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.

Source: NSE

Figures are bond issuances with one year or more maturity in the primary market in the first quarter of
2006-07.
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. It is believed that well
run and liquid corporate bond markets can play a critical role in supporting economic development in
developing countries, both at the macroeconomic and microeconomic levels. Though the corporate debt
market in India has been in existence since independence in 1947, it was only after 1985-86, following
some debt market reforms that state owned public enterprises (PSUs) began issuing PSU bonds.
However, in the absence of a well functioning secondary market, such debt instruments remained
highly illiquid and unpopular among the investing population at large.

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, which were
determined by administrative fiat and not by the market. 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, 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. The
debt-equity norms on bond funds were more rigorous than the ones that the institutions allowed
in respect of their term loans. Another highly discouraging factor was the high level of stamp
duty that the state governments levied on secondary market transactions in bonds.
• Problems with commercial banks: Indian banks also have to live with several policy
constraints. One major area of concern for them continues to be the priority sector lending,
which is mandated to account for 30% of their total advances. On account of regional and
political pressures on banks their NPA levels in priority sector advances are quite high. With
much smaller size of average account, the operating costs of priority sector advances to small-
scale industry, agriculture, small road transport operators, etc. which are mandated by the
government, are very high for the banks.
• Diversity of investor base: A diverse investor base fosters trading activity.
Different investors have a variety of investment horizons, risk appetite and needs, which would
also diversify the instruments available. Different investors tend to hold different opinions
leading to different valuations and hence more trading. In India, this diversity seems to be
lacking. Corporate bonds are generally held by government controlled provident funds,
insurance companies and banks. Tendency on the part of these institutions to hold these
securities till maturity and consequent reduction in supply is also a problem. Investors like fixed
income funds, hedge funds are dormant in the market. Also the ease of entrance for foreign
investors would also do well for the corporate bond market.
• Market opaqueness: Ex-post transparency encourages competitive pricing which in turn boost
 investor's confidence and hence leads to more trading and higher liquidity in the market.
• Flow of timely information: A key factor influencing the effectiveness of risk controls is the
promptness with which relevant information is available. A payments system that operates in
real time, for example, should provide participants with real-time information on their
settlement balances, and where applicable, their positions against risk management limits. A
system that does not operate in real time should provide relevant information as frequently and
as promptly as necessary for good decision-making. Corporate bond market in India has very
limited flow of timely information about issuers. In more developed markets like US, Japan, flow
of information and relevant news is done through various means. Quarterly Financial reports,
profit reporting, financial press and information services report on major deals and transactions
and important corporate events; news and analysis from credit rating agencies, etc can lead to
increase in better information flow in the market.
• Public offering of bonds being expensive, time consuming and procedure oriented, corporate
have been finding it easier to either borrow from banks or make a private placement of their
bonds.

Need for an active corporate bond market:

• Infrastructure financing: Infrastructure financing in India does not entirely depend on the
growth of the bond market, it does provide an opportunity for developing the corporate bond
markets. Infrastructure projects are generally are of long gestation periods and financing these
through bank loans is not feasible. This is because banks accept deposits for 5-10 years and
thus cannot give 30-year loans, as this would create asset liability mismatch. But a bank would
be perfectly comfortable buying a 30-year bond if a liquid market exists in case it needs an exit
route. 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.
• Securitization: Another important and a related issue for the infrastructure financing is the
need for a market in securitized products. In India, the need for asset securitization is being felt
in three major areas - Mortgage Backed Securities (MBS), Infrastructure Sector and other Asset
backed securities (ABS). 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.
• Private Players can also access the debt market to finance long-term projects such as special
economic zones (SEZ). With expanding domestic demand and export growth, growth in
industrial investments will undoubtedly accelerate leading to greater demand for bond financing.
• 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, thereby marginalizing systemic risk posed by today's inflow of portfolio money.
• One of the causes of the Asian financial crisis was over-dependence of Asian corporations on
short-term foreign funds and mismatch of currencies. Before the crisis, 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. 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. If bond markets had been
more developed in Asia and if domestic bond markets, denominated in their own currencies, had
worked efficiently the impact of the crisis would have been softened or entirely prevented. The
development of local currency bond markets has been seen as a way to avoid crisis, with these
markets helping to reduce potential currency and maturity mismatches in the financial system.
The Tarapore committee also recommends the development of an active debt market as a
prerequisite for capital account convertibility3.
• Apart from its fundamental role of achieving allocative efficiency, a well-developed government
bond market strengthens the monetary policy implementation framework by equipping a central
 bank with market-based indirect instruments.
• 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. But
corporates don't have a choice of issuing significant amount of bonds in India. As a result
incremental bank credit is up from Rs 2.5 lakh crore in 2004-05 to Rs 3.7 lakh crore in 2005-
064. Sooner than later, banks may find that their entire appetite for lending is soaked up by top
tier corporates. If there is no market for bonds where they can sell/securities the loans, banks
may find their ability to lend to smaller corporates impaired. Once large and well-run
enterprises develop a preference for financing through bond markets, commercial banks will get
the message and divert more of their resources to financing SME business.
• 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. 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 1,00,000.
• The emergence of the Pension fund industry has certain obvious forward linkages with the
capital market of any country. Given the nature of returns required from pension fund
investments, the debt market assumes an even more important role in assuring fixed returns.
In light of this excessive addiction to safety, most pension funds in India invest heavily in
Government securities. Further, investment restrictions imposed by statutory bodies only
exacerbate pension fund investment in other sections of the capital market like corporate bonds
and equity.
However, due to growing fiscal concerns, Government is favoring defined contributory schemes.
This along with the entry of private pension funds requires other investment avenues to
enhance their risk return universe. This is likely to create greater demand for corporate bonds.

