Strengthening the Future of Corporate Bonds

Finally, it seems “Achchhe Din” are ahead for theIndian corporate bond market (CBM). The capital market regulator Securities and Exchange Board of India (Sebi) has decided to put in place a framework for operationalisation of the market that Finance Minister Arun Jaitley had hinted in his 2018-19 budget speech. Jaitley had stated that “Sebi  will also consider mandating, beginning with large corporates, to meet about one-fourth of their financing needs from the debt market.”

India is an emerging market economy and has been facing a severe deficit in growth capital that is required for its all-round economic development, mostly for its infrastructure development. As per global infrastructure Outlook forecast published in the Economic Survey of 2017-18, around $4.5 trillion, (roughly Rs280.35 trillion) of infrastructure investment will be required by India till 2040 and the expected shortfall will be $526 billion (roughly around Rs 36.82 lakh crore).

This is why India needs a well-developed CBM, as it is beyond the means of the Indian banking sector to finance this huge amount, in form of risk capital to the Indian corporate sector for the development of country’s infrastructure network. It is beyond the reach of the banking sector primarily for two reasons. First, the money needed for the projects will be held for a long period and second, the infra-projects to be undertaken might prove to be risky bets for the banks. In such a scenario, a well-developed capital market can play the role of a savior.

Jayant Thakur, a Mumbai-based chartered accountant and securities law specialist, says, “A vibrant market for corporate bonds is a win-win situation, both for the corporate and the investors. Corporates can access the markets directly and possibly at a lower cost, while investors can acquire such bonds and possibly  get higher returns on funds as compared to traditional instruments like fixed deposits.”

In this context, Sebi has already floated a consultation paper to plan a framework for enhanced market borrowings by the large corporates. It has proposed that from April 2019, any corporates (except for the banks) which has outstanding long-term borrowing history of `100 crore or above and at least a AA rating, will be classified as a large corporate and such companies will have to raise 25 per cent of their incremental fund requirement from the bond market.

Sebi had asked for public feedback on the consultation paper (open till August 13, 2018), which was put up on its website on July 20, 2018. Scrutinising those, the Department of Debt and Hybrid Securities will be submitting its report to Sebi for further discussions. The matter might be taken up by the board for approval sometime in October or November to make the necessary changes in the newly formed framework for the CBM, to be implemented before April 2019.

The Indian banking sector is currently going through a very rough time. Most of the public sector banks and major private sector banks are suffering from huge number of non-performing assets (NPAs). Madan Sabnavis, Chief Economist, CARE Ratings, says, “Even in this situation, companies seeking to raise long-term capital have to depend on banks.” And, there are several reasons for them to prefer the banks over the bond market. First, not all the companies have an adequate rating to lure investors in the bond market. Therefore, they prefer to go to banks and get funds, even though the costs are higher. Second, this market is collateral based that makes life  easier for them.

Third, Sabnavis adds, “In the absence of Development Financial Institutions (DFI), which existed earlier, corporates are forced to go to banks. All the DFIs have been converted to universal banks.” 

Fourth, though the External Commercial Borrowing market is open to all, given the rating complications of the companies, access is again limited. “Also banks’ funding are based on relationships built over the years. This has led to banks lending now close to 55 per cent of their total as term loans, which should not be the case, as it creates Asset Liability Mismatches,”  he points out.

Why is the Indian bond market lagging behind?

There are two reasons for it. First, the process to enter the bond market is complex and regulatory compliance increases the cost of raising funds. In order to keep the cost under check, companies instead of the public route prefer to go for private placement  of bonds.

As per data released by Sebi in its consultation paper, most of the corporate bond issuances are done primarily through the private placement route. Further, almost 60-70 per cent of the total number of issuances are done by financial sector entities, while the private sector non-financial entities constitute only around 20 per cent.

Second, there is a regulatory obstacle behind this anomaly. Financial sector companies, including non-banking finance companies, doing private placement have been exempted from the requirement of maintenance of debenture redemption reserve (DRR), while all issuances by non-financial entities and entities doing public issues are required to set aside a part of their profit (equivalent to 25 per cent of its outstanding debentures) as DRR. Further, these companies have to invest at least an amount (equivalent to 15 per cent of the debentures maturing during the year) as bank deposits, government securities etc. Such allocations of funds impose an opportunity cost  on the issuer.

In order to reduce the cost of public issuance and private placement of bonds, and for protection of (bond) investors, in case a default has been addressed by Insolvency and Bankruptcy Code (IBC), which came into existence in 2016, Sebi has proposed to dispense with the DRR requirement. This will provide a window for more corporates to  access the bond market for their financing needs.

