Way Ahead for Corporate Bond Markets in India

By

Rahul Gulati Rahul Abrol
IInd Year, MIB IMT, Ghaziabad

Executive Summary A well-developed capital market consists of both the equity market and the bond market. The limitations of public finances as well as the systemic risk awareness of the banking systems in India has led to growing interest in developing bond markets. It is believed that well run and liquid corporate bond markets can play a critical role in supporting economic development in India, both at the macroeconomic and microeconomic levels. Corporate debt in developing countries has traditionally been raised from banks through plain vanilla bank lending. Inspite of a well developed regulatory and financial system corporate bond markets in India are only 0.4 % of GDP compared to Korea at 21.1%.1 Therefore, this paper seeks to address the following questions: • • • • What are the reasons for a lacklustre bond market in India? What are the potential benefits of an active debt market to the economy? What are the prerequisites to the development of bond market? How to further deepen and impart greater liquidity to bond market?

Introduction: At the time when trading volumes in equity market have exploded, the debt market is still asleep. The daily volume of debt traded on the NSE has dropped from Rs 19911.57 crore in August 2003 to a mere Rs 605.23 crore in July 2006. Corporate bonds make up small 3% of this shrinking market. The lack of active corporate debt market was more of a policy concern than a business obstacle recently. It is not only India, which has an inactive debt market, but that it is generally found that the debt market segment of the capital market develops more slowly than the equity market. As the Patil Committee has documented, just under half the world's corporate bond market is in the US, and another 15 per cent in Japan2. Among other countries, the UK has a long-standing bond market, but the European one is still developing, with financing in many countries still being bank dominated. Among developing countries, it is perhaps only South Korea that has a reasonably well-developed bond market.

Figures are turnover on the wholesale debt market segment of NSE.

Different investors have a variety of investment horizons. On account of regional and political pressures on banks their NPA levels in priority sector advances are quite high. One major area of concern for them continues to be the priority sector lending. Corporate bonds are generally held by government controlled provident funds.Source: NSE Figures are bond issuances with one year or more maturity in the primary market in the first quarter of 2006-07. both at the macroeconomic and microeconomic levels. which would also diversify the instruments available. It is believed that well run and liquid corporate bond markets can play a critical role in supporting economic development in developing countries. Also the ease of entrance for foreign investors would also do well for the corporate bond market. which were determined by administrative fiat and not by the market. Tendency on the part of these institutions to hold these securities till maturity and consequent reduction in supply is also a problem. Problems with commercial banks: Indian banks also have to live with several policy constraints. The debt-equity norms on bond funds were more rigorous than the ones that the institutions allowed in respect of their term loans. following some debt market reforms that state owned public enterprises (PSUs) began issuing PSU bonds. With much smaller size of average account. the operating costs of priority sector advances to smallscale industry. are very high for the banks. etc. which are mandated by the government. Market opaqueness: Ex-post transparency encourages competitive pricing which in turn boost . Diversity of investor base: A diverse investor base fosters trading activity. such debt instruments remained highly illiquid and unpopular among the investing population at large. this diversity seems to be lacking. Reasons for non-existent (almost) debt market: The debt market suffers from several infirmities: • • • • Over regulated financial market: The problem was with regulated interest rates. hedge funds are dormant in the market. Investors like fixed income funds. risk appetite and needs. which is mandated to account for 30% of their total advances. Different investors tend to hold different opinions leading to different valuations and hence more trading. small road transport operators. In India. in the absence of a well functioning secondary market. However. Though the corporate debt market in India has been in existence since independence in 1947. it was only after 1985-86. insurance companies and banks. Another highly discouraging factor was the high level of stamp duty that the state governments levied on secondary market transactions in bonds. The RBI administratively fixed interest rates charged by DFIs and commercial banks and even rates that corporate entities could offer on their bonds were fixed by the finance ministry. agriculture. Source: Prime Database The limitations of public finances as well as the systemic risk awareness of the banking systems in developing countries have led to growing interest in developing bond markets. which used to regulate the capital markets till SEBI was set up. Usually the interest rates on bonds and the interest rates of the DFIs were such that the corporate units did not have much attraction to raise funds from the market.

