Y

9Y

10Y

As on 31st March 2006 As on 31st March 2004

Source: FG Research, Bloomberg

Yield on G Secs of various maturities from the start of CY07 7.25%

8.50%

7.00%

8.25%

6.75% 8.00%

6.50% 6.25%

7.75%

6.00%

7.50%

5.75% 7.25%

5.50% 5.25% 4/1/06

7.00% 5/1/06

3M (LHS)

6/1/06

7/1/06

6M (LHS)

8/1/06 1 Yr (LHS)

9/1/06

10/1/06 10 Yr (RHS)

Source: FG Research, Bloomberg The recent decline in the 10-year G sec yield from its year high of 8.38% has come as a small relief of sorts to the bond market, as the yield on smaller maturity G secs (T-Bills) is still trading at close to the highs achieved in July 2006. And the firm yield on shorter-term maturity makes us confident that the yield on longer maturity will once again move towards the year high levels during the months to come.

The recent decline in the 10-year G sec yield from its year high of 8.38% has come as a small relief of sorts to the bond market, as the yield on smaller maturity G secs (T-Bills) is still trading at close to the highs achieved in July 2006. And the firm yield on shorter-term maturity makes us confident that the yield on longer maturity will once again move towards the year high levels during the months to come. A correlation analysis between the yield on G secs of different maturity shows a strong relationship (please refer to the matrix on next page).

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Correlation between yield on G Secs of different maturities 3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 8Y 9Y 10Y

3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 8Y 9Y 10Y 1.00 1.00 1.00 0.99 1.00 1.00 0.99 0.99 1.00 1.00 0.98 0.99 1.00 1.00 1.00 0.98 0.98 0.99 1.00 1.00 1.00 0.98 0.98 0.99 1.00 1.00 1.00 1.00 0.98 0.98 0.99 1.00 1.00 1.00 1.00 1.00 0.98 0.98 0.99 0.99 0.99 0.99 1.00 1.00 1.00 0.98 0.98 0.99 0.99 0.99 0.99 0.99 1.00 1.00 1.00 0.98 0.98 0.99 0.99 0.99 0.99 0.99 1.00 1.00 1.00 1.00

RBI’s stance on interest rates After a low interest rate regime that prevailed until late CY04, the RBI switched to raising interest rates (via its signal reverse repo rate). The move was in sync with the global trend of interest rates being raised by most of the central banks across the globe, led by the US. And while the US has halted its rate hike spree, we still feel that the RBI will continue to raise interest rates for at least a couple of quarters, based on the rising concern over excessive credit growth, money supply and the expected fear of inflation. We expect the RBI to increase the reverse report rate by another quarter percentage point in its “Mid Term Review of the Annual Policy Statement on October 31, 2006”.

Reverse Repo Rate in India 6.00 5.75 5.50 5.25 5.00 4.75 4.50 4.25

Source: FG Research, Bloomberg

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Jun-06

Apr-06

Feb-06

Dec-05

Oct-05

Aug-05

Jun-05

Apr-05

Feb-05

Dec-04

Oct-04

Aug-04

4.00

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And the not-so-known factor Current account balance and its impact on interest rates Historical data suggests that as the current account shows a deficit, the yield on G Sec bonds go up. The graphs below show that the correlation is very strong. The underlying logic that pushes up the yield with the current account balance turning negative is that the current account deficit (that is equivalent to the net Historical data suggests that as inflow of capital from abroad) leads to an appreciation in the current account shows a domestic currency, followed by expanding imports and a deficit, the yield on G Sec deteriorating current account balance. And in order to bonds go up. The graphs below continue to attract capital inflow so as to bridge any current show that the correlation is account deficit, the interest rates rise further. And the latest very strong. current account balance figures make a solid case for a rise the in G sec yield in the near future. However, there are also some fundamental reasons that make a case for such CAD to continue for some more time in the future, which will keep the interest rates on the higher side. In fact, as India’s growth trajectory takes off, the CAD is likely to remain high for some time to come – just as it should for any country at this stage of growth – just as it should for a country at our stage of development. In fact, the only reason for a lowering of the deficit will be lower oil prices, but this is unlikely to be enough for driving the CAD. The capital goods imports, for instance, have grown at a CAGR of 32% over FY03-05. Current Account Balance vis-à-vis yield on 10-yr G Sec bonds historically 15000

12.0%

10000 10.0% 5000 8.0%

0 -5000

6.0% -10000 -15000

4.0% FY00

FY01

FY02 FY03 FY04 FY05R FY06P Average yield on 10 Year Gsec Bond (RHS) Current Account Balance (USD mn) (LHS)

Current Account Balance vis-à-vis yield on 10-yr G Sec bonds over last nine quarters 6,000

8.0%

4,000

7.5%

2,000

7.0%

0

6.5%

-2,000

6.0%

-4,000 -6,000

5.5%

-8,000

5.0% Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Average yield on 10 Year Gsec Bond (RHS) Current Account Balance (USD mn) (LHS)

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IMPORTANT DISCLOSURES Price Target Price targets (if any) are derived from a subjective and/or quantitative analysis of financial and non financial data of the concerned company using a combination of P/E, P/Book, Dividend Yield, earnings growth, Dividend Discount Model and its stock price history.

The risks that may impede achievement of the price target/investment thesis are 1) Any slowdown in credit growth may lead to interest rate softening as against our opinion of rise in interest rates. 2) Any reduction in planned borrowing of Government in FY07 as well as FY08 as against our rough estimates may leave SCBs with sufficient funds to lend given no slowdown in credit growth and hence interest rate may soften in that scenario. 3) The Current Account balance, which at present is showing deficit balance, may turn in to positive with fall in oil prices and rise in invisibles and hence may end up pushing interest rates even higher.

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Rating system of First Global Our rating system consists of three categories of ratings: Positive, Neutral and Negative. Within each of these categories, the rating may be absolute or relative. When assigning an absolute rating, the price target, if any, and the time period for the achievement of this price target, are given in the report. Similarly when assigning a relative rating, it will be with respect to certain market/sector index and for a certain period of time, both of which are specified in the report.

Rating in this report is relative to: CNX Nifty 50 Index

Positive Ratings (i) Buy (B) – This rating means that we expect the stock price to move up and achieve our specified price target, if any, over the specified time period. (ii) Buy at Declines (BD) – This rating means that we expect the stock to provide a better (lower) entry price and then move up and achieve our specified price target, if any, over the specified time period. (ii) Outperform (OP) – This is a relative rating, which means that we expect the stock price to outperform the specified market/sector index over the specified time period.

Neutral Ratings (i) Hold (H) – This rating means that we expect no substantial move in the stock price over the specified time period. (ii) Marketperform (MP) – This is a relative rating, which means that we expect the stock price to perform in line with the performance of the specified market/sector index over the specified time period.

Negative Ratings (i) Sell (S) – This rating means that we expect the stock price to go down and achieve our specified price target, if any, over the specified time period. (ii) Sell into Strength (SS) – This rating means that we expect the stock to provide a better (higher) exit price in the short term, by going up. Thereafter, we expect it to move down and achieve our specified price target, if any, over the specified time period. (iii) Underperform (UP) – This is a relative rating, which means that we expect the stock price to underperform the specified market/sector index over the specified time period. (iv) Avoid (A) – This rating means that the valuation concerns and/or the risks and uncertainties related to the stock are such that we do not recommend considering the stock for investment purposes.

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