The stock exchanges are playing their part too. In a recently organised event to rebrand the NSE logo at New Delhi, speaking exclusively to Outlook Money, Vikram Limaye, Managing Director, NSE said, “The exchange plays a very important role in any market development including bond markets. We are focusing to develop that particular area. I have seen some positive traction on that front in the last 12 months, also because the interactions between Sebi and RBI have been more streamlined. They have coordinated to develop the  bond market.”

What are the roadblocks?

The Indian bond market is growing as companies are increasingly getting interested in it. With around `six lakh crore being borrowed, the numbers are satisfactory when compared with the incremental bank credit which is around `seven-eight lakh crore. “However, it is dominated by companies with AA rating and above and there are fewer issuers with ratings lesser than A,” says Sabnavis. It is basically an investors’ market, where they decide which companies to lend.

The Sebi in its consultation paper said, the IBC coming into force has addressed the default risk of bonds to a large extent, as the bond holders have been kept on a higher priority than even government dues in the liquidation waterfall.  It is expected that, in the medium term, this would facilitate deepening of the bond market.

As per Bank of International Settlement (BIS) data, implementation of bankruptcy reforms created a significant impact on deepening of the bond market in countries which have already executed such reforms. For example, the corporate bond as a percentage of Gross Domestic Product (GDP) increased from 12.7 per cent to 26.3 per cent in Brazil, 8.1 per cent to13.1 per cent for Russia, 18.8 per cent to33.4 per cent in China and 68.4 per cent to 106.8 per cent in the UK, over the five-year period from the year of reform (for all the markets). For India, at present, the share of corporate bonds as percentage of GDP is 17 per cent and if the trend is the same as that seen in case of other countries, then it can safely be presumed that the bond market to GDP ratio should move from current 17 per cent to 22-23 per cent by 2022-’23, just on account of successful implementation of IBC. “In case of disputes, resolution issues have always been a concern for the lenders. For banks it is easier, as it deals with companies. In case of bonds, it is the investors (as a lender), who have little recourse in case of default. If IBC plays out well, it will further boost the corporate bond market,” Sabnavis explains.

Majority of institutional investors channelise most (90 per cent) of their investments into government securities, some in AAA rated bonds and a fraction in equities. In order to address this issue, certain announcements were made in the budget of 2018-’19. It said, “Corporate securities rated as BBB or equivalent are investment grade. In India, most regulators permit debt securities with the AA to A grade ratings. The government and concerned regulators will take necessary action.” The operationalisation of this budget announcement is likely to facilitate even lower rated borrowers (rated between AA- and A) to raise funds from the bond market, the Sebi consultation paper claimed.

Apart from the move listed above, the rating profile of the corporates could be further augmented by providing credit enhancement facilities. This is especially relevant for companies in the infrastructure sector, as they generally have a lower rating. With a view to improve the credit rating of infrastructure companies, the Government, in the Union Budget of 2016-17, has guaranteed to issue debt securities to them. Once this announcement is operationalised, it would help the infrastructure companies to further access institutional funding from the bond market. While there needs to be vigilance on investing in poor quality papers, increasing the investment mandate to papers rated as ‘AA’ and ‘A’ would certainly aid financing needs.

Institutional monies in India are regulated by Insurance Regulatory Authority of India, Pension Fund Regulatory Development Authority, Sebi and RBI.

There is a critical need for all regulators to align and synchronize the investment framework of their respective institutional investors as soon as possible, says Sabnavis.

A word of caution for the Regulators

If the Indian policymakers want to make its CBM more liquid and vibrant, they have to relax certain norms, which they have already announced and discussed earlier. However, Sebi and other regulatory bodies need to more cautious.

While raising a flag, Thakur says, “There would be some obvious concerns going ahead. The 2008 sub-prime crisis is just 10-year-old. It would be sheer over optimism to expect that Indian investors are more mature and better informed than those in the western market, or expect the corporates to be more honest, or that the rating agencies have more integrity here.”

Ideally, the market forces would ensure a fair value for such bonds and thus make weaker corporates pay higher interests. Rating agencies would also ideally rate such bonds in a way reflecting underlying fundamentals well, he hoped.

Sebi has claimed in its consultation paper, given the current stage of development of the bond market in India, any mandatory requirement would need to be subtle and would also need to provide enough leeway.

In this context, Thakur says, at least in the initial years, it is therefore likely -and suggested- that there would be regulation in force with a closer watch on such fund-raising and operation of bond markets. In particular, limits over the extent to which corporates can raise monies through such bonds such as debt equity ratio, etc. may have to be imposed. A proper mechanism may have to be put in place, to ensure that in case of secured bonds, the underlying security is duly available, properly valued and in the hands of independent trustees or other agencies.

yagnesh@outlookindia.com