etc can lead to increase in better information flow in the market. had worked efficiently the impact of the crisis would have been softened or entirely prevented. denominated in their own currencies. Corporate bond market in India has very limited flow of timely information about issuers. and where applicable. Quarterly Financial reports. should provide participants with real-time information on their settlement balances. thereby marginalizing systemic risk posed by today's inflow of portfolio money. corporate have been finding it easier to either borrow from banks or make a private placement of their bonds. Apart from its fundamental role of achieving allocative efficiency.Mortgage Backed Securities (MBS). Infrastructure projects are generally are of long gestation periods and financing these through bank loans is not feasible. with these markets helping to reduce potential currency and maturity mismatches in the financial system. news and analysis from credit rating agencies. as this would create asset liability mismatch. Before the crisis.• • investor's confidence and hence leads to more trading and higher liquidity in the market. it does provide an opportunity for developing the corporate bond markets. The essence of securitization is an instrument which is easily marketable and without an active debt market securitization of assets may not take off in India. flow of information and relevant news is done through various means. Asian banks were dependent on short-term foreign currency (similar to external commercial borrowings in India) funds and corporations were dependent on short-term funds from such banks. The Tarapore committee also recommends the development of an active debt market as a prerequisite for capital account convertibility3. Japan. If bond markets had been more developed in Asia and if domestic bond markets. for example. Securitization: Another important and a related issue for the infrastructure financing is the need for a market in securitized products. In India. a well-developed government bond market strengthens the monetary policy implementation framework by equipping a central . Private Players can also access the debt market to finance long-term projects such as special economic zones (SEZ). time consuming and procedure oriented. A system that does not operate in real time should provide relevant information as frequently and as promptly as necessary for good decision-making. Such dependence on short-term foreign currency funds was the reason for the rapid outflow of capital from Asian countries as soon as confidence in these countries started to fade. Need for an active corporate bond market: • • • • • • Infrastructure financing: Infrastructure financing in India does not entirely depend on the growth of the bond market. growth in industrial investments will undoubtedly accelerate leading to greater demand for bond financing. With expanding domestic demand and export growth. One of the causes of the Asian financial crisis was over-dependence of Asian corporations on short-term foreign funds and mismatch of currencies. profit reporting. Infrastructure Sector and other Asset backed securities (ABS). A payments system that operates in real time. the need for asset securitization is being felt in three major areas . their positions against risk management limits. Flow of timely information: A key factor influencing the effectiveness of risk controls is the promptness with which relevant information is available. Public offering of bonds being expensive. This is because banks accept deposits for 5-10 years and thus cannot give 30-year loans. A developed debt market will inter alia facilitate fund-raising for infrastructure and provide an incentive to FIIs to stay invested in India if and when the down cycle in the equity market takes place. But a bank would be perfectly comfortable buying a 30-year bond if a liquid market exists in case it needs an exit route. The development of local currency bond markets has been seen as a way to avoid crisis. financial press and information services report on major deals and transactions and important corporate events. On the other hand an insurance firm or a pension fund would be perfectly comfortable holding on to a long tenure bond but even they would like the flexibility to sell which a vibrant secondary market would provide. In more developed markets like US.

