PSU banks no longer proxy to bond yields:: Credit Suisse

■ PSU banks historically treated as proxy to bond yields: Over the past
two months, Indian benchmark bond yields have fallen over 50 bp on the
back of easing inflation, RBI rate cuts and increased limits for participation
by foreign investors in the bond market. Indian banks, particularly the stateowned banks, have historically been traded/treated as bond proxies owing to
their large long-duration bond holdings (partly on account of SLR
requirements) and historically high earnings sensitivity to bond yields.
■ Current cycle different owing to large pension liabilities: These banks,
in the previous credit cycle, had used large gains on the bond books for
balance sheet clean-ups. There are expectations that history may repeat
itself. However, over the past decade: a) size of bond portfolio has dropped
from 80% of loans to 40% of loans; b) investment portfolio yields are similar
or lower than current bond yields in contrast to the 500 bp gap in the
previous cycle; c) pension liabilities are up 3-4x, and with discount rate here
pegged to the bond yield, a drop in yields increases the liability.
■ Earnings are no longer positively correlated with bonds: Therefore, in
contrast to popular perceptions, we estimate that earnings of most Indian
government banks, including SBI, are now inversely correlated to bond
prices. We hence continue to prefer private banks to the state-owned banks,
despite the continued widening of the valuation gap, and a recovery in the
state-owned banks will have to be led by a turn in the asset quality cycle
rather than just a rally in the bond market. HDFC, HDFC Bank and Axis
Bank are our preferred picks in the sector

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PSU banks no longer a proxy to
bond yields
PSU banks historically treated as proxy to bond
yields
PSU bank stocks have historically traded in tandem with the bonds. Downswings in bond
yields have typically triggered a rally in these banks as their relatively large bond books
make mark-to-market (MTM) gains on the bond books significant. Over the past six
months, bond yields have dropped 60 bp to 7.55% on the back of RBI rate cuts. With
further expected easing in inflation and RBI rate cuts, bond yields are trending down.
The large bond portfolios of the banks are partly on account of SLR requirements.
However, even as the SLR has been lowered to 23%, bond holdings for banks continue to
be well above this threshold at 24-28%. Loan-deposit ratios for the banks at 78% are now
at an all-time high (57% in 2003). Consequently, share of investments has dropped from
40-45% of assets to 20-25% of assets. More importantly, investments book size has
virtually halved from 80% of loans in 2003 to under 40% now.
We estimate that for a 100 bp decline in bond yields, potential MTM gains for the banks
are 7-17% of PBT. Among private banks, ICICI, Axis and Yes, given larger share of
available-for-sale (AFS) book, have potential gains of 8-14% of PBT. Additionally, banks
are allowed to annually shift 10% of held-to-maturity (HTM) portfolio to AFS portfolio.
Moreover, post the recent credit policy announcement, banks have to bring down the size
of their HTM books from 25% to 23% over the next four quarters. Taking this potential shift
from HTM also into account, we estimate MTM gains of 10-20% for the banks. PNB and
BOI are the most levered on account of the long duration of their AFS portfolio.
Current cycle different owing to large pension
liabilities
Pension liabilities are up 3-4x over the past five years and with discount rate here pegged
to the bond yield, a drop in yields increases the liability. Therefore, in contrast to popular
perceptions, we estimate that earnings of most Indian government banks, including SBI,
are now inversely correlated to bond prices.
The pension liabilities of the banks are based on assumptions of a discount rate of 8.5%-
9% and a wage cost increase of 4-5%. Given that bank wages and pensions are indexed
to CPI, this translates to a real bond yield assumption of 4%. In contrast, real bond yields
(in CPI terms) has been running at a negative 0.2% for the past ten years. As the
divergence in assumptions with actual experience narrows post the Indian Bankers’
Association (IBA) negotiations, the pension liability for the PSU banks is likely to rise.
Earnings no longer positively correlated with bonds
The divergence in earnings trends reported by private banks and government banks has
been further increasing during the current quarter. While private banks, both retail (HDFC
Bank, Kotak, IndusInd) and corporate-focused (Axis, ICICI and Yes), reported no major
deterioration in asset quality (stable NPAs and restructurings within guidance range),
government banks’ results to date have been weaker.
We continue to prefer private banks to the state-owned banks, despite the continued
widening of the valuation gap, and a recovery in state-owned banks will have to be led by
a turn in the asset quality cycle rather than just a rally in the bond markets. Among private
banks, Axis (8%), ICICI (8%) and Yes (14%) have significant sensitivity to bond yields.