Bond yields at 7% to cushion PSU banks‘ NPAs: First Global

Moneycontrol Bureau

A slowing economy and rising instances of bad loans have made state-owned banks the least-preferred stocks among investors. And for the time being, nothing seems to be going right for public sector banks. With elections due in about 18 months, the specter of loan waivers looms large. Then, there are also doubts on how the cash-strapped government will be able to provide additional capital to these banks.

But brokerage firm First Global is of the view is that all is not lost for state-owned banks, yet.

Should interest rates fall sharply, yields on the government bonds held by these banks will decline. This in turn will push up the prices of the bonds, and thereby profits. That is the core of First Global’s argument.

When interest rates decline, the value of previously issued bonds increases, as those fetch a higher rate of interest at maturity than the newly issued ones. Naturally, investors will be willing to pay more for the older bonds. Conversely, if interest rates rise, the old bonds will have less value because the newer bonds offer a higher rate of interest.

According to First Global, if the yields on 10-year government bonds (G-Secs or government securities) declines to 7% (currently 8.15%), state-owned banks will be able to report good numbers, even if gross non-performing assets increase by 50 basis points. That is because the increase in value of the bond portfolio will be greater than the increase in the value of NPAs.

Banks are required to invest a minimum 23% of their deposits in government bonds under the Statutory Liquidity Ratio (SLR) requirement. Many state-owned banks are investing more than 23% in government bonds, because demand for loans in the system has reduced due to the slowdown in the economy.

As on August 31, data by the Reserve Bank of India shows total investments of all banks in SLR (statutory liquidity ratio) at 30.8% of their deposits.

"Our analysis of the investment books of the major PSU banks shows that around 80-90% of their investment books are comprised of investments in government bonds," says the First Global note.

"In FY12, investment of banks in G-Sec grew 16.2% Y-o-Y(year-on-year). Considering the huge government borrowing program ahead and expected decline in credit growth, we expect the growth in the G-Sec book of banks to increase to around 18% Y-o-Y for FY13," the note says.

And why should yields on government bonds decline? Here is First Global’s argument:

"An analysis of the Y-o-Y growth in non-food credit and investment of banks in G-Sec shows that whenever there is a decline in credit growth, there is a corresponding increase in G-Sec. An increase in the demand for G-Sec will result in a decline in bond yields. Moreover, the government’s recent measures on the reforms and fiscal front, expected moderation in inflation and concerns over moderation in growth and industrial output, could prompt the RBI to cut the Repo rate and consequently, a reduction in the interest rates may result in lower bond yields."

According to data analysed by First Global, bond yields have hovered between 7.3-9.0% in the last couple of years.

First Global has analysed thirteen state-owned banks (SBI, Punjab National Bank, Oriental Bank of Commerce, Union Bank of India, Vijaya Bank, Dena Bank, Canara Bank, Corporation Bank, Bank of Baroda, Allahabd Bank, UCO Bank, Bank of India, United Bank) and sees the value of their combined bond portfolio increasing by Rs 20,860 crore if bond yields come down to 7%. And this should offset the around Rs 13,600 crore increase in NPAs if they were to rise 50 basis points.