An analysis of the Indian Bond Market

An analysis of the Indian Corporate Bond Market

Introduction

The Corporate Debt Market in India is in its infancy, both in terms of the market participation and the structure required for efficient price discovery. Primary corporate debt market is dominated by non-banking finance companies and relatively a very small amount of funds are raised by manufacturing and other service industries through this market.

Indian firms are still seeking bank finance as the path to fulfill the funding requirements. While, the secondary market activities in corporate bonds have not picked up till date. Efforts of Securities Exchange Board of India (SEBI) and the stock exchanges to bring the trading to electronic stock exchange platforms have not yielded desired results.

On the flip side, the government securities market has grown exponentially during last decade. This is mainly down to the many structural changes introduced by the Government and Reserve Bank of India to improve transparency in the market dealings, method of primary auctions, deepening the market with new market participants like Primary Dealers, borrowings at market determined rates, and creating technology platforms like NDS to recognize the institutional characteristics of the market. The same kind of impetus has been lacking in the corporate bond markets in India and as a result this major source of corporate funding is all but non-existent.

The US and other countries experience with corporate bonds clearly bears out that the Indian private corporate sector is adopting a myopic approach by overlooking the advantages of financial disintermediation achieved through accessing the bond markets directly rather than going down the loan path. Sooner it gets out of the habit of depending excessively on the banks, institutions, and the private placement market, the better it would be for it from a long-term point of view.

The problem of asset - liability mismatches is catching up with the banks and their appetite for term debt would decline in future. Since DFI's access to long-term funds had dwindled, they are not in a position to meet demand for term funds of industry and infrastructure sectors when investment activity picks up from the present low levels. When the demand term debt increases significantly to finance high level of investments, continued excessive dependence on banks is also not in the interest of good credit-worthy borrowers, as they would end up paying up more than what they would have to pay if they decide to raise funds from the market directly.
For creating robust corporate debt markets it is desirable that appropriate policy reforms are introduced to encourage building up of necessary market infrastructures that facilitate growth of an active primary market as also a vibrant and transparent secondary market.

The Demand Side Scenario

The corporate bond market in India has suffered because of the attitude of the various market participants:-

Corporates - Since the cash credit system of banks operates in effect like a loan in perpetuity, many corporates prefer it to bond financing where the amount has to be returned on a specific date. Also, corporates do not relish the idea of getting a credit rating done to calculate the premium to be charged over the zero-risk government bond of comparable maturity.

FIIs are major players in the equities market. However, due to the ceiling on their investment in the debt market (currently there is a cumulative sub-ceiling of $0.5 bn on investment in corporate debt), they are present only in a limited way in the bond market.

Pension funds and the Insurance Sector could be another constituency, but the absence of pension funds and low insurance penetration has meant limited demand for long-term bonds.

Households could be a big constituency, but they, too, are almost completely absent from the market, in part due to the lack of an efficient legal system that is critical to investor confidence, and unhappy experience with debenture trustees.

Supply Side Scenario

For too long Corporates have got accustomed to raising loans from banks and term lending institutions as they find this route to be relatively hassle-free. They feel that it is far more difficult to raise funds through bond flotation as it involves convincing a larger number of highly demanding investors, many of whom may be raising far more searching questions about the viability of the projects for which funds are being sought.

There is a problem of illiquidity. A large part of the market does not mark-to-market the corporate bond portfolio. As a result, once any bond goes into the books, it does not come out. This takes away liquidity from the market.

Trading is concentrated in AAA - rated bonds, as they carry the highest safety and are the most liquid. A large part of the market, including insurance companies, provident funds and banks, have restrictions on private sector paper. And thus the bonds of public sector units are much more liquid than private sector bonds.

Benefits of an Efficient Market for Various Market Participants

Corporates

An efficient bond market helps corporates reduce their financing costs. It enables them to borrow directly from investors, bypassing the major intermediary role of a commercial bank. They still have to go through underwriters, brokers and dealers to raise debt finance. But since competition among them is intense compared to banks, it helps to push costs down.

