the Indian Corporate Bond Market

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analytical construct and mode that shows how liquidity, transparency and informational problems contribute not only to higher costs of financing but may create low level equilibrium trap in the bond market where few issuers, investors and market makers participate.In section 6, we summarise the policy implications

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ISBN - 978-93-81583-46-3 

The Indian Corporate Bond Market: Potential and Challenges
K. B. Singh1, Dr. Abhishek Singh2 1,2 Assistant Professor 1,2 Birla Institute of Technology 1 [email protected], [email protected]

National Conference on Emerging Challenges forSustainable Business 2012 327 

The Indian Corporate Bond Market: Potential and Challenges

The Indian Corporate Bond Market: Potential and Challenges
ABSTRACT
Post liberalization, India has achieved phenomenal growth and technical sophistication in equity market, but corporate debt market in India has remained virtually a non starter. The Debt Market plays a very critical role for any growing economy which needs to employ a large amount of capital and resources for achieving the desired industrial and financial growth. The Corporate Debt Market in India is active mainly in the form of private placements (table 2), while public issue market and secondary retail market has yet to pick up. As an alternative source of funding corporate debt market has a very important role to play. A well functioning corporate debt market imposes discipline on firms to perform better by imposing pressure of potential financial distress. It can also help banking sector to focus more on priority sector lending by de-stressing it through diversification of credit risk across the economy. Corporate bond market provides a stable source of finance when equity market is volatile. It also helps firms reduce their overall cost of capital by allowing them to adjust their capital structure. It is also very useful for professional fund managers and sophisticated investors to immunize their portfolio from interest rate fluctuations, matching their portfolio‘s duration with that of their obligations using high yield corporate bonds. Convexity of these coupon bearing corporate bonds also ensure that immunized portfolio‘s value is always sufficient to meet the obligation‘s cash requirements. The present paper explores the importance and usefulness of a well functioning corporate debt market for both the financing companies and the sophisticated investors. It also explores the potential and challenges to develop a well functioning corporate debt market in India. KeyWords: Corporate Debt Market, Whole sale debt market, Duration, Convexity, G-Sec

1. INTRODUCTION The Debt Market plays a very critical role for any growing economy which need to employ a large amount of capital and resources for achieving the desired industrial and financial growth. The Indian debt market is today one of the largest in Asia and includes securities issued by the Government (Central & State Governments), public sector undertakings, other National Conference on Emerging Challenges forSustainable Business 2012 328

The Indian Corporate Bond Market: Potential and Challenges government bodies, financial institutions, banks and corporates. The Indian debt markets with an outstanding issue size of Government securities (Central and state) close to Rs.13,474 billion (or Rs. 1,34,7435 crore) and a secondary market turnover of around Rs 56,033 billion (in the previous year 2007) is the largest segment of the Indian financial markets.(Source RBI & CCIL). The kind of astronomical growth and sophistication we have achieved in the equity markets is truly world class. All these years we have continued to live with FII inflows, which by its very nature are very volatile. The pain when the FIIs retreat, lasts much longer, as against the pleasure one derives in welcoming them. Though the dependence has reduced over the period of time, we today have a very large and liquid forex OTC spot and derivatives market and a very large Government securities market. What we don't have as yet: in terms of market segments, is an active secondary market in corporate bonds. A strong government securities market is often cited as precursor to a healthy corporate bond market. The Government Securities (G-Secs) market is the oldest and the largest component of the Indian debt market in terms of market capitalization, outstanding securities and trading volumes (table 2).

