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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?
Fiscal consolidation unlikely
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.
Underweight, but rays of hope ahead
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.