The next wave of financial sector reforms: On the Indian Corporate Bond Markets
The last few decades have witnessed the introduction of a plethora of financial sector reforms in India, but one area where progress has been slow-footed despite efforts, is the corporate bond market. The Indian domestic debt market can be divided into 2 broad categories – government debt market and corporate debt market. In the government debt market, financial instruments like T-bills, dated G-Secs, bonds and other fixed income securities are traded. While the central government can issue both T-bills and bonds, state governments are allowed to issue only bonds or dated G-Secs, also known as State Development Loans (SDLs). The corporate bond market, on the other hand, is a market for the purchase and sale of fixed income securities that are issued by companies, both public and private, to raise funds for a variety of purposes like business expansion, purchase of new equipment, diversification etc. It includes securities having maturity period ranging from 1 year to 15 years and includes commercial papers, certificate of deposits, debentures, and bonds.
How corporate bonds work?
Corporate bonds are issued for a given period of time at a pre-determined rate of interest, known as the coupon rate. The interest, in the form of coupons, is paid regularly every year (usually semi-annually) and on maturity, the company repays the face value of the bond to the bondholders. The interest yield on the bond is the return that the investor makes. Unlike equity shareholders, bondholders do not have any stake in the ownership of the company. However, they are entitled to regular fixed income, payable in the form of coupons. Investing in bonds is also seen as a more stable investment compared to equity, which is vulnerable to stock price volatility. But lower returns in the long term serves as one of the drawbacks. Investors looking for a low-risk investment with fixed income can also opt for corporate bond funds – mutual funds that predominantly invest in corporate debt securities of varying maturities.
A comparison with peers
The domestic debt market in India has a total size of 67% of the GDP, of which, the corporate bond market accounts for a meagre 16% of GDP as compared to 123% in US; this also puts India behind its Asian peers like China (19%), South Korea (74%), Singapore (34%), and Malaysia (44%). What places these countries ahead of India is a well-developed corporate debt market that caters to the long-term financial needs of a dynamic corporate sector in these countries.
Since the 2008 financial crisis, corporate bonds have increasingly gained prominence as a source of corporate finance in the US and other advanced economies. In 2018, the global corporate bond issuance amounted to USD 1.7 trillion as compared to USD 864 billion in 2008. The United States remains the largest market for corporate bonds. The development of a strong corporate debt market in the US was a result of a series of macroeconomic policy changes that kept bond yields near zero, making long term borrowings cheaper for the corporate sector. Companies in the US have, thus, since the aftermath of the 2008 crisis, preferred corporate bonds as a source of fund raising thereby limiting dependence on bank credit. After the 2008 financial crisis, the Fed (US central bank) adopted an expansionary monetary policy; it lowered interest rates to improve liquidity in the system and stimulate economic activity. When a central bank lowers interest rates, the benefit gets passed on to the people in the form of lower interest rates on bank loans, thereby encouraging borrowing activity in the economy followed by spending and increased demand. This is the main rationale behind an expansionary monetary policy (though in reality, the transition is not so smooth and proportionate, but that is a different topic all together).
As opposed to the US, India has a more bank-dominated financial system. And so do other emerging market economies. In India, a large number of firms still prefer to raise debt through bank borrowings while only a small proportion relies on market-based sources like commercial paper (CPs), bonds, and debentures. A number of factors explain why India has an underdeveloped corporate bond market.
- Less liquidity – With a smaller number of buyers and sellers, there is lack of liquidity in the corporate bond market. Issuers of corporate debt are limited to infrastructure and financial services companies. Absence of liquidity acts as a deterrent to investors who might want to participate in the corporate bond segment but do not wish to hold their investments till maturity. A large number of companies opt for private placement – identifying a set of investors and selling the bonds to them to save time and avoid big disclosures. This reduces the availability of bonds for trading in the secondary market and also limits price discovery.
