Biodiversity bond raises the stakes for paper firms
Biodiversity bond raises the stakes for paper firms
India’s ballooning debt levels amid a structural growth slowdown have raised the risks of an imminent downgrade by credit ratings agencies. Here’s what this could mean for investors in regional fixed income markets.
Fifteen years ago, it seemed the sky was the limit for India. The economy was growing at more than 8 per cent, fiscal reserves were strong and net external debt was negative. A millions-strong wave of internal migration from the countryside to cities was poised to deepen consumption and drive further expansion. By 2007, the major credit rating agencies had stamped their approval, upgrading India to investment grade status for the first time in its modern history and broadening the investor base for its government bonds.
Fast forward to today and the picture is very different. Growth has entered a structural slowdown and debt has ballooned, while emerging market rivals like Vietnam and Thailand have built stronger manufacturing presences in key export markets.
As a result of these and other challenges, including the economic fallout from the country’s deepening Covid-19 outbreak, our fixed income analysts think India is on the verge of being downgraded to junk status by one of the global ratings agencies. This in turn could create dozens of corporate ‘fallen angels’, or companies whose bonds are downgraded to noninvestment grade. What went wrong with India’s macro outlook, and how should investors position for a potential downgrade?
The structural downshift in GDP growth is the main reason for India’s current position. Long before the Covid-19 pandemic, India’s growth was increasingly being driven less by manufacturing and exports and more by domestic demand. To compound matters, domestic demand was largely financed by debt, adding stress to the banking sector. Then came the economic and health devastation of the coronavirus outbreak.
India had some of the most stringent lockdown measures among emerging countries last year. At least 10 million migrant workers returned to their rural villages as work dried up in the large cities amid lockdowns, temporarily reversing a decade of urbanisation. Many of them remain out of work and reliant on government support. This hinders growth in urban sectors as opportunities remain scarce, capping domestic demand.
The rising fiscal deficit and slowing growth means we are unlikely to see fiscal consolidation by the government. Instead, it has launched several measures to reenergize the manufacturing sector, including those in its latest budget in February. This should, in theory, boost medium-term growth, but the implementation remains critical, as India has a mixed track record of carrying out reforms.
Given that we view a sovereign downgrade as a likely outcome, we’ve moved India to a relative underweight in our Asia fixed income universe. But over the longer term, we think the fallout from a sovereign downgrade will be largely contained and could present some buying opportunities, as we expect fundamentals for most Indian investment grade corporate credits to remain solid. The caveat is India’s current new wave of Covid infections could reverse the reopening progress we’ve seen thus far, and we are watching the recent surge in cases closely.
While corporate credit downgrades tend to be widespread in the wake of a sovereign rating downgrade, most corporate bond issuers do not have firm-specific issues to justify such a move. In fact, we think corporate credit metrics should remain stable or improve due to underlying trends. For example, we expect the telecom sector to continue its positive trajectory on widening internet adoption, while the energy sector would be supported by higher oil prices.
In terms of potential market reactions, two recent examples may prove instructive, though it is worth remembering that past performance is no guide to the future. Power Finance’s 2027 bonds were downgraded by S&P in 2020, and Bharti’s 2025 bonds by Moody’s in 2019. Both underperformed slightly following their downgrades, then outperformed their benchmarks in the subsequent months. But a sovereign level downgrade could have a deeper impact on the market, as the large number of fallen angels may cause the forced exit of many investment grade institutional investors.
On the other hand, our equity analysts are still positive on India, especially after the recent budget. Higher targets for capex and infrastructure spending have led to earnings upgrades, supporting equities. This could also help high yield credit names, which should benefit from normalizing growth due to their cyclical nature. Most of the Indian high yield corporates that sell dollar-denominated bonds are quality credits with solid businesses and good access to funding, so a sovereign downgrade should have little impact on them. Technicals also remain supportive, with limited refinancing pressure, low net new supply, and demand for diversification outside China.
Bonds have poor risk-reward at current prices
India’s debt-to-GDP is likely to have surpassed 90 per cent at the end of March when the 2021 fiscal year concluded, worse than most of its BBB-rated peers. The fiscal deficit tends to run high, yet the 5-year target of 4.5 per cent announced in February (compared to 3 per cent previously) is much higher than the market and rating agencies were expecting.
