Credit market indicators

Anup Menon

THE behaviour of the credit markets provides an interesting insight into the conditions prevailing in the economy. A key credit market indicator is the difference or spread between the corporate and government bonds. The spread between the two categories of bonds keeps fluctuating over time. A reduction in the spread tends to indicate that the credit risk associated with the corporate sector is lower. Hence, they have to pay a lower risk premium over the treasury securities and this usually comes about when the fortunes of the corporate sector are better.

The average monthly spread in the three-month, six-month and one-year maturity has gone up over the time. For instance, the average spread in the three-month maturity was 62 basis points in June 1999. It rose to 126 basis points in July 2000 and at currently is ruling around 101 basis points.

Behind the spreads: The treasury-corporate debt spread is a combination of two types of risk for which investors demand compensation. The first type is prepayment risk. This arises from the fact that when interest rates decline in the economy, corporate issuers tend to substitute high cost debt with low cost debt. This is possible since most corporate bonds come with call options attached. Under normal circumstances, the spread between the yield to call on the corporate bonds and the treasury yield of similar maturity would be the right indicator. In this situation, investors in corporate bonds face the risk of prepayment. Hence, they tend to demand compensation for this risk.

The other risk faced by investors is in liquidity by market participants. This is especially so in the case of the Indian market where the debt market is not very deep.

Slower growth in offing: The widening of spreads in the near term maturities may be a pointer towards slower economic growth. The spread prevailing currently in August at 101 basis points would have been much higher, had not the RBI intervened in the market and hiked interest rates which resulted in the upward movement in short-term treasury yields. The average yields on the longer maturities have remained more or less constant with a marginal reduction.

This possibly indicates that growth prospects over the long term are not being threatened at least for the time being. However, conclusions based on maturities longer than a year may be misleading since liquidity is a major problem in the Indian market. Most corporate bonds are not actively traded. This affects the quality of information that yields on these bonds convey and therefore, that of the signalling effect from the prices and spreads.