Background
Looking at last 12 months, the market regulators in India have been on action to come up with suitable avenues to strengthen the bond market in India. Recently, there have been changes sought to stimulate the action in bond market. On August 18, 2016, in a bid to deepen the corporate bond market in India a report of the Working Group on Development of Corporate Bond Market in India released by the Reserve Bank of India (RBI) suggested standardization of corporate bond issuance by allowing investments by foreign portfolio investors, creation of a bond index, encouraging corporates to tap the market among other recommendations.
In this write up, we intend to discuss about the various recommendations of the report and analyze its probable impact on the Indian corporate bond market.
Review of the performance of the Indian bond market
Before we analyse the recommendations, let us first have a quick recap of the performance of the corporate bond market in India.
The measures taken by MCA, RBI, SEBI and MoF have resulted in considerable increase in issuance of corporate bonds. Total corporate bond issuance has increased by around 236% from Rs.1,74,781 crore in 2008-09 to Rs.4,13,879 crore in 2014-15. Similarly, the number of issuances has increased by almost 153% from 1,042 in 2008-09 to 2,636 issuances in 2014-15. The primary market has been performing strongly but there is significant lack of trading volume in the secondary market with trading being limited at around Rs. 2000 crore per day.
In India bank financing is way more popular than bond financing, as compared to other developing countries. Bonds are an incremental, additional source of funding, and not the first source of borrowing for most companies. India’s corporate bond market is smaller than 10% of the country’s gross domestic product. The corporate-bond markets in both China and Brazil are worth 40% or more of their respective GDPs.
Recommendations of the working group
The Working Group has recommended total 29 amendments in order to deepen the regime of corporate bond market in India. Recommendations include allowing investment by Foreign Portfolio Investors (FPIs) in certain non-permitted segments; allowing reissuance of bonds through same ISIN; extending EBM mechanism to all issuances; following uniform method of valuation; creation of centralized database, etc. Let us discuss these recommendations separately.
Reissuance and exemption of stamp duty
The primary market has seen a surge in corporate bonds in India, but trading in secondary market has lacked volume. One such attributable reason is non-availability of sufficient floating stock for each International Securities Identification Number (ISIN) as corporates have preferred for fresh issuances rather than reissuing of bonds. As new issue comes with new ISIN, older ones become illiquid.
To augment market liquidity, it is recommended to encourage corporates to reissuance bonds under the same ISIN by consolidating various issues into one large issue. Though this may result in mismatch of assets and liabilities, it can be resolved can by spreading out the redemption amount across the year through amortizing the payments. This could also help in reducing the cost of borrowing.
SEBI has allowed reissuance of bonds[1], it is observed that the issuers of debt securities do not undertake re-issuances due to stamp duty and the bunching of repayment liabilities. The group recommended that reissuance not be treated as fresh issuance of bonds for the purpose of stamp duty.
Allowing FPIs to invest in unlisted and pass through securities
Currently, in the bond market, FPIs are only allowed[2] to invest in unlisted non-convertible debentures / bonds issued by infrastructure companies and in listed or to be listed debt securities. To attract more foreign funds into markets, the Union Budget envisaged FPIs to invest in unlisted debt securities as well as in securitised debt instruments i.e. pass through securities issued by special purpose vehicles (SPVs) or special purpose distinct entity (SPDEs).
It is therefore recommended to introduce necessary amendments, by August 2016, in FEMA Regulations allowing investments by FPIs in unlisted debt securities and pass through securities issued by SPVs / SPDEs.
Another recommendation is to permit FPIs to transact in corporate bonds both in the OTC segment and in the Request for Quote platform of a recognized stock exchange, subject to certain restrictions. This move is sought enable FPIs to trade directly on electronic trading platforms and thereby help in enhancing liquidity in the bond market.
Market Making
Looking at the current state of Indian bond market, the liquidity and the frequency of transactions in India is very low. One such method to make the market liquid is by way of introducing a market making scheme. Market making can help the issuer to improve the market liquidity and also provide the investors to the option of entry and exit in the market. SEBI, though had allowed stock exchanges to introduce the market making scheme, stock exchanges are yet to come up with the mechanism.
The Group therefore recommends Stock Exchanges to operationalize market making scheme in consultation with SEBI. For this, banks and primary dealers may be allowed to act as market makers upon developing an appropriate risk management framework
EBM for all
The debt market in India is dominated by bringing issue by way of private placements. The percentage is as high as 90%. Many market participants have indicated that private placements lack transparency and access is not available to a large pool of investors. The Union Budget 2016-17 announced that SEBI may operationalise electronic auction platforms to facilitate transparent private placements. In this regard, guidelines have been issued by SEBI on April 21, 2016 which enable introduction of Electronic Book Mechanism (EBM) by the stock exchanges and mandate that all private placements of debt securities in primary market with an issue size of Rs. 500 crores and above, inclusive of green shoe option, if any, should be through such a mechanism. Such EBMs have been operationalized by the Stock Exchanges. Bonds with issue size of less than Rs. 500 crores, are required to disclose the coupon, yield, amount raised, number and category of investors to the Electronic Book Provider and / or to the information repository for corporate debt market.
With the margin of private placement being as high as 90%, the working group is of the recommendation that EBM shall be made compulsory to all issuances of corporate bonds, but only after reviewing the success of the EBM for the existing issues and market feedback.
Uniform valuation norms
Currently, RBI and IRDAI have advised the entities under their ambit to follow the valuation norms issued by Fixed Income Money Market and Derivatives Association of India (FIMMDA), a quasi-self-regulated organisation. Mutual funds follow valuation norms as advised by Credit Rating Agencies. Also, mutual funds require daily valuations as they have an obligation to publish net asset value of their schemes on a daily basis, but FIMMDA norms for valuation of corporate bonds are calculated on a monthly basis. So, use of different norms has led to adverse effect on the market to some extent.
Therefore, it is recommended to follow / establish a uniform valuation methodology available on a daily basis by the regulated entities for valuation of their holdings of corporate bonds. The working group, therefore, advised regulators to explore a mechanism for valuation including engaging the Financial Benchmarks India Pvt. Ltd. (FBIL) or credit rating agencies for the same with necessary safeguards and regulatory oversight.
Disclosure norms for CRAs and Banks
CRAs are, currently, required to disclose