Fitch put India on negative outlook in June 2020, and the agency normally tries to resolve the outlook in 12 to 18 months. If there is a sovereign level downgrade from Fitch, over 90 per cent of the investment-grade corporate bonds and quasi-sovereigns will be downgraded to high yield as well, because the sovereign rating level serves as the ceiling for a country’s corporate bonds.
Judging from recent issuance and spreads, the market is not pricing in any sovereign downgrade risk. India’s investment grade spread has outperformed Asia BBBs and Indonesia investment grade bonds over the last six months, and is now trading tighter, after trading wider than both the indices for most of 2020. India bonds are back at pre-Covid levels, so we see poor risk-reward returns at these prices.
While on balance we think a downgrade from Fitch is likely, there is still a chance it may not materialize. In a best case scenario, if growth accelerates enough to cap the debt-to-GDP ratio at 85 per cent, this would buy some time for India to offset the economic harm caused by the pandemic and restore the fiscal deficit to a more manageable level. But valuations are tight and present an asymmetric risk-reward profile, so we’re comfortable reducing risk in India even if a sovereign downgrade can be averted, especially given the latest spike in Covid cases.
On the plus side, India’s external debt balance remains strong, and funding the deficit is unlikely to be a problem given the abundant liquidity available from the Reserve Bank of India. Moreover, other large emerging market countries like Turkey have lost and then quickly regained investment grade status in the past decade. If the Indian government’s attempts to boost economic growth go according to plan, then a sovereign downgrade could be nothing more than a speed bump on the road back to the more prosperous future that was envisioned for India over a decade ago. Even fallen angels can get their wings back.
This document is for Investment Professionals only and should not be relied on by private investors.
This document is provided for information purposes only and is intended only for the person or entity to which it is sent. It must not be reproduced or circulated to any other party without prior permission of Fidelity.
This document does not constitute a distribution, an offer or solicitation to engage the investment management services of Fidelity, or an offer to buy or sell or the solicitation of any offer to buy or sell any securities in any jurisdiction or country where such distribution or offer is not authorised or would be contrary to local laws or regulations. Fidelity makes no representations that the contents are appropriate for use in all locations or that the transactions or services discussed are available or appropriate for sale or use in all jurisdictions or countries or by all investors or counterparties.
This communication is not directed at, and must not be acted on by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity is not authorised to manage or distribute investment funds or products in, or to provide investment management or advisory services to persons resident in, mainland China. All persons and entities accessing the information do so on their own initiative and are responsible for compliance with applicable local laws and regulations and should consult their professional advisers.
Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes. This material was created by Fidelity International.
Past performance is not a reliable indicator of future results.
This document may contain materials from third-parties which are supplied by companies that are not affiliated with any Fidelity entity (Third-Party Content). Fidelity has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content.
Fidelity International refers to the group of companies which form the global investment management organization that provides products and services in designated jurisdictions outside of North America Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice based on individual circumstances.
Issued in Europe: Issued by FIL Investments International (FCA registered number 122170) a firm authorised and regulated by the Financial Conduct Authority, FIL (Luxembourg) S.A., authorised and supervised by the CSSF (Commission de Surveillance du Secteur Financier) and FIL Investment Switzerland AG. For German wholesale clients issued by FIL Investment Services GmbH, Kastanienhöhe 1, 61476 Kronberg im Taunus. For German Institutional clients issued by FIL (Luxembourg) S.A., 2a, rue Albert Borschette BP 2174 L-1021 Luxembourg.
In Hong Kong, this document is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Future Commission. FIL Investment Management (Singapore) Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. FIL Asset Management (Korea) Limited is the legal representative of Fidelity International in Korea. In Taiwan, Independently operated by FIL Securities (Taiwan ) Limited, 11F, 68 Zhongxiao East Road., Section 5, Xinyi Dist., Taipei City, Taiwan 11065, R.O.C Customer Service Number: 0800-00-9911#2 .
Issued in Australia by Fidelity Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”). This material has not been prepared specifically for Australian investors and may contain information which is not prepared in accordance with Australian law.
ED21 - 050
Biodiversity bond raises the stakes for paper firms