Table 1: Turnover of Debt Securities The G-Secs market plays a vital role in the Indian economy as it provides the benchmark for determining the level of interest rates in the country through the yields on the government securities which are referred to as the risk-free rate of return in any economy. Well functioning government securities markets give public support to private fixed-income market (both cash and derivatives) in the form of pricing benchmark, while they also provide a tool for interest rate risk management. A well functioning corporate debt market imposes discipline on firms to perform better by imposing pressure of potential financial distress. It can also help banking sector to focus more on priority sector lending by de-stressing it National Conference on Emerging Challenges forSustainable Business 2012 329

The Indian Corporate Bond Market: Potential and Challenges through diversification of credit risk across the economy. Corporate bond market provides a stable source of finance when equity market is volatile. It also helps firms reduce their overall cost of capital by allowing them to adjust their capital structure. It is also very useful for professional fund managers and sophisticated investors to immunize their portfolio from interest rate fluctuations, matching their portfolio‘s duration with that of their obligations using high yield corporate bonds. Convexity of these coupon bearing corporate bonds also ensure that immunized portfolio‘s value is always sufficient to meet the obligation‘s cash requirements. The present paper explores the importance and usefulness of a well functioning corporate debt market for both the financing companies and the sophisticated investors. It also explores the potential and challenges to develop a well functioning corporate debt market in India. We present the importance and usefulness of a well function corporate debt market for financing companies in section2. Section 3 discusses its usefulness for the institutional investors. Section 4 discuses the developments made by the corporate debt market in India and its potential challenges.

2. IMPORTANCE AND USEFULNESS OF A WELL FUNCTIONING CORPORATE DEBT MARKET FOR FINANCING COMPANIES As an alternate source of funding, debt market has an important role to play. While the public-sector debt market is fairly liquid, constituting approximately 35 per cent of GDP, the stock of listed non- public sector debt is an abysmal 2 per cent of the GDP (Goldman Sachs, 2007). This is far below the depth of the equity market capitalization placed almost at 100 per cent of GDP. Even emerging countries such as Malaysia, Korea, and China have a higher percentage of corporate bonds to GDP. Consequently, there is a tendency to adopt lopsided structures in the form of over-reliance on equity. While the government uses tax revenues and PSUs surplus to fund infrastructure, a large percentage of capital requirements in the private sector too are met through equity and bank finance. Of the total expenditure of the Eleventh Plan (2007-12), nearly 52 per cent is likely to be financed through internal accrual/equity primarily appropriating the internal and extra budgetary resources of the PSUs. For private sector, the share of debt is relatively less at 30 per cent. Of the total debt requirement at Rs. 9, 88,035 crore (USD 247.01 billion), the actual availability during the Eleventh Plan period is estimated to be around 83.5 per cent. More than half of the total estimated resource flows are likely to come from bank credit, while close to 15 per cent is National Conference on Emerging Challenges forSustainable Business 2012 330

The Indian Corporate Bond Market: Potential and Challenges estimated to come from external commercial borrowings. The resource flow from pension/insurance companies, which is potentially a high source of long term debt, is expected to provide resources by less than 7 per cent. Here one need to understand that bank credit is not the answers to all funding requirements. The credit extended by commercial banks is also restricted through exposure norms. Say for example infrastructure, finance requirements cannot be filled by banks alone but would have to be met by financing from long term debt finance. Infrastructure financing brings additional risks in view of their long-term nature and is not good for the banks from an asset-liability management perspective to increase their exposure excessively. Corporate bond market provides a stable source of finance when equity market is volatile. It also helps firms reduce their overall cost of capital by allowing them to adjust their capital structure. The Corporate Debt Market in India is active mainly in the form of private placements (table 2), while public issue market and secondary retail market has yet to pick up.

