IDFC research: PSU Banks - Downgrade to Underperformer

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Flattening yield curve and tight liquidity….: PSU banks are bond proxies and hence underperform when G-sec yields harden. 10-year yields had touched 8.2%, up ~30bp over the past month, led by government borrowing programme and tight liquidity. Liquidity has remained scant despite RBI's soothing measures (as second LAF, de-facto SLR cut, etc). We expect it to remain stretched in the next few months due to the following: i) uptick in credit offtake in the busy season; ii) low government spending (further exacerbated by the recent newsflow); iii) advance tax outflow (~Rs550bn) end-December.

…with increasing risks to a stubborn inflation – bad news for G-sec yields: While WPI inflation is declining yoy on a high base, sequentially it is showing signs of increase (WPI index is up 0.2% mom in Sep-10, 0.4% mom in Oct-10). Inflationary pressures could escalate further with rising crude oil prices and fuel price hikes domestically. As taming inflation remains one of the primary concerns, we believe the impact of RBI interventions to manage liquidity (with buybacks, etc) will be short lived. Moreover, with the government borrowing programme near its end (~70% already over), RBI could lose incentive to ‘indirectly manage’ G-sec yields. Therefore we believe G-sec yields would rise from the current levels.

NIMs - the best is over: With systemic deposit growth continuously lagging credit offtake by a wide margin, as reflected in the historic high CD ratio of ~73%, the rise in deposit rates would outpace loan rates – which would impinge on NIMs. We were already building in a softening bias in NIMs from H2FY11 but a continued rise in deposit rates could spring further negative surprises.

Asset quality – negative news galore: While delinquencies have started displaying encouraging signs, the pace of improvement has been slower than expected. Negative surprises continue to flow in from restructured and mid-sized corporate portfolios. Also, stress on micro-finance and real estate loans could aggravate and lead to higher NPLs for banks in the near term.

Downgrading PSU banks to Underweight; remain positive on private banks and NBFCs: We are downgrading PSU bank stocks to Underweight owing to their bond proxy nature except for Bank of Baroda and Punjab National Bank (maintain Outperformer rating). These banks are characterized by lower sensitivity to yields and have exhibited consistent performance in the past few quarters. PSU bank stocks have underperformed the Sensex by 10-17% since 5 Nov 2010 and we expect the underperformance to continue in the near term. However, we retain our long-term positive bias on these stocks and would look to enter into these banks at lower valuations and higher margin of safety in G-sec yields. We reiterate our Overweight stance on private banks and NBFCs with access to priority sector funding; these have a strong earnings outlook and are relatively insulated from rising G-sec yields. Our key picks in the space are HDFC Bank, ICICI Bank, IndusInd Bank and HDFC.