However. Sooner than later. they should be allowed to issue bonds of maturities over 5 years subject to their asset liability matching norms. But corporates don't have a choice of issuing significant amount of bonds in India. Once large and well-run enterprises develop a preference for financing through bond markets.00. banks and other financial institutions. Government is favoring defined contributory schemes. A vibrant corporate debt market would allow corporates to get a standardized rate and fees instead of individually negotiating these with a syndicate of banks for loan finance. Exchange traded derivatives have their own role to play in the debt market . on the other hand can be customized to the requirements of the trading entities. Widening the issuer base: Currently banks are allowed to issue bonds of maturities over 5 years only for financing infrastructure sector. In India too there is a huge potential for municipal bonds with about 35 cities that have a population of greater than 1 million and about 400 cities with population exceeding 1. Quasi government agencies such as municipalities: Growing urbanisation will need large urban infrastructure investment and hence the associated need for funds could be a potential candidate for bond issuance. Further. banks may find that their entire appetite for lending is soaked up by top tier corporates. most pension funds in India invest heavily in Government securities. As a result incremental bank credit is up from Rs 2. such that investors can have more alternatives to finance their short-term capital needs. this amount is too small for taking any active interest in this market meaningfully.000. What needs to be done? • Investor base needs to be broadened:FII's need to be given higher limits for investments in corporate bonds since this is one major investor class. Some of the foreign funds do feel that.but by their very nature they have to be standardized products. despite the recent hike in the limit up to which FIIs can invest in corporate bonds (USD 1. The development of an interest rate derivatives markets is a major prerequisite to facilitate this. If there is no market for bonds where they can sell/securities the loans. 1956 (SCRA). The emergence of the Pension fund industry has certain obvious forward linkages with the capital market of any country. which can bring volumes to the corporate bond markets. This is likely to create greater demand for corporate bonds.5 lakh crore in 2004-05 to Rs 3. This along with the entry of private pension funds requires other investment avenues to enhance their risk return universe. Given the nature of returns required from pension fund investments. In light of this excessive addiction to safety.5 billion)5. the debt market assumes an even more important role in assuring fixed returns. There have been apprehensions regarding legality of OTC derivatives with section 18A of the Securities Contracts (Regulation) Act. OTC derivatives.7 lakh crore in 2005064. commercial banks will get the message and divert more of their resources to financing SME business. due to growing fiscal concerns. This may encourage these funds to invest in high quality corporate bonds. banks may find their ability to lend to smaller corporates impaired. Governments should develop the repo market. making only derivatives contracts that are executed on exchanges legal and valid. Certain modifications need to be made to the act to ensure legality of OTC derivative transactions. investment restrictions imposed by statutory bodies only exacerbate pension fund investment in other sections of the capital market like corporate bonds and equity. Thus both OTC and exchange traded derivatives are essential for market development. The investment guidelines for the provident and pension funds need to be rationalized and they should be allowed to invest on the basis of rating rather than in terms of category of issuers. Development of derivatives market: Derivatives play a very crucial role in reallocating and mitigating the risks of corporate.• • • bank with market-based indirect instruments. Since banks are one of the leading issuers of bonds. • • • .

a great deal of attention will have to be given to minimize the issuance cost and the time taken to make public issue. disclosure and marketing requirements makes the public issue of bond expensive making private placement a preferred alternative for most issuers. However. companies which are not listed and which are opting for the private placement mode should be subjected to stringent disclosure norms. We are fortunate in India to have built up first-rate credit rating institutions. leading to confusion in calculating accrued interest. clearing and settlement mechanism: A robust trading platform would go a long way in enabling efficient price discovery in corporate bonds as also in creating depth and vibrancy to the market. The practice of suspension of trading/delisting of securities in case of non-compliance with listing norms by an issuer needs to be replaced by heavy penalties on the promoters and directors of the erring company. Developing a trade reporting system: There is an urgent need to put in place a mechanism that captures all the information relating to trades in corporate bonds. Specialized debt funds for infrastructure financing: As recommended by the High Level Expert Committee on Corporate Bonds and Securitization. As the corporate bond market develops and expands. One way is to encourage the investment bankers involved in the placement of the bonds. which is quite common in developed markets. Bonds issues by AAA rated corporates and PSU's could be used by banks to fulfill their SLR requirements thereby increasing the attractiveness of such bonds. in the US four companies focus mainly on bond insurance. Developing a market for debt securitization: Apart from reducing the stamp duty on debt assignments. For instance. disseminate the same and keeps a data base of trade history. In fact. Some fundamental ingredients are missing in the Indian microstructure. Trading. Listing norms to be eased: For already listed entities. If the corporate bond market is to develop. quotes.• • • • • • • • • • • • Market making: Market making should be encouraged for promoting the corporate debt market. there is a case for creation of specialized Debt Funds to cater to the needs of the infrastructure sector. pass through certificates and security receipts. Various regulators should direct the regulated entities to report all the transactions done by them to the trade reporting system. Bond Insurance: To increase liquidity for the bonds of less-known or infrequent issuers. for dated government securities the market follows the 30/360-day count convention the corporate bond market does not follow any specific convention. the same reporting system and the same real-time gross settlement system as there are important . they should be allowed an abridged version of disclosure. Such Debt Funds registered with SEBI should be given the same tax treatment as the one extended to venture capital funds. listing. A certain percentage of interest income and capital gains from Debt Instruments for certain individuals say Non resident Indians and institutions such as pension funds be exempt from tax to give an initial fillip to the bond markets. This requires incentivising large financial intermediaries like primary dealers to take up this job. diversifying and expanding investor interest will need institutional measures for credit enhancement. Since the G-sec market in India is of considerable size the corporate and government bond markets could have the same market infrastructure: they could share the same dealers. there listing norms should be simpler. like standardization of the day count convention. the government should also endeavor to resolve the uncertainty in taxation issues pertaining to securitized paper. Standardization: Standardized trading and settlement processes should enhance liquidity by reducing transaction costs and may see the materialization of demand for arbitrage and hedging transactions thus improving market liquidity. and yields. An efficient clearing and settlement system would further the development of corporate bond markets by reducing the counter party risk and settlement risk. there is a need to encourage the insurance industry to market bond insurance. Cost of Issuance: Cost of issuance in term of rating. There is a need to rationalize and reduce the stamp duty.

