Despite being a niche lender, Power Finance Corp. (PFC) has admirably weathered the turbulent situation in the country’s power industry. So far, at least. Its return on equity continues to be in the high teens. The firm’s capital adequacy ratio improved to 20.34% at the end of March from 20.10% a year ago.

Yet, it is not as if the company has been totally insulated from the grief surrounding the power sector. Restructured loans stood at 9.4% of its loan book at the end of March; gross bad loans at another 1.1%. Around 70% of its loan is exposure toward state utilities which have some of the weakest balance sheets going around now. The top 10 borrowers account for around 43% of its total exposure.

What saves PFC is, of course, that it is a state-owned company and it lends to similarly owned firms. There is an implicit sovereign guarantee on this portfolio. Ratings agencies acknowledge as much when they equalize PFC’s ratings with India’s. It is in the country’s interest to ensure that state electricity boards don’t default as the alternative means disastrous consequences for the sovereign rating.

But with there being no quick solution in sight for this mountain of bad debt, it is simply a case of kicking the can down the road. Credit costs are likely to increase. Beginning this year, PFC will have to set aside higher amounts as provisions. On its restructured book, provision coverage has to go up to 5% by financial year 2018 from 2.75% now. Standard asset provisioning has to increase by 10 basis points over the next three financial years.

Loan growth will also suffer because of a slowdown in power sector investments. The quality of loans will also be suspect since incremental loans to state utilities will be mostly to fund losses rather than capital expenditure. Of course, PFC can increase its exposure to the power sector, but that is not an exciting prospect either. Capacity utilisation among generators is near a 15-year low; there are no power purchase agreements signed for some 29,000 MW of capacity.

That’s being reflected in the valuations. PFC trades at below its one-year forward book value now compared with around three times half a decade ago. But apart from the spectre of a debt default, what should worry investors is the contraction in margins because of increasing competition from banks. Also, higher credit costs could compress its return on equity. It is questionable whether that is fully reflected in the stock price.