New bond market framework: A big push for corporate borrowings

While SEBI has done its bit, it is necessary to get in more investors and this is where other regulators need to build their framework. A one-year tenure bond would appeal to mutual funds, but probably not insurance companies or provident funds. There also has to be more paper and derivatives working in consonance for this market to develop in the desired manner.

The Securities and Exchange Board of India (SEBI) draft report on deepening the bond market is pragmatic, and when read along with the RBI regulations regarding large exposures, it seeks to change the face of corporate borrowing from April 2019 onwards. The premise is that companies should progressively access the bond market for meeting long-term requirements, and banks should ideally be lending for working capital purposes and not term lending.

There are two reasons for this. First, there is a definite asset liability mismatch where deposits are for a short duration while assets are for a long tenure. Second, it is these long-term assets that have been part of the sordid NPA story and hence should be addressed through the bond market, with the Insolvency and Bankruptcy Code (IBC) playing in the background.

A large exposure has been defined as a company with more than `100 crore of long-term borrowing of above one-year tenure, which excludes external commercial borrowings (ECBs) and inter-corporate borrowings. The one-year criteria probably needs to be revised upwards to more than three years, given that bank deposits would normally be for three years, and a one-year classification could be too conservative. It is clear that the reference is to `100 crore of aggregate long-term borrowing and not just from banks, which was the case with the RBI large exposure norms. The proposed rule says that all such companies that have a rating of AA and above will perforce have to borrow 25% of incremental requirement from the bond market. Therefore, if a company needs `100 crore more, it can get only `75 crore from other sources and `25 crore must come from the bond market. This move will give a fillip to the bond market.

By starting off with AA-rated companies, SEBI has ensured that there is no risk of default as data shows that the default rate for such paper is negligible. There is a sop thrown in, which says that there is no need to have a debenture redemption reserve created—which is the case today for non-financial companies or those that choose to go for public issues.

There would be two challenges for corporates. First, in case they were using banks for term lending earlier and now have to partly use the debt market, they would have to look at two sources and, to this extent, bear the additional expense. Second, which is more pertinent, is the cost of funding. It was observed that corporate bond yields are smarter to react to the interest rate environment. Hence, when the repo rate is increased, bank MCLR—the marginal cost of funds-based lending rate—moves sluggishly, while bond yields are quicker to respond. It was observed that when rates were moving down, the non-banking financial companies (NBFCs) in particular would move from banks to bonds. Similarly, ever since G-Sec (government securities) yields have increased post the credit policy, they have moved back to banks. Therefore, the cost of funding would increase in a rising rate scenario and come down in a falling interest rate environment. NBFCs in particular, which are large and continuous borrowers in this market, would be affected the most here. Interest rate risk management would become more important for these companies.

Banks will be relieved on the whole as they can run on more prudent lines. However, with the 25% rule coming in, they will have to strive that much harder for meeting their own top-line targets as the concept of term loan gave them the leeway to go in for big tickets, which served the purpose. But they will have to be more choosy when it comes to lending, as in case the AA-rated clients—which are the cream—partly move to the bond market, they would be left with the lower rated portfolio. To this extent, their capital requirements in terms of risk-weighted capital will need to be worked on.
On the whole, this move initiated by the government and conceptualised by SEBI is very good for the market as it brings in more order. Depending on how the IBC turns out, the same paradigm can be extended to lower-rated investment-grade paper. It will also take us to the global level where bond markets dominate and banks are investors in this market. A collateral benefit that can be seen here is the development of the credit default swap (CDS) market progressively as well as credit enhancement scheme. Both have not taken off due to status quo in the market. As companies with lower rating seek to raise funds, CDS would become more compelling and lead to its development. Maybe at some stage, the regulation could also insist on such a cover for lower-rated paper.

Credit enhancements have not quite taken off today. However, once the A-rated companies see value or advantage in borrowing from this market, they would perforce look for enhancements and hence would work towards getting a higher rating. This would be off-balance sheet exposure for banks and not fund-based. Therefore, a lot of change can be expected in this market.

The Indian financial system has evolved over the last two decades or so, which involved the conversion of development finance institutions (DFIs) into universals banks. The erroneous thinking at that time was that these banks would continue to do what DFIs did. Banks had the lure of CASA deposits (current account and savings account), and assumed that since these funds remained constant in proportion over the longer term, it actually provided the asset liability management (ALM) congruence. This led to higher exposures to infra projects and other heavy investment projects, which got associated with non-performing assets (NPAs).

In retrospect, the pertinent question is, whether or not banks have the ability to evaluate long-term projects when they converted to banks? Unfortunately, instead of building the debt market before letting DFIs become banks, we chose to jump the queue. The situation had to deteriorate to the extent it has today, before these drastic changes have been made. This move will certainly create the right structure for future borrowing and the financial system will emerge stronger than before.

While SEBI has done its bit, it would also be necessary to get in more investors and this is where the other regulators need to build their framework. A one-year tenure bond would appeal to mutual funds, but probably not insurance companies or provident funds. In addition, there needs to be more paper and derivatives working in consonance for this market to develop in the desired manner. Also, this agenda has to be taken up simultaneously.

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