Table2: Resource mobilization through Debt Issue in India

3. IMPORTANCE AND USEFULNESS OF A WELL FUNCTIONING CORPORATE DEBT MARKET FOR INSTITUTIONAL INVESTORS A well developed corporate debt market is also very useful for professional fund National Conference on Emerging Challenges forSustainable Business 2012 331

The Indian Corporate Bond Market: Potential and Challenges managers and sophisticated investors to immunize their portfolio from interest rate fluctuations, matching their portfolio‘s duration with that of their obligations using high yield corporate bonds. Convexity of these coupon bearing corporate bonds also ensure that immunized portfolio‘s value is always sufficient to meet the obligation‘s cash requirements.The immunization procedure as well as its refinements, is in fact one of the most widely used analytical techniques of investment science, shaping portfolio consisting of billions of dollars of fixed income securities held by pension funds, insurance companies, and other financial institutions. Many banks and thrift institutions have a natural mismatch between assets and liability maturity structures. Bank liabilities are primarily the deposits owed to customers, most of which are short term in nature and consequently, of low duration. Bank assets by contrast are composed largely of outstanding commercial and customer loans or mortgages. These assets are of longer duration than are deposits, and their values are correspondingly more sensitive to interest rate fluctuations. In periods when interest rates increase unexpectedly, banks can suffer serious decrease in net worth-their assets fall in value by more than their liabilities. Similarly, a pension fund may have mismatch between the interest rate sensitivity of the assets held in the funds and the present value of their liabilities. As interest rates fell, the value of their liabilities grew even faster than the value of their assets. The solution is that funds should match the interest rate exposure of assets and liabilities so that the value of assets will track the value of liabilities whether interest rates rise of fall. This can be done by matching the duration of their assets and liabilities. A well developed corporate debt market helps in bond portfolio immunization by providing high yield corporate bond of varying maturities. Investing in corporate bonds of varying maturities and duration and having weighted average duration that equals the weighted average duration of liabilities immunize the portfolio from interest rate fluctuations. Modified duration measures the relative slope of the price-yield curve at a given point. This leads to straight line approximation to the price-yield curve. An even better approximation can be obtained by including a second order term. This second order term is based on convexity, which is the relative curvature at a given point on the price-yield curve. Convexity of the bonds generally considered a desirable trait. Bonds with greater curvature gain more in price when yield fall than they lose when yield rise. The corporate bonds are convex and provide higher yield than the zero coupon bonds issued by the government and RBI. Liabilities of pension funds as well as banks and other financial institutions are generally like zero coupon liabilities which are National Conference on Emerging Challenges forSustainable Business 2012 332

The Indian Corporate Bond Market: Potential and Challenges not convex. Thus in immunization use of corporate bonds provide higher yield and convexity function ensures that immunized portfolio‘s value is always sufficient to meet the obligation‘s cash requirements.

4.

DEVELOPMENT

OF

CORPORATE

DEBT

MARKET

IN

INDIA

AND

POTENTIAL CHALLENGES Over the past few years, some significant reforms have been undertaken to develop the bond market and particularly the corporate bond market. The listing requirements for corporate debt have been simplified. Issuers now need to obtain rating from only one credit rating agency unlike earlier. Further, they are permitted to structure debt instruments, and are allowed to do a public issue of below investment grade bonds. One more welcome change was the exemption of TDS on corporate debt instruments issued in demats form and on recognized stock exchanges. As a result of these reforms, the volume in the primary market has increased by almost 150% over the last four years from Rs. 634 billion in FY 06 to Rs. 1,597 billion in FY 09. Though there has been an increase in the volumes, the trading activity is still negligible in the secondary markets. If we look at the ratio of secondary market volume to primary market volume, the ratio is below 1 indicating very low trading activity in the secondary market. In a recent move, SEBI has stipulated that all trades in corporate bonds would now be routed through stock exchange platform. This would help in reducing settlement risk and reduce transaction costs. At the same time the exchanges would document the trades, thus creating transparency as well as assist in price discovery. The transparent dissemination of corporate bond prices and quantities traded will also facilitate better participation by market participants. While there have been some important steps in corporate bond market development, a lot needs to be done. Some of the issues, which need to be addressed, are as under: International experience shows that Institutional investors play a key role in the market. It is believed that foreign participation in these markets wherein the ceiling has been raised to $15 billion annually gets impacted due to the imposition of the withholding tax of 20%. A rationalization or removal of this tax could attract more inflows. Analysts say a similar measure by South Korea in May 2009 has already helped it in attracting more foreign funds. Net purchases of Korean bonds by foreign investors rose to 9.5 trillion won in June, from 3 trillion won in May. Another hurdle is the Stamp Duty, which is high, typically 0.375% and on an ad-valorem basis. National Conference on Emerging Challenges forSustainable Business 2012 333

The Indian Corporate Bond Market: Potential and Challenges There is no volume discount and it varies across states, issuers, and investors. There is also a need for Market Makers in the corporate debt segment. Otherwise the issues of price discovery and liquidity would not be realistically addressed. The risk of default for corporate paper too can be mitigated to some extent by the market makers. This does not call for the creation of new institutions to add to the existing plethora. Since India already has an established system of Primary Dealers, it should be possible to utilize the same for good corporate paper. As a pilot project some PSU debt paper could be assigned to the existing PDs for market making. Once this gets established the list could be expanded. A bigger issue for corporate debt would be credit risk or the risk of default. This is apparently one of the main concerns of foreign investors. We need to evolve a system as it exists in the equity market, wherein the exchange clearing houses and depositories guarantee the settlement. CONCLUSION A robust domestic corporate bond market can be associated with greater transparency, price discovery, credible rating agencies, a wide range of corporate debt securities, efficient disclosure norms for corporate and a wider range of investors with varied risk profiles. This would not only help create an important alternative funding source in times of unstable equity markets, but would also reduce the cost of capital for corporate, as corporate bonds carry less interest burden than the bank financing. It would also diversify sources of debt funding for corporate and enable greater transparency in pricing of credit risk. It is also very useful for professional fund managers and sophisticated investors to immunize their portfolio from interest rate fluctuations, matching their portfolio‘s duration with that of their obligations using high yield corporate bonds. Convexity of these coupon bearing corporate bonds also ensure that immunized portfolio‘s value is always sufficient to meet the obligation‘s cash requirements. For creating a vibrant and transparent corporate debt market, it is important that appropriate policy reforms are introduced to put in place necessary market infrastructure that facilitates the growth of an active primary and secondary corporate bond market. Following table summarizes the various trading platform for corporate bonds in different countries.

Table 3: Characteristics of Trading Frameworks for corporate Bonds

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The Indian Corporate Bond Market: Potential and Challenges

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(July-August

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The Indian Corporate Bond Market: Potential and Challenges

―Duration: Its Development and Use in Bond Portfolio Management, Financial Analytics Journal, 39, no.4, 15-35. • • • Fabozzi, F.J., and F. Modigliani (1992), Capital Markets: Institutions and Instruments, Prentice Hall, Englewood Cliffs, NJ. Fabozzi, F.J., and T.D. Fabozzi (1989), Bond Markets, Analysis and Strategies, Prentice Hall, Englewood Cliffs, NJ. Fisher, L. and R.L Weil (1971), ―Coping with the Risk of Interest Rate Fluctuations: Returns to Bondholders from Naïve and Optimal Strategies, Journal of Business, 44, 408-431. Macaulay, F.R (1938), Some Theoretical Problems Suggested by the Movement of Interest Rates, Bond Yield, and Stock Prices in the United States since 1856, National Bureau of Economic Research, New York. • • Redington, F.M. (October 1971), ―Review of Principles of Life Office Valuations, Journal of Institute of Actuaries, 78, 286-315. Thorat, Usha. (June 2002), ―Developing Bond Markets to Diversify LongTerm Development Finance: Country Study of India, Asia Pacific Development Journal, Vol. 9 No.1. Reddy, Y.V. ―Developing debt markets in India – review and prospects 2007. Retrieved from http:// rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/82026.pdf. Report of High Level Expert Committee on Corporate Bonds and Securitization, Dec 2005. Retrieved from http:// finmin.nic.in/reports/Report-Expert.pdf.



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