Public sector undertakings are shifting toward the bond market for funding as bank loans become more expensive. Extra risk and strategy premiums added by banks are making loans costlier for top-tier companies than issuing bonds. Recent data, including a Rs 4,000 crore issuance by REC Limited, highlights this growing trend in debt financing.
Public sector undertakings are increasingly bypassing traditional bank loans in favor of the corporate bond market to meet their capital requirements. While both sources of funding are sensitive to interest rate changes, top-tier borrowers are finding that bank loans carry hidden costs that make them less efficient than raising money through bonds.
The Cost of Borrowing
Banks typically add extra costs on top of their standard lending rates for corporations. These are often categorized as a credit risk premium and a business strategy premium. For high-quality, top-tier borrowers, these additions can add anywhere from 50 to 200 basis points to the loan cost. Even when bond market yields rise, the effective interest rate on these bank loans often remains higher, prompting companies to look for more competitive options in the domestic debt market.
REC Limited Case Study
Evidence of this shift can be seen in recent financing activities. REC Limited successfully raised Rs 4,000 crore through five-year bonds at a yield of 8.3 percent. When this is compared to standard bank lending rates, which are often around 8.25 percent before factoring in the additional risk and strategy premiums, the cost advantage of the bond market becomes clear. This price difference is significant enough to influence the funding decisions of large public sector entities.
Banking Liquidity and Rising Yields
While bond markets are currently preferred, the cost of capital is not static. The banking system has seen a notable contraction in liquidity in recent weeks, as surplus funds have fallen from over Rs 11 lakh crore in September to lower levels. Factors contributing to this tightening include Reserve Bank of India operations, such as bond sales, alongside regular tax outflows and currency leakage. This liquidity crunch has pushed yields higher for various financial instruments, with 10-year AAA-rated PSU bonds now seeing yields between 8.25 percent and 8.35 percent.
Investor Perspective
For investors, this trend highlights a few important factors. Companies that can effectively manage their borrowing costs through diverse funding channels are better positioned to protect their profit margins. However, the broader trend of tightening liquidity implies that the cost of capital is rising across the economy. This can put pressure on the margins of companies that lack the high credit rating to access the cheaper bond market. The key monitorable for investors going forward will be how long this tight liquidity environment persists and whether bank lending rates adjust to remain competitive against rising bond yields.