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, which can bring volumes to the corporate
bond markets. Some of the foreign funds do feel that, despite the recent hike in the limit up to
which FIIs can invest in corporate bonds (USD 1.5 billion)5, this amount is too small for taking
any active interest in this market meaningfully.
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.
This may encourage these funds to invest in high quality corporate bonds.
• Widening the issuer base: Currently banks are allowed to issue bonds of maturities over 5
years only for financing infrastructure sector. Since banks are one of the leading issuers of
bonds, they should be allowed to issue bonds of maturities over 5 years subject to their asset
liability matching norms. The development of an interest rate derivatives markets is a major
prerequisite to facilitate this.
• Development of derivatives market: Derivatives play a very crucial role in reallocating and
mitigating the risks of corporate, banks and other financial institutions. There have been
apprehensions regarding legality of OTC derivatives with section 18A of the Securities Contracts
(Regulation) Act, 1956 (SCRA), making only derivatives contracts that are executed on
exchanges legal and valid. Exchange traded derivatives have their own role to play in the debt
market - but by their very nature they have to be standardized products. OTC derivatives, on
the other hand can be customized to the requirements of the trading entities. Thus both OTC
and exchange traded derivatives are essential for market development. Certain modifications
need to be made to the act to ensure legality of OTC derivative transactions.
• Governments should develop the repo market, such that investors can have more alternatives
to finance their short-term capital needs.
• Market making: Market making should be encouraged for promoting the corporate debt
market. This requires incentivising large financial intermediaries like primary dealers to take up
this job. One way is to encourage the investment bankers involved in the placement of the
bonds.
• Listing norms to be eased: For already listed entities, there listing norms should be simpler;
they should be allowed an abridged version of disclosure. However, companies which are not
listed and which are opting for the private placement mode should be subjected to stringent
disclosure norms.
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, disseminate the same
and keeps a data base of trade history. Various regulators should direct the regulated entities to
report all the transactions done by them to the trade reporting system.
• Trading, 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. An efficient clearing and settlement system would further the
development of corporate bond markets by reducing the counter party risk and settlement risk.
As the corporate bond market develops and expands, diversifying and expanding investor
interest will need institutional measures for credit enhancement. We are fortunate in India to
have built up first-rate credit rating institutions.
• Specialized debt funds for infrastructure financing: As recommended by the High Level
Expert Committee on Corporate Bonds and Securitization, there is a case for creation of
specialized Debt Funds to cater to the needs of the infrastructure sector. Such Debt Funds
registered with SEBI should be given the same tax treatment as the one extended to venture
capital funds.
• Developing a market for debt securitization: Apart from reducing the stamp duty on debt
assignments, pass through certificates and security receipts; the government should also
endeavor to resolve the uncertainty in taxation issues pertaining to securitized paper.
• Cost of Issuance: Cost of issuance in term of rating, listing, disclosure and marketing
requirements makes the public issue of bond expensive making private placement a preferred
alternative for most issuers. If the corporate bond market is to develop, a great deal of
attention will have to be given to minimize the issuance cost and the time taken to make public
issue. There is a need to rationalize and reduce the stamp duty.
• Bond Insurance: To increase liquidity for the bonds of less-known or infrequent issuers, there
is a need to encourage the insurance industry to market bond insurance, which is quite common
in developed markets. In fact, in the US four companies focus mainly on bond insurance.
• 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.
Some fundamental ingredients are missing in the Indian microstructure, like standardization of
the day count convention, quotes, and yields. For instance, for dated government securities the
market follows the 30/360-day count convention the corporate bond market does not follow any
specific convention, leading to confusion in calculating accrued interest.
• 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.
• 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.
• 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, the
same reporting system and the same real-time gross settlement system as there are important
 economies of scale in such infrastructure. Similar systems are used in bond markets in Kuala
Lumpur6.

Annexure: Initiatives on Budget 2006-07

Over the past few years, due attention has been given to the development of the Indian debt market.
As a matter of fact, the Union Budget, 2006-07 paid special attention to debt market restructuring.
Efforts were taken to increase bond market liquidity and make it more broad-based and competitive.
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. To date, the Government has injected Rs.168 billion into
nationalized banks. Adding the perpetual securities issued earlier, the total net capital support
stands at Rs.228 billion. Thanks to the capital support, a sound-banking sector has emerged. As
a result, the budget proposed to wind down the special arrangements between the Government
and the banks by conversion of non-tradable special securities into tradable, SLR Government of
India dated securities. 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 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$ 0.5
billion to US$ 1.5 billion.
• 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. He has further allow a limited number of qualified Indian mutual
funds to invest, 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, global markets
and will enable investors to hedge their risks through international portfolio diversification.
• The RBI had introduced the anonymous electronic order matching trading module called NDS-
OM on its Negotiated Dealing System. In the first phase, RBI-regulated entities, banks and
Primary Dealers were allowed to trade on the system. The system has now been extended to all
insurance entities. In view of the encouraging response of market participants and to further
deepen the Government securities market, the Ministry of Finance has proposed to extend
access to qualified Mutual Funds, Provident Funds and Pension Funds as well.
• The importance of the corporate bond market has been recognized and the budget felt the need
to take steps to create a single, unified exchange-traded market for corporate bonds.

• Given that the common debt market investor is increasingly being exposed to market based
volatilities in return, the Budget has proposed the establishment of an Investor Protection Fund
under the aegis of the SEBI. This will boost retail investor confidence and will help diversify the
market base.