various reforms by regulators and the Government over the last three decades since liberalization, this market is still struggling to grow in India.
Globally, bank and development finance institutions led financial systems have been prevalent in developing economies. Most developing economies have graduated from such a system to a bond market based system at times of crises during their growth journey. In India, we had several government backed development finance institutions which provided capital to long
term industrial and infrastructure projects. The source of funds for these institutions was the government or in some cases long term bonds with special features, such as tax-free coupons. Yet these were plagued with problems of crony capitalism, high NPAs and were a burden on government finances. Over time these were converted into universal banks, but a deep long term bond market to take over their role wasn’t established. Till date, these and other banks prefer to give out loans instead of buying bonds, as bonds would need to be marked to market. The recent failure of the recent TLTRO 2.0 auction, characterized by the RBI receiving only 50% bids by banks for the offered amount, further highlights the discomfort of banks at buying corporate bonds issued by medium and small enterprises.
Pension and Insurance funds are amongst the largest investors in Debt Markets. But in India, they are extremely tightly regulated and mandated to invest a majority of their funds in government securities. For the balance of funds they are constrained to hold bonds of rating AA and above. Mutual Funds have developed over the last decade as another major investor in the
Debt Markets, but lack of risk appetite amongst investors keeps them limited to short maturity (less than 5 years) and high quality bonds (AA and above). Recent defaults by IL&FS and DHFL, both AAA rated issuers, have shaken up bond markets and debt mutual funds, scaring away investors. Even the recent SEBI push for large corporates to access debt market for 25% of incremental borrowings is for those rated AA and above. This has led to a situation where 60% of the issuance is rated AAA, 20 % is AA and the rest is either below AA or even unrated. 75% of the issuers are from the financial sector. Almost all of the bonds issued are privately placed. Globally, BBB rated bonds are categorized as investment grade, yet we in India maintain an 1 RBI Bulletin, January 2019 artificial level of AA. Transitioning this immediately to A grade and in phases to BBB, will be a major step in bringing in more issuers and allowing investors access to a wider variety of issuers with varying risk and return characteristics.
This aversion to credit risk is also exacerbated by the absence of a Credit Default Swap (CDS) market. CDSs are used by bond owners to purchase insurance on their bonds, and also by speculators to benefit from defaults. Such participants in the CDS market deepen the underlying bond market by giving buyers the comfort of available default protection. The linkage between risk and yield also solidifies with the entry of new CDS issuers, leading to less risky firms getting access to cheaper capital even while remaining in the same risk rating. Globally, CDSs are a market providing risk protection on 22 Trillion US$ worth of bonds annually.
Another large hurdle in fast-tracking the growth of these markets is the involvement of a large number of different regulators in this market. Apart from SEBI and RBI, the government (via the Companies Act), NHB and FEMA are also involved in setting regulations for the bond markets. Multiple regulators end up issuing overlapping and duplicate regulations, creating confusion amongst the participants. Some regulators are stringent, whereas others are trying to ease regulations to allow market to grow. There has been discussion related to removing the government debt management from under RBIs purview, and making SEBI the sole regulator of Debt Markets, but there has been little action. In such a situation, the time has come to appoint a new independent regulator for bond markets, with its board having members from all the present regulatory bodies and with a mandate to simplify regulations and promote growth. The financial year 2019-2020 also saw external commercial borrowings by Indian Corporates rise to a record level of 45 Billion US$ in the first eleven months of the year itself. The financial sector itself was responsible for 40% of these funds whereas infrastructure, telecom and other real sector industries made up for the rest. Even the government explored the option of raising
debt in foreign markets, but it was ultimately scuttled. The benefits included raising funds at the prevalent low rate of interest, access to a larger pool of investors and de-crowding the local bond market, allowing easier access to funds for local borrowers. But the risk of currency fluctuations worsening the fiscal deficit and creating macroeconomic shocks overshadows all these benefits. To benefit from foreign capital, it makes more sense to ease the various norms which restrict foreign investment in government and corporate bonds. Issuing rupee-
denominated “Masala” bonds in the foreign markets may also be a possible solution, but it would not be easy to convince foreign investors to absorb the risk from currency fluctuations. Not all is lost. Two welcome developments in Indian Bond Markets have been the emergence of debt ETFs and attempts by the government to get certain sovereign bonds included in international bond indices. Innovations such as debt ETFs (Bharat Bond being the frontrunner for the same) should be encouraged, along with promoting similar products for private issuers. This will bring in new investors as these ETFs following roll-down target-maturity strategies form the bridge between the traditional Fixed Deposits and Open ended debt mutual funds. If attempts at including certain sovereign bonds in international bond indices such as Barclays Bond Index succeed, then we may be able to access a pool of 2-3 Trillion US$ of stable sticky investment in sovereign bonds. This will lead to de-crowding of the market and allow private firms easier access to long term capital.
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