Sangeeta Lakhi
Rajani Associates
I wonder whether my cup will runneth over! I wonder whether my need will be satiated with expanding an additional avenue of funding!
On Budget day, India sought to expand its bond market beyond the traditional ambit of sovereign debt. The finance minister said that SEBI will consider making it mandatory for large companies to raise about a fourth of their financing needs in the bond market. The scope may later extend even to smaller companies. This move will broaden the corporate bond markets in terms of more corporates selling bonds to raise funds.
If large corporates are mandated to meet their one-fourth funding requirement through the bond market, it will improve the supply of bonds as more companies will tap the debt market. Ideally, the move should provide insurance companies, provident and pension funds an opportunity to invest in high yielding instruments and open up a new funding source for lower-rated companies. By mandating a 25 percent quota for the bond market, the government will limit corporates' dependence on banks and the risk associated with it. However, we will need an expanding investor base for implementation of these rules.
Initiatives announced towards the investment grades status
The finance minister also mentioned the need for investing in lower-rated bonds and that it is time to move from 'AA' to 'A' grade ratings. After the government announcement, the regulations will need to be liberalised to allow more investments in less than AA-rated securities. This change will impact pension and provident funds more because they have largely invested in AAA-rated securities. As of today, even the provision to invest in up to AA-rated instruments is hardly explored by most of the larger investors.
Corporate bonds rated 'BBB' or equivalent are investment grade. In India, most regulators permit bonds with the 'AA' rating only as eligible for investment, the Finance Minister said, adding, It is now time to move from 'AA' to 'A' grade ratings. According to rating agency ICRA, more than 80 percent of bond issuances come from the 'AAA' and 'AA' rated pool of corporates and the top 10 issuers account for nearly 40 percent of issuances.
How will these initiatives impact investor interest
The proposed measure to expand the pool of investment-grade issuers will help remove entry barriers for lower-rated corporates. Small borrowers were so far going only to banks to raise funds through the loan route. Through bonds, they may get better pricing because investors are keen to diversify their investments. Investors are quite open to more borrowers entering the bond market and they would be happy to include smaller companies in their portfolio. It may be useful to classify BBB-rated corporate bonds as investment grade and thus allow pension funds and insurance companies to enter that space.
Opportunities presented by the move
As a result of this decision, many sectoral regulators will be asked to relax investment rules in their respective industries; for example, the insurance regulator might henceforth allow insurance companies to invest in A rated bonds when the current rules draw the line at AA rating. To facilitate growth of the corporate bond market, the Finance Minister also promised to reform the stamp duty regime in consultation with the states. This will be an opportunity to buy bonds of lower-rated companies that could later be upgraded. It will give insurance companies the leeway to invest even in lower-rated securities. This will also provide an alternative investment option away from PSU companies, which currently dominate the bond market. This means, in addition to the choices of tapping the equity market, making rights issues to existing investors, or borrowing directly from banks, corporates would be encouraged ('nudged') to issue debentures.
In most developed nations, the bond market is often several multiples larger than the equity market. There is a high degree of secondary market liquidity for debentures. By law, debentures are secured debt and in theory, a bondholder has strong legal recourse in case of default.
Investor's risk appetite is key to improving participation in lower-rated bonds. Relative pricing between the bond market and bank loans will also play a role in issuers' choice of borrowing. One may have to educate the investor that risks in these instruments are justified by the returns.
One of the reasons for this is lack of takers for lower-rated and longer papers. For this to change, there is need for regulators such as Pension Fund Regulatory and Development Authority, and Insurance Regulatory and Development Authority to liberalize investment norms for the entities they regulate, who have appetite for lower rated bonds. Alternatively, credit enhancement mechanism is seen as a way of helping lower rated companies, especially from the infrastructure sector having higher funding requirement.
Reasons for the recent push for the bond market
India has no secondary market for corporate bonds to speak of. There are the laws to enforce debt servicing but its legal structure in practice is not efficient and, therefore, there are high risks in the Indian bond market. Those risks would increase if the amount of paper issued suddenly increases, without commensurate deepening of the secondary bond market and without serious improvement in the speed of legal redress for defaults.
The sorry state of affairs is as much due to apathy as it is due to risk aversion. The financial ecosystem in India does not support risk taking because of various factors like an illiquid debt market, lack of investor awareness and bad press in case of a default. The fear of default is also blown out of proportion as data shows that lower-rated bonds have defaulted, but not to the extent that it could dent returns so badly to scare away investors.
On the positive side, bonds are the ideal way to raise financing for a certain kind of long-gestation infrastructure project. Typically, infra projects are capital-intensive and long-gestation. It takes years to roll out toll-roads, build ports and attract traffic, dig mines or put steel plants into operation or start generating power. The project developer has no cash flow to service debt until the project is running.
Banks suffer from asset-liability mismatches in funding such ventures as bank funding is short-tenure. But unlike a vanilla loan, a bond can be structured to pay up only after a project is up and running. Given a liquid secondary market, bond pricing will adjust accordingly and investors can trade these at will. If a bond has investment-grade rating, players with long-gestation funds at their disposal, such as insurers and pension funds may buy it for high long-term returns.
If India does develop a corporate bond market, it would take a lot of pressure off banks, which are reeling under bad debts. It would also make it possible to raise capital for private sector infra-projects, which are currently starved of funding. Retail investors will also get a chance to invest in such projects via debt funds. There would be big risks and commensurately huge rewards.
Further initiatives that can stimulate the bond market
A robust corporate conflict resolution mechanism will go a long way in building investor confidence in the product. Investors will look at corporate bonds as an attractive asset class if they are confident that conflicts can be resolved quickly and fairly. While corporate bond markets benefit all issuers, the greatest benefit is usually for issuers who have a relatively lower credit rating. If India could create an extremely efficient bankruptcy resolution mechanism, then such a mechanism would make a strong case for large public pension funds and insurance companies to start investing in corporate bonds slightly below investment grade. Such a move would significantly improve market liquidity in corporate bonds.
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