- Lack of trust – In recent years, credit rating agencies (CRAs) have received severe criticism for inconsistencies in their ratings. The credibility of their ratings has been under question, especially in the aftermath of the ILFS crisis which brought to limelight the complacency of some of the top rating agencies like ICRA, CARE etc. Lack of trust in the bond ratings is another reason why investors refrain from investing in corporate bonds.
- Gap between corporate and government bond yields – Government bond yields act as a base for all other interest rates prevailing in the country. Since government securities have no credit risk, the yields on such securities are usually lower than the yields on corporate bonds. In other words, since corporate bonds involve a risk of default, their yields are typically higher in order to compensate investors for taking that risk. Higher the risk perception, wider is the spread between the two yields. Though higher yields could mean better returns for the bondholder, it also indicates unwillingness to invest in corporate bonds due to which companies are forced to offer higher yields to woo the investors. This increases the cost of debt financing for the issuing company, giving them more reasons to prefer bank credit over bond issuance.
Reforms undertaken so far to develop the corporate bond market
Unlike equity markets where liquidity and trading volumes are high, the corporate debt market in India has a limited investor base and low liquidity. Thus, trading of corporate bonds in the secondary market is low. Over the years, several reform measures have been undertaken by the government, RBI and SEBI owing to which the trading in the secondary market for corporate debt has increased at a modest pace. Some of these measures have been listed below:
- In 2018, the Securities and Exchange Board of India (SEBI) introduced a new framework that requires large corporate (having long term borrowings of at least Rs. 100 crores) to raise 25% of borrowings from corporate bonds. The idea was to reduce dependency of corporates on the banks and simultaneously develop a more liquid and active corporate bond market.
- SEBI has made it mandatory for companies that plan to issue debt securities through private placement to execute the transaction on an electronic platform only if the total issue size is Rs.200 crore or more. This step is aimed at bringing transparency and will lead to more efficient price discovery.
- In the budget of 2019-20, the finance minister announced the creation of a Credit Guarantee Enhancement Corporation, a NBFC that would provide guarantee to bonds issued by infrastructure companies thereby facilitating new sources of infrastructure financing for them. This will help bond issuers improve their bond ratings and enable them to raise additional funds without having to rely on banks, who can focus on lending money to other core sectors in the economy.
- Tri-party repo market platform has been introduced by NSE to provide boost to the much-needed liquidity in the corporate bond market. Repo is a mechanism using which participants can borrow money from the lender by pledging their securities as collateral and repay the amount with interest by repurchasing the securities at a mutually agreed date in future. Under the tri-party repo mechanism, participants will be able to pledge securities like corporate bonds, commercial papers and certificate of deposits as collateral, thereby increasing demand for these securities and expanding the corporate debt market.
- In Feb 2020, RBI announced measures like Long Term Repo Operations (LTRO) and Targeted Long Term Repo Operations (TLTRO) to ensure adequate liquidity in the system and to encourage banks to lend to sectors that were experiencing liquidity constraints due to the Covid-19 pandemic. LTRO and TLTRO are a mechanism through which banks can borrow long term funds (up to 3 years) from the RBI for further lending. Under these, banks have been asked to deploy at least 50% of the funds raised towards investment grade commercial debentures and corporate bonds. This move is likely to increase demand for corporate bonds and will ensure that the secondary market for corporate debt remains liquid.
The overall structure of the corporate debt market in India is yet to evolve in terms of size and depth. The issuance of corporate bonds is dominated by infrastructure and housing finance companies while the share of non-financial sector companies remains negligible. Private placement of bonds is another factor that prevents participants from entering the corporate debt market due to apprehensions of less liquidity. It is time that we gradually move away from the concept of asset backed lending towards a more market-based lending framework as prevalent in most advanced economies. But before that, we need to build up on our expertise to gauge the credit risk of market based unsecured lending. Nevertheless, the budget announcements of 2019-20 and the ongoing efforts by RBI and SEBI are likely to bring some positive changes in this segment and can go a long way in improving liquidity, transparency and vibrancy in the corporate bond market in India.