the Union Budget. Efforts were taken to increase bond market liquidity and make it more broad-based and competitive.5 billion. Thanks to the capital support. cumulatively up to US$ 1 billion. in overseas exchange traded funds. This will facilitate the integration of the Indian bond market with the more developed. the total net capital support stands at Rs.economies of scale in such infrastructure.5 billion to US$ 1. Given that the common debt market investor is increasingly being exposed to market based volatilities in return. In the first phase. the Government has injected Rs. To date. The system has now been extended to all insurance entities. the Budget has proposed the establishment of an Investor Protection Fund under the aegis of the SEBI.168 billion into nationalized banks. global markets and will enable investors to hedge their risks through international portfolio diversification. RBI-regulated entities.228 billion. a sound-banking sector has emerged. As a matter of fact. The importance of the corporate bond market has been recognized and the budget felt the need to take steps to create a single. SLR Government of India dated securities. due attention has been given to the development of the Indian debt market. The RBI had introduced the anonymous electronic order matching trading module called NDSOM on its Negotiated Dealing System. This will facilitate increased access of the banks to additional resources for lending to productive sectors in the light of the increasing credit needs of the economy and will simultaneously add to bond market volumes. the budget proposed to wind down the special arrangements between the Government and the banks by conversion of non-tradable special securities into tradable. banks and Primary Dealers were allowed to trade on the system. He has further allow a limited number of qualified Indian mutual funds to invest. Adding the perpetual securities issued earlier. Following are some points of action that were included in the budget: • • • • • As part of the reforms in the banking sector introduced in 1993-94. capital was infused in the banks by issue of special securities. Similar systems are used in bond markets in Kuala Lumpur6. As a result. Provident Funds and Pension Funds as well. The Finance Minister has increased the limit on FII investment in Government securities from US$ 1. • .75 billion to US$ 2 billion and the limit on FII investment in corporate debt from US$ 0. This will boost retail investor confidence and will help diversify the market base. 2006-07 paid special attention to debt market restructuring. the Ministry of Finance has proposed to extend access to qualified Mutual Funds. Annexure: Initiatives on Budget 2006-07 Over the past few years. The Finance Minister has also raised the ceiling on aggregate investment by mutual funds in overseas instruments from US$ 1 billion to US$ 2 billion and has removed the requirement of 10% reciprocal share holding5. In view of the encouraging response of market participants and to further deepen the Government securities market. unified exchange-traded market for corporate bonds.