The government, in close cooperation with Sebi and RBI, has taken many steps to boost the corporate bond market since 2005 when the High Level Expert Committee under RH Patil submitted its report. Subsequently, many other government committees also recommended steps to boost this market. The changes made in the corporate bond market framework, following from various expert committees recommendations, have been incremental and cautious. Taken together, however, they constitute significant changes.
What reforms have delivered so far
As a major step, the government clarified the regulatory roles of different segments of the corporate bond market, making Sebi responsible for all primary and secondary market activities in corporate bonds issued by listed entities, and RBI being responsible for repos in corporate bonds.
Compulsory reporting of all trades in corporate bonds to any one of the reporting platforms set up by BSE, NSE or FIMMDA has been mandated. Also, NSE and BSE have set up dedicated trading platforms for corporate bonds. The Union Budget 2008-09 removed taxes on interest from corporate bonds. A major reason for issuers to shun the corporate bond market was the high cost of issuance. Sebi has simplified disclosure and listing requirements under Sebi (Issue and Listing of Debt Securities) Regulations 2008. Various structural restrictions on the designing of bonds have also been done away with. Issuers with listed equity are now required to make only brief incremental disclosures. To enhance the investor base, the market lot size has been reduced from Rs 10 lakh to Rs 1 lakh. Further, the limit of FIIs investment in corporate bonds has been increased to $15 billion. In what is being hailed as a major development, RBI has allowed introduction of repos in corporate bonds since March 2010.
Following above measures and more, the activity in these markets has shown some improvement. Secondary market trades in corporate bonds (including OTC trades and trades on exchanges) have increased from Rs 95,890 crore in 2007-08 to Rs 4,01,198 crore in 2009-10. Primary issuance by corporates in the form of private placement has also increased from Rs 1,18,485 crore in 2007-08 to Rs 2,12,635 crore in 2009-10. However, the corporate bond market still remains small in the country. One finds that corporates still show a marked preference for availing of loans rather than floating bonds. Among those who prefer to tap the bond market, there is a penchant for private placement even among the large corporates.
According to an ADB report, Indias bond market was just 3.9% of GDP as of March 2008. This level, though comparable to levels in the Philippines and Indonesia, remains small in much of the Asian regionwith the exception of Korea where the corporate bond market is 62% of GDP and Hong Kong, China where the size is 38% of GDP.
The report noted that even in absolute terms Indias corporate bond market is minuscule in relation to its economic size.
Resurrection of the corporate bond market in India will require action on two counts. First, regulators need to complete the unfinished reform agenda. Some reform actions that remain to be taken include providing for a more liberal shelf registration, permitting banks to offer credit guarantees to enhance the creditworthiness of sub-investment grade bonds, lowering the margin requirements for AAA-rated bonds to incentivise repos in corporate bonds, mandating settlement of all corporate bond trades in designated clearing houses through DvP and further enhancing FIIs investment limits in this market to attract their interest. Second, to be effective, further policy reforms need to be informed about the unique nature of this market.
Why issuers remain more comfortable with loans
For example, on the demand side of the market, banks are more geared towards giving credit rather than investing. Typically, the credit department of a bank is much larger than the investment (treasury) department. While credit decisions are decentralised, investment decisions are more centralised. This dichotomy in the internal business model of banks also creates a barrier between the two forms of lending. Also, banks prefer loans to bonds since loans do not need to be marked-to-market and hence require less regulatory capital. Prudential norms also limit permissible exposure of banks to corporate bonds.
From the point of view of the issuers, again, there is a preference for loans over bonds. In case of a loan, any impending default is often managed by a bank through restructuring or rollover of the loan following prescribed guidelines that are, however, not made public. In contrast, for a corporate bond, even a non-repayment of Re 1 for one day will be treated as a default, with this information being publicly disseminated. Issuers may be more comfortable disclosing their data to bankers rather than disclosing the same through offer documents in public domain. Again the resources mobilised through corporate bonds have to be effectively deployed by the treasury department of the issuing company. For a small issuer, it is thus better to utilise his cash credit limit with his bank as and when required than maintain a full-fledged treasury department to manage the same. The mechanism of raising money through corporate bonds may not be suitable for a small corporate when it requires money intermittently as the shelf registration scheme is open only to a select group of entities. Further, because of poor liquidity in corporate bonds and the fact that bondholders have poor rights as creditors under the existing bankruptcy code, investors need to be compensated with higher interest rates. This implies that a big corporate can often negotiate a better rate with a bank. Even a syndicated loan is available on attractive terms compared to the corporate bond market. These factors, along with the fact that under the benchmark prime lending regime up to 70% of the loans were given below the prime rate, meaning that bank loans are preferred to corporate bonds. Indian corporates have also taken advantage of tapping offshore funds in the form of External Commercial Borrowings and Foreign Currency Convertible Bonds.
Some experts have suggested replicating the Primary Dealers (PDs) system in wholesale government securities (G-secs) markets for the corporate bond market. It is widely believed that PDs have brought liquidity in the G-sec markets by offering two way quotes (bid-ask rates). Currently, RBI prohibits PDs from utilising call money finance for any activity other than G-sec transactions. However, even if PDs are permitted to operate in an unsecured corporate bond market, they will do so only if they find the operations viable. This will happen if there is improvement in the settlement system and liquidity in the corporate bond market. Further PDs can give two-way quotes only if they have the particular bond in their possession or are aware of a holder interested in selling the same. Given the shallow nature of the market, it is not clear whether grafting the PD system will work. Even though corporate bonds are repoable, the margin of 25% is considered too high by international standards. Further, restrictions that securities cannot be resold and disallowance of securities with an initial maturity of less than one year limits the utility of repo transactions. PDs basically undertake the task of underwriting for government bonds. Merchant bankers anyway perform the same function for corporate bonds. Further, PDs currently deal with only one entity, namely RBI, which makes their operations viable by providing them lucrative underwriting commission. This is cost effective for RBI given the scale of government borrowing requirement. This arrangement is not likely to be viable for private entities that access the market only two or three times a year.
Further, it needs to be recognised that it may not be possible to replicate the success of introducing an electronic, anonymity-based trading platform in toto in the corporate bond market because of the differing nature of the two markets. Institutional investors, who usually account for the bulk of bond trading, trade in large lots, often involving a number of issues in a single ordermaking it extremely complex to handle. Thus, this mode of trading is not easily amenable to trading on the exchange market that has to follow a standardised form of trading. In contrast, an OTC deal involving one-on-one striking may be more practical and efficient.
The current framework for the corporate bond market is an equity framework that lays emphasis on an exchange trading environment. However, the trading environment needs to recognise the illiquid nature of major corporate bonds, the small size of issuance series, their non-fungible nature and so on. The order exposure model works for equity markets but may not work for bond markets.
Indias corporate bond market seems to be caught up in a vicious circle of low liquidity, poor depth and restricted breadth. To break this circle, concerted action, in recognition of the ground realities, is required.
The authors are with the Indian Economic Service. Views are personal