The Indian Corporate Debt Market- Need of the Hour

India has aggressive targets for GDP growth rate at 8 percent to 10 percent per annum and would require USD 1 trillion to fund infrastructure requirements during the Twelfth Five Year Plan period. In order to achieve this target, it requires a massive capital for which debt market can contribute significantly.

Although the corporate debt market is an alternative source of funding, it is still at its nascent stage in India. The corporate debt market in India is merely 6.5% of the GDP whereas the government debt sector is nearly 40% of the GDP. This figure is very insignificant when compared to that of in US, South Korea, Brazil. The table below gives the government and corporate debt as a percentage of GDP for different countries.

The table below gives the corporate debt as a percentage of the total debt. It is evident from the figures that India is lagging far behind other countries in the corporate debt market sector which is contributing only around 14% of the total debt market, a figure very less when compared to other countries.

Need for a well developed debt market

Funding the Indian Growth Story- A reasonably well developed bond market could supplement the banking system in meeting the requirements of the corporate sector for long term capital investment and asset creation.

Spare Tire Theory- A much cited simile coined by Alan Greenspan (2000) is that bond markets can act like a “spare tire”, substituting for bank lending as a source of corporate funding at times when banks’ balance sheets are weak and banks are rationing credit. This was the case during the 2008 financial crisis when banks had a liquidity problem, where we saw an unprecedented quarter-on-quarter growth of 130 per cent in primary debt issuances in the third quarter of 2008-09. The economic crisis thus served to highlight the importance of a robust and resilient debt market in India.

Huge Infrastructure Funding- A developed bond market can be an appropriate route of channelizing the savings of the country in capital formation. A constraint in bank funding of infrastructure projects is the long term nature of the infrastructure funds which cause an asset liability mismatch for banks.

Bank Funding Regulations- The banking industry faces several lending restrictions such as maximum position exposure, sector exposure etc which play a role in the lending decisions. Debt market allows the corporates to raise funds directly from the public bypassing the intermediaries.

Mopping Public Savings- Corporate debt could also be an attractive investment alternative for investors as it provides them with higher returns as compared to time deposits; this would help in accelerating the mobilisation of funds to savings which again can be used in the investment by the companies concerned.

Reasons for failure of Corporate Debt Market in India

There are number of issues which have prevented the development of Corporate Debt Market in India.  The main issues among them are as follows:

1)      The demand for corporate bonds is restricted to only highly rated issues and generally the investors are pension funds, commercial banks and insurance companies. The problem with this is that Banks & Insurance companies are limited by restrictions on the amount of money they can invest in Corporate Paper.

2)      Investing in bond generally carries two kinds of risks, Credit risk and Interest risk. In case of government bonds only interest risk exists, however without a well developed secondary market for corporate bonds, both Credit risk and Interest risk are present (An efficiently functioning secondary market system, where trades are settled and where the clearing system ensures protection from default by individual market participants, erases the credit risk).

3)      Risk Management: Absence of liquid market for CDS (Credit Default Swap) and other interest rate options have prevented investors from getting into the debt market as a whole. These interest rate instruments help in hedging some of the risk and are sought after generally by investors purchasing corporate debt.

4)      Tax Deducted at Source (T.D.S.) has been another issue which has hindered the growth of debt market. After recommendation by the RBI to GOI, it was abolished for Government bonds, however it still continues to exist for corporate bonds, but insurance companies/pension funds have been spared. This partial treatment makes it difficult to introduce a uniform computerized trading system.

5)      Stamp duty has been one of the major deterrents as it is levied both at the time of issue and transfer. Also the stamp duty applicable differs according to the class of investors discouraging corporates from issuing bonds to retail investors (either directly or through mutual funds), and to long-term investors like insurance companies, provident and pension funds.

6)      The corporate bond market is quite fragmented as the bonds are issued as and when money is required .The companies prefer private placements route rather than public issue which results into creation of large number of small debt issues. This makes the market illiquid.

7)      The liquidity of the corporate bond markets has been an issue and there is a pressing need for a robust exchange traded secondary market. The larger and credit worthy corporates find it cheaper to raise bonds in the international market through ECB’s & FCCB’s. The problem with an illiquid market is that the investor cannot get his money back and is exposed to interest rate risk if he holds on till the maturity. Also there is no proper price discovery and it leads to improper valuation of the bonds.

8)      One of the most important missing links is a Market Maker who offers two way quotes for trading in corporate bonds, just as it is being done in case of G-secs which have increased their liquidity. Market maker would also help in greater price discovery, liquidity and insurance against default.

9)      The demand for issuances of corporate bonds is limited from the banking sector, as banks prefer giving loans to buying bonds as bonds are marked-to-market, which may lead to negative impact on the balance sheets of banks (erosion of capital) due to negative movement of interest rates.

Steps taken to address some of the issues, revive the bond market and the road ahead

1)      Before 2007 only bonds having credit rating of Investment Grade or above could be issued. Moreover bonds had to be rated by two credit agencies. These norms were relaxed by SEBI in 2007, thereby allowing more corporate to raise money through debt and lower the cost of all corporate debt issuances.

2)      SEBI recently simplified documentation and disclosures for companies which are listed on an Indian exchange. These listed companies now have minimal additional disclosures requirements for public issue or private placement of corporate debt. These positive initiatives have lowered the cost of issuances and have made the debt market attractive for corporate.

3)      Recently the corporate bonds having a rating of “AA” or above have been allowed to be used in the Repo market as collateral (with a minimum 25% haircut to contain leverage). This move would again increase liquidity which is much needed in the corporate bond market.

4)      Risk of corporate debt can be managed by hedging their credit or default risk. Introduction of hedging Instruments such as Plain Vanilla Credit Default Swaps (CDS) is being considered by the RBI.

5)      To increase liquidity in the secondary market for corporate debt, Current Primary Dealers who act as Market makers for government securities could be utilized for market making of high rated bonds as a pilot test. If the experiment leads to increase in secondary trading by attracting the interest of investors, the idea can be replicated for lower grade bonds as well.

An efficient domestic corporate bond market needs to have greater transparency, price discovery, credible rating agencies, wide range of corporate debt securities, efficient disclosure norms for corporates and a wider range of investors with varied risk profiles. This would not only help create an important alternative funding source in times of disruptions in sources of external financing, but would also reduce the cost of capital for corporates. It would also diversify sources of debt funding for corporates and enable greater transparency in pricing of credit risk. 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 would facilitate the growth of an active primary and secondary corporate bond market.

By: – Varun Khanna, Priyanka Padmanabha, Pratik Agarwal