A well-functioning corporate bond market allows firms to tailor their asset and liability profiles. If companies fear they will not be able to raise long-term resources, they are likely to stay away from long-term investments or entrepreneurial ventures that have a long-term payoff. In the long run, this can affect economic growth.

The Financial System

The corporate bond market could exert a competitive pressure on commercial banks in the matter of lending to private business and thus help improve the efficiency of the capital market as a whole.

A well developed corporate bond market would lead to a reduction in the systemic risk and probability of crisis. This is because the presence of such an environment is associated with greater accounting transparency, a large community of professional financial analysts, respected rating agencies, a wide range of corporate debt securities and derivatives demanding sophisticated credit analysis, an opportunity to make private placements, and efficient procedures for corporates.

Also in case of the present system, if a bank extends term loans it is stuck up with the borrower until the loan matures. It cannot easily reshuffle its portfolio of term loan assets to adjust its developing asset liabilities. It would be in the interests of banks themselves that the corproates meet at least a part of their funding requirements through the bond route so that they have freedom to pass on part of their portfolio to others whenever it suits them.

Investors

For the investors it is important that this segment develops fast and becomes liquid so as to provide another option for diversification of risk. Also, the present bond market in India is different from that of the old times, in the sense that there are players who are out there to make money from debt instruments, rather than just invest funds in some interest-bearing government securities to fill up asset-liability `gaps'. The modern treasury manager will have to take advantage of the small jumps in bond prices on account of policy announcements and changes in demand driven by the FIIs to make money, through the first-mover advantage.

Thus despite the benefits that such a market can bring, we have virtually no corporate bond market (Unlike developed markets). Thus in India, development of a vibrant corporate debt market is essential, especially to reduce the cost of borrowing of the corporate sector at a phase when the manufacturing sector in India is on an upswing.

Ways of developing the Corporate Bond Market

Infusion of Liquidity

Any liquid market in corporate bonds requires a few basic ingredients -

Consolidation of Privately Placed Bonds

improved disclosure standards

good quality papers

The major concern for RBI is the large number of private placements/unlisted bonds for which the disclosure and documentation standards are unsatisfactory. There is a need to have a standard practice in this regard (mandatory credit ratings), irrespective of whether the debt is publicly issued or privately placed. Also consolidation in this market is necessary to strengthen the issuance process to create large floating stocks which would enhance liquidity in the market.

Reliable Credit Rating Agencies
A credit rating system is an essential component of any well-functioning corporate bond market, as it encourages the most efficient allocation of capital raised by debt issues. Such a system:

1. gives the quality and quantity of information on issuers
2. provides the measurement of the relative risk of bonds in question,
3. provides bond issuers an incentive for financial improvements
4. It also helps the investor by compensating for the higher credit risk implied by a lower rating and encourages companies to improve their financial performance.

Setting up a Trading Platform

Unified exchange-traded market + well-functioning clearing and settlement mechanism

If corporate bond market needs to be developed efficiently, it would be desirable to adopt a flexible approach that allows adoption of different types of market structures that wouldbring more transparency into the existing system and create infrastructure that would bring trading and settlement efficiency.

It is therefore desirable that banks and institutions are given freedom to set up their own trading - cum - clearing and settlement system that would facilitate their OTC deals. Also, an efficient corporate debt market requires proper order-matching and guaranteed settlement system. Restricting trading to a single exchange may be counter-productive in the long run. There are well defined clearing and settlement mechanism in place in global markets which can form role models for Indian corporate bond market as it has almost the same institutional structure. A trading-cum-clearing corporation set up by leading market participants on for - profit model may be suitable for clearing and settlement purposes.

Developed Government Securities and Bond Market

A Developed Government securities market provides market infrastructure and supports a profitable, skilled dealer community and provides the benchmark yield curve for default risk-free securities. The leading role of the government bond market is more obvious as a well functioning government bond market helps facilitate the growth and functioning of a corporate bond market by establishing a benchmark yield curve for pricing fixed-income instruments like bonds.

Free Market Forces - for Price Discovery

The interest rates as reflected by the market prices of corporate debt instruments are influenced basically by the credit-worthiness of the borrowing entities and the prevailing level of interest rate at which the government borrows for similar maturities.. The same degrees of freedom as are currently applicable to the equity market should also be made applicable to the corporate debt without causing any problem to the financial system.

A corporate entity with good track record, sound financial position and expected good cash flows enough to service the debt can raise funds at highly competitive rates, which are not significantly above the rate at which government raises funds with instruments of similar maturity. The level of interest for the debt issued by a corporate with good credit rating will be higher than the rate applicable to the government loan of similar maturity, with the difference explaining the credit risk attached to a corporate debt.

Uniform TDS

TDS on interest income from corporate bonds is not uniformly applicable to all the investors. While insurance companies and mutual funds are exempt from the provisions of TDS all other market players are subject to it in respect of interest paid on corporate bonds.

An automated computerized trading system and a meaningful price discovery process cannot be introduced because of the differing TDS treatment for different market player. Therefore it is desirable to have a uniform TDS rule for all the market players.

Development of Primary Market

Creating an enabling environment for issuance of bonds in the primary market is very important for the development of corporate bond market. A vibrant primary market leads to the growth of secondary market.

The issues that need to be addressed for the development of the primary market in corporate bonds are:

1. Enhancing the Issuer base: As discussed in the supply side problem, the corporate entitities over a period of time have become used to a culture of approaching banks for meeting all their financing requirements as they find this route to be relatively hassle-free. It would be in the interests of banks themselves that the corporates meet at least a part of their funding requirements through the bond route. Hence banks, as a group strategy, should consider advising their better credit rated corporate borrowers to meet a part of their term loan requirements in the form of bonds.

2. Market Makers: Market makers play a very important role in development of any bond market .They provide psychological support as well as exit options to investors to buy or sell bonds whenever desired by the investors. The market making in corporate bonds is necessary as the market is in a nascent stage and it would require the psychological comfort in the beginning. Investment banks that help corporates to raise money from the market can possibly be roped in to market making in the bonds which they have helped in issuance.

3. Enhancing Investor Base: - a solution to the supply side problems. Globally provident and pension funds are large investors in corporate bonds.but in India the underdeveloped and illiquid conditions of the corporate bond market do not attract these investors.

Currently, these funds are allowed to invest only upto 10 percent of the accruals in a year in private corporate bonds and 40percent of the corpus can be invested in bonds issued by public sector undertakings.

As the Risk profile of a large number of the PSUs established by the state governments is not materially different from that of several private corporate sector companies. Hence, investment that rating quality as indicated by the recognised rating companies should become the main criteria for investment in corporate bonds and not category of bonds in terms of issuers. Thus the guidelines issued to PFs and EPFs need not discriminate between State Govt. PSUs and private corporate sector entities.

Co-operative banks are permitted to investonly a small part of their deposits in bonds issued by PSUs and only scheduled co-operative banks are allowed to invest in private sector bonds. Allowing all co-operatives banks to invest in high quality corporate bonds would be helpful as cooperative banks have large deposits.

Retail investors should be encouraged to participate in the market through stock exchanges or to approach banks that would be willing to market make bonds from their own portfolio through their branch network. These investors may also participate in the market through mutual funds.

FII investment in corporate debt is limited at present to USD 500 million without any tenor restrictions. FII participation in debt market has helped many emerging markets . In the case of India these participants invest heavily in equities and have no mechanism to include debt in their portfolio. In order to encourage flow of funds the sub limit needs to be removed and the limit should be on an overall basis fixed for debt instruments including government securities.

In addition to this the other that factors which could help boost liquidity in bond markets relate to the existence of a diversified and heterogeneous investor base. Diversity of investment horizons, risk tolerance levels and investment objectives among investors which will provide opportunities for trading and in turn help in enhancing market liquidity and efficiency of pricing. The role of the fund management industry is also important, particularly if regulators provide them with incentives to traded.