Here's how Indian bonds market can be revived

For a long time there hasn't been too much development in the Indian bond market. In the period between 2005 and 2010, lots of products for the corporate bond market were introduced. Credit default swaps was introduced a year ago, but, barring interest rate swaps nothing much has come of the other products.

In an interview to CNBC-TV18, V K Sharma, executive director, Reserve Bank of India, Neeraj Gambhir, head of fixed income Nomura and Jayesh Mehta, managing director and country treasurer at Bank of America discussed the issues that are hampering the Indian bond markets. Below is the edited transcript of their interview with CNBC-TV18. Q: One of your own papers that you had presented on the anomalies in the financial market, you point out that the healthiest or maybe the most traded market, not healthiest, the interest rate swaps (IRS) market is throwing up a yield curve which is 50 basis points lower than the comparable government securities market – why don’t we start with that? According to you what ails the IRS market, which according to me is the best functioning market? Sharma: This yield curve consistently and persistently is trading through the government yield curve, it is not 50 bps, it is more than 100 bps. In a sovereign country, inter bank dealer market which is a non-sovereign cannot trade through the sovereign which is risk-free in the country of its own currency. Q: So, the yields can't be lower in a market which is not sovereign? Sharma: If one looks at the global financial crisis what has happened there is, there was a huge under pricing of risk, under pricing of risk is typically captured by the spread of the risk assets relative to the risk period. The spread between junk bond yields of the US territory has almost disappeared. We will have same kind of situation if we use that framework, which is generally used framework. The signal they are getting from IRS market is that there is a huge bubble there in the IRS market because it is consistently trading through the risk free government sovereign. Q: Why do you think the IRS curve is trading lower? Gambhir: Reality is that the size of fiscal deficit is huge. The cumulative amount of supply that is coming in the government bond market is very large. The market has to absorb it. Even though we have statutory requirements of banks and other institutions to hold government bonds but, if one sees the increase in the government bond supply over the last 4-5 years, it has been quite high. On the other hand, the interest rate swap market is not a very well traded market. I would tend to disagree with you that you say that, it is a good market, is the best performing market, I think it is not. The reason is the participation level is actually very limited. It is just a bunch of foreign banks, private sector banks. The real long-term investors in the market, which is nationalized banks, public sector banks, insurance companies, mutual funds, corporates, they are not participating in that market so, it is a very narrow subset. That narrow subset trades amongst itself. The trading volumes are good, so the total amount of outstandings just keep on growing. The two markets are not speaking their same language, they are very different segments of the market and hence there is mispricing. The people who are best positioned to arbitrage between the two markets which is the nationalized banks who hold very large portfolio government bonds are not acting to arbitrage both the markets out. If they were to step in, arbitrage the markets out, we would see this anomalies tend to go away over a period of time. I would think it is a good opportunity for them to step into this market given the fact that they hold a huge amount of interest rate risk in their books, pay-off in the swap market, let the curve get priced well and we will see this anomaly getting priced away. _PAGEBREAK_ Q: What is your comment on the IRS market? Mehta: I think it is a traders market right now. Reality is that hedgers and users are not participating in that market. So Mr Gambhir summed it up pretty well. On the other side, you also have large supply of government bond. As we go towards the year-end when the bond supply is reduces, that 100 might become 90 or 80. I am not saying it will correct the yield curve. Then again when the new borrowing comes in, it will still widen. On the bond side, it is purely the supply which is keeping the yield high. People, who buy bonds, are not hedging it out and that is what is creating that anomaly. People are expressing their trading view. They maybe be right or wrong, only time will tell. Q: According to you, what should one do with the IRS market? If there is a bubble there, should the regulator move in? Sharma: The nationalized banks have huge amount of government securities sitting on the balance sheet. However, they are not using these instruments for a simple reason that they do not have to mark-to-market upto 25 percent of SLR. That explains only the hedging part of it. Coming to the arbitrage, nothing prevents from these same foreign banks which are taking a trading position to exploit this huge arbitrage opportunity. They are leaving not cents but dollar on the table. I do not know why that is happening. Gambhir: In a sense it is an anomalous market. We all understand it is an anomalous market. I am not sure I would call it a bubble because the characteristics of a bubble are hard to define according to me. In my view, the way out of the situation is to encourage the large players. The public sector banks to step into this market and do some bit of arbitraging. Once they do that, I think the market will start correcting. Q: Coming to your point that one should not have hold-to-maturity (HTM) as a concept at all that banks should be asked to hedge their portfolio and not be given this advantage of being able to hold almost 23 percent of their total book as not mark-to-market. Will the regulator move in that direction? Sharma: Going back to 2004 and before that, IRS yield was above the IRS. That time banks were actively using because they had gone almost upto 90 percent of the fixed income portfolio government security being mark-to-market. So it has been, like we have come back from there. If you give accounting hedge to banks as opposed to an instrument to market based hedge which is a derivative like IRS interest rate futures, then you have to have the brokerage fees, transaction costs and the margin money. Observe the screen on their toes rather than lying back in the chair. So it is as simple as that, they have no incentive compulsion for banks. Q: Do you expect this from regulator? Sharma: Yes. Infact the committee in which I was chairman, strongly recommended that we must phase out. Even the Gandhi committee has recommended that.  My sense is that phasing out can be a bit faster. If one looks at IRS market, it is two times outselling of the government security bonds. So that will be absorbed here. Q: Would that help in taking off the bond markets, if this massive portfolio of USD 30 trillion bonds has to be hedged? Mehta: That was just adjusting the spread between IRS and bond market. I do not think that is going to be a complete booster for the bond market. So, the liquidity in the bond market has its own different characteristic. Even if two large nationalized banks decide to run an arbitrage book, it is not that foreign banks don’t do it. All of them are running arbitrage book but then there is a limit. Both the sides are mark-to-market. Today you think 70 bps spread is good and great, what if the spread widens to 80 bps. Q: Several products were brought by the regulator to boost the corporate bond market. Why did it not take off? Mehta: There was couple of issue there. I think people are also very comfortable currently using the repo and government bond market. The simple reason is it is Clearing Corporation of India Ltd. (CCIL) - central guaranteed. There are not bilateral clearing houses in between. Repo and corporate bond also would happen, but it will take time because it is bilateral. It takes lot of time from a lender’s perspective also and more importantly we still haven’t gone to a longer term repo. Once we have longer term repos and proper margining situation on the corporate bond that is when people would be actually going big time into the corporate bond repo market. However, standalone will not be enough. Daily mark-to-market margining would create enough different risk. _PAGEBREAK_ Q: Is the daily margining angst in that market? Gambhir: I am a huge believer in corporate bonds. I have personally been involved in lot of discussions with policymakers as to why do we need a corporate bond repo market. As I look across the world I think the collateralized borrowing and lending as a product post the financial crisis has actually gained a huge amount of credence. They are driven by the balance sheet constraints that people have, the risk characteristics in it. So I believe the product will take off. I think it is a good product that people will have as the markets come around to trade, have the infrastructure in their own respective institutions. We will see the benefits to trade it. I also believe that the holdings of corporate bonds by non-bank participants. Especially the financial institutions and non-bank finance companies will actually increase as the corporate bond repo as a product sort of gains concurrence. Then it will be a good treasury management product for these players. We should be little patient around this product and there is a huge merit. Q: Infrastructure will be funded by the corporate bond market, but it is not really a market that takes off. How do you think liquidity can be boosted in this market? One suggestion was that insurance companies now can invest largely only in AA+. Below that is restricted. Perhaps that level should be brought down to A or maybe BBB+. I would think it is unsafe as a person who only buys insurance, but do you think that would be a step ahead for the corporate bond market in general, not repos? Sharma: Going back to corporate bonds, we seemed to be missing the trees for the woods. The repo and corporate bond market is not an end itself it is a mean to that. They refer to the liquidity in the sense I have this cup and I can lend it out as collateral and I get some cash against that at loan to value ratio. That is not the meaning of liquidity in the context of either government securities market or the corporate bond market. What the liquidity means specifically, in theory and practice globally and specially in US and other markets is that the bid offer spread - the buying and selling should be very narrow. That comfort comes from the fact that one is able to short sell a dealer who is making a market or able to buy a bond and fund it in the repo market. So the repo market is incidental to this main definition of liquidity in the corporate government securities market. Coming to the corporate bond market I have very different take on this. While definitely there is a national debate about a need for the development of a very active and happening corporate bond market, but let us go back to the true cultural settings only in United States. In the USA corporate bond market and commercial paper originated in the cultural context. There is a huge desensitization of the banking sector. It is a matter of culture. Europe was like India. In Europe it is bank funded. Most of the assets are funded by banks like in India. So what I am saying is corporate bond market only substitutes or competes with the traditional banking market. So we can say that this is a market whose time has not come like it came in the Europe after the crisis. Q: So again it is mindset you are saying? Sharma: No, they demand for it. If my demand can be met by this, why should I go for this? Europe immediately after the crisis, bank credit became huge concern so automatically by force what has happened now is there is increasing preference of depositors, who have much higher level of comfort. They can invest their deposits from banks taking it to the corporate bonds either through mutual funds, money market funds or fixed income funds. Q: What would you say can be done for the corporate bond market? Mehta: If you look at the corporate bond, government bond or any bond market in India or globally there are six kind of investors and we have six kind of investors here also. There is like bank, insurance companies, provident fund, pension provision fund, FIIs, retail and mutual fund. Mutual fund retail is the same bucket because there is the pass-through and the anomaly which we talked about on the deposit side like deposit being the highest yielding as of right now than any bond whether it is government bond or PSU bonds deposit is the highest yielding, so there is no incentive for individuals or their surrogate investment through mutual fund to be in the bond market. So we are left with the four categories. Now in that three categories if you look at the end investors, the number of end investors and can you create a market when you have one trader and thousand investors? The number of end investors that is three categories of bank, if you take 10 banks they are 90 percent of banking segment in terms of assets. If you take one insurance company which is 70 percent of insurance segment and if you take four provident funds which is 75 percent of provident fund market. So you have 15-16 end players, I am not taking FIIs right now, we will discuss that separately, but 15-16 end players and you have 35 intermediaries, you have 35 market makers, traders in between for 15 players, how can there be a market for 15 end users which constitutes 75 percent of the market. Gambhir: I think within that macro construct that Jayesh described my take would be that we have spent an enormous amount of time and energy in building the infrastructure and I think the regulators have done a fantastic job in giving us a world class infrastructure now at least in the government bond market and it is getting there in the corporate bond market. My take would be that now the focus has to shift towards the end users which is the long-term investors. Do we have the right policies in place for them? For example, if you tell an insurance company that you can only invest 80-85 percent of your investable portfolio in government or AAA rated bonds, is that the right strategy and approach for them? That is one aspect that I think needs to be dealt with. The second that needs to be dealt with is the fact which is exactly what Mr. Sharma said, ultimately bonds are a credit channel and if we recognize bond market as a credit channel both for the government and for the private sector we need to keep them at par if we want to develop that. If we do not want to develop that we need to have an odd case. Q: How do you make that? Gambhir: Precisely, we said that there should not be HTM. My argument is that the loan portfolio is nothing but an HTM. So, if you have a large loan portfolio and the bond market is HTM which lender will prefer to lend in bond market. He talked about accounting hedge, I said it is an accounting swap. I think it is an accounting option. Banks are long in accounting option because till the time the portfolio is bleeding you keep it in HTM. The moment it goes into money you sell it into the market and realize the gains and book them. Till such time these anomalies within the regulatory setup will persist between bonds and loans. One will not see bond market develop as a proper and full fledged credit channel. I would also say within that context, not withstanding all this Indian bond markets have developed fairly well. The primary markets have done substantially well. There is a huge amount of private placements that go through. So we need to continue to work on some of these areas. Latha: The problems that you all are pointing out look very longstanding. Perhaps the one thing that maybe achieved a little earlier would be asking banks to mark-to-market even their government bond portfolio. That may remove one anomaly, but that will still leave a lot of questions unanswered on how to develop and render robust the corporate bond market.