Indian Yield Curve - 25/09/2013

Long-term bond yields beyond 15-yrs are still close to their highest values in the last 3-4 months (between 9 to 9.5%).

However, judging by the trend of 10Y yields over 6M, 1Y, 2Y, 5Y yields, the corrections seems to have begun. The 1Y, 2Y, 5Y yields have all fallen below the 10Y yield for the first time after 16/07/2013. The chart is below:

Eight rules for PPP policy makers

There are several papers regarding best practices in formulating PPP policies, but Public-Private Partnerships: Eight Rules for Governments (October 2008) by Aidan Vining and Anthony Boardman is probably one of the easiest to read.

This post is just a précis of the paper (do go through the original). Though it is meant for policy-makers, the paper should be read by lenders and advisors trying to get a sense of potential risks that cannot be modeled mathematically on an excel sheet. It is especially informative for managers / financiers / consultants who work with projects in multiple geographies and have to deal with different deal structures and concessions.

The rules are simple enough:

1. Establish a jurisdictional PPP constitution

As far as possible, use existing constitutional institutions and constructs to ensure transparency in the contractual structure. Ensure public availability of contracts (except for legitimate trade secrets).

If such constitutional means are not already available, the legal & constitutional framework should be put in place before the PPP process gets underway. An well-structure framework also discourages parties from following 'win first, renegotiate later' policies.

2. Separate the analysis, evaluation, contracting / administration, and oversight agencies

Separate the agencies that (a) analyzes projects feasibility, including social cost-benefit analysis; (b) decides which of the alternative provisioning modes to employ (government production, contracting or P3); (c) organizes the tendering of bids, selects the partners, makes the final decision whether to proceed with a P3 (or not) and monitors the implementation of the contract; and (d) evaluates the overall success of projects.

Though this step introduces several layers of bureaucracy, it ensures the avoidance of the conflicts of interest which would exist if all these functions came under the same body. Discrete, independent bodies also reduce the chances of a project being undertaken due to political or external pressures, rather than the primary motive: highest social benefit with lowest possible social cost.

3. Ensure that the bidding process is reasonably competitive

The policy should be to ensure that a sufficient number of serious bidders are competing with the project. Public sector companies should also be encouraged to participate in bidding.

This ensures that the competitors put up their most cost-efficient bids, and makes it difficult for bidders to raise costs through collusion and cartelization. A sufficient number of bidders also reduces the risk of the process being rigged or influenced, and thereby being at the risk of legal action or review at a later point of time.

4. Be wary of projects that exhibit high complexity and uncertainty

Any infrastructure project involves some form of complexity or uncertainty. Change in costs, changes in design or scope over the construction period should be expected and accounted for in the contractual framework. However, political changes, unexpected events, changes in law during the project lifetime cannot be anticipated in advance.

Therefore, the framework must include a provision for a simplified, low-cost process for renegotiation when the changes are not under control of the public or private parties involved in the project.

Additionally, it is wise for both parties to ensure that any unnecessary complications (unproven technology, unrealistic milestones, etc) are not introduced by the counter-party in the pre-construction phase.

Projects that can be broken into discrete packages, should be broken down and tendered separately.

5. Include standardized, fast, low-cost dispute resolution / arbitration procedures

Disputes take a lot of time to reach a resolution or a conclusion. They are extremely expensive and increase transaction costs due to legal fees, capitalized interest expenses, insurance expenses, project management costs, etc. 

The bigger issue is that the longer an infrastructure project takes to complete, the more its viability comes under question by investors, lenders and suppliers. If the project loses the support of investors and lenders, it can be quite difficult to restart and conclude the project.

Stakeholders in such long-term projects occasionally find themselves in situations where they do not necessarily agree with each other, and a solid dispute resolution process goes a long way towards attracting potential investors.

6. Avoid standalone deals with Private Sector shells bringing limited equity

PPP projects are often undertaken by private parties through project-specific SPVs. This allows them to finance these projects off-balance sheet, at a higher leverage than would have been possible if the project were financed on the parent company's balance sheet. The SPV structure simplifies tax assessments, transfer of project assets at project closure, etc. and therefore is a widely accepted structure.

However, it is important for lenders and policymakers to ensure that leverage does not reduce the equity requirement to a level where the promoter is incentivised to abandon a project rather than work towards a solution, in case that the project does not perform as per expectations.

7. Prevent the Private party from exiting the contract / project too early

The riskiest phase in the tenure of the concession is the construction phase. Therefore, the valuation of a project jumps as soon as the project is operational. This means that a developer has the incentive to sell the project and recover the invested capital as soon as the construction period is past. If this is allowed the developer may just complete a project, book their profits and leave without any further liability.

Therefore it is important to ensure that developers are present during the post-completion liability period, thereby forcing them to maintain construction standards and avoid under-investment during the construction phase.

8. Have a direct conduit to lenders / debt holders

Most PPP projects are too large to be secured with collateral. Since project assets are to be transferred to the government at the end of the concession period, the contract usually does not allow for a way to recover the outstanding debt by liquidating the project assets. Thus, projects debt is mostly unsecured in nature.

Therefore, financing a project is going to be difficult if lenders do not have some sort of recourse to the authority which awarded the contract. In the event of a default due to the concessionaire / developer, there must be a mechanism for lenders to approach the authority for redressal.

The tale of India's wagging yield curve

Readers of this blog may be forgiven for thinking that the graph above is a crude animation of a wagging tail, or a cracking whip. The movement of India G-Sec Zero Coupon yield curve in recent times (the graph illustrates movement between April through September 2013) has been as violent as that of the stock market indices and the foreign exchange rates. 

The dotted lines form the bounds within which the yield curve has moved over the mentioned period. There is a spread of over 450 bps for bonds maturing within 6 months, and a spread of 200 bps for the 10-yr maturity G-secs. 

What is a yield curve?

Although any entity which issues bonds may have a yield curve, we will discuss the yield curve in terms of sovereign bonds ('G-Secs' or Government Securities, t-bills, etc). If the issuer (the Indian govt, in our case) is a regular borrower from the money market, at any point of time there are several bonds of different maturities (i.e. the period of time before the principal amount borrowed through the bond is repaid along with interest). 

Therefore, at any point of time the money market is likely to have bonds which mature in 1 month, 3 months, 6 months, 1 year, 5 years, 10 years, 30 years, etc. When the yields (annual return on the invested amount) of these bonds are charted on a graph with maturity on the horizontal axis and yield on the vertical axis, the resultant curve is called the Yield Curve.

This is not to be confused with the graph of the bond yield over time.

A quick primer about yield curves can be downloaded here:

PIMCO Yield Curve Primer 

Basics of Yield Curve Strategies 

Importance of the Yield Curve

In the medieval ages, soothsayers used to divine the future by observing various natural occurrences, flight patterns of birds, organs of sacrificed animals, etc. Economists nowadays use the slope of the yield curve to predict approaching periods of economic expansion and contraction.

The yield curve is probably one of the best-known leading economic indicators. Even as early as 1965, Reuben Kessel (The cyclical behavior of the term structure of interest rates) pointed out that spreads between long-term and short-term rates (for example, Yield of 10 yr bond - Yield of 3 month bill) tend to be narrow or even negative at the start of recessions and widen at the beginning of expansionary periods. 

The yield curve has been shown to predict GNP and GDP growth, consumption trends, investment trends and industrial production with a lead time of around a year to 18 months. The National Bureau of Economic Research in the US actually monitors the yield curve and dates recessionary periods. Data shows that the yield curve has successfully predicted every US recession since 1950 with just one exception. Studies have shown that this is true for many other major developed economies as well.

Do note that this correlation is much stronger in developed economies than in emerging economies, for the simple reason that money markets and debt capital markets in emerging economies are not as liquid or efficient as in developed economies. The yield curve is not the only leading indicator used by policy-makers. Several other indicators are used in conjunction with the yield curve.

What are the factors that affect the shape of the yield curve?

A risk premium is required by investors for the heightened risk of investing their money in a longer tenure bond, rather than a shorter tenure bond. Due to this, long-term bond yields are higher than short-term yields and the yield curve slopes upward. This is the normal shape of the yield curve.

However free market forces may modify the shape of the yield curve. The major forces affecting this shape are:

1. investor expectations for future interest rates, and
2. risk premiums on longer term bonds

* When the yield increases, it means traded bond prices are going down. This means an increase in the yield implies lower demand for traded bonds, higher risk perception etc. Decreasing yields imply higher bond prices in the market. This means higher demand for the bonds and lower risk perceptions regarding the economy and investment tenure.

As the shape of the curve partially depicts investors' expectations for future interest rates and future economic performance, the yield curve is considered to be a leading economic indicator. 

1. Normal shape (gently upward sloping) - A gently upward sloping yield curve denotes expectations of stable economic growth with stable inflation rates. 
2. Steep upward sloping - A steep upward slope implies that there is a wide, positive spread between long-term & short-term bond yields, and usually precedes periods of economic expansion and growth. High growth scenarios also bring the risk of higher inflation (and higher interest rates to control this inflation), therefore risk premia required by investors for longer term investments are correspondingly higher.
3. Downward sloping (or the Inverted Yield curve) - A flat or downward sloping yield curve implies that there is either a narrow spread (flat curve) between long-term & short-term bond yields, or that this spread is negative (inverted curve). Inverted curves have been noticed before economic slowdowns and depressions.

Apart from market forces, the yield curve is also affected by changes in monetary policy (Read: Does Monetary Policy make the Yield Curve move: CRISIL). For example, the increasing interest rates, and liquidity curbs put in by RBI to control inflation have caused an inverted yield curve. Does this mean a (further) slowdown is on the cards for India?

While the 'coming slowdown' theory is the dominant view, some people feel that yield curve signals may not necessarily be the same for emerging markets and developed economies. Lower long-term yields may signify the growing comfort of investors with extended investment horizons in emerging markets. Read: Inverted Yield Curve Signals Lower Inflation, Not Recession

What is the relation of the yield curve with investment decisions, financial markets and the forex market?

In simple terms, an inverted yield curve means that investors feel that the risk of investing in the short-term is equal to or higher than investing long-term. This means corporates avoid capital expenditure in the short-term and investors postpone investment decisions to a later date. This brings down growth expectations and depresses stock valuations, affecting the stock markets. Due to falling valuations, fund managers pull out their investments and park them where the risk-return scenario is better. (Read: FIIs pull out $10.5 b from Indian capital market in June-July)

In emerging economies like India which depend on inflows of foreign funds, this pull out is especially painful as it drastically increases the supply of local currency in the markets, playing havoc with the supply-demand equilibrium in the currency markets. 

Do note that the events do not necessarily occur in the order I mentioned above. Any combination of these events may trigger a shift in the shape of the yield curve.

Further reading:

Yield Curve FAQ at the New York Fed website 

Predicting power of Yield Curve - A study of Indian sovereign yield spread

Yield Curve as a Predictor and Emerging Economies

Request to readers: I would like to compare this with the behavior of the Yield Curves of the other BRICs over the same period, but I need the datasets. Do drop me a message in the comments section if you would like to collaborate regarding this study.

Indian Yield Curve - 06/09/2013

What a wild couple of months its been!

The Indian yield curve is now inverted, in an attempt by the RBI to make it more expensive to short/sell the Indian Rupee. Is that the correct response keeping in mind the accelerating slowdown?

Further Reading - 

Reuters: India's inverted yield curve fails rupee and slams economy

EconoMonitor: RBI’s Battle With Currency Weakness Inverts the Yield Curve; Will Cost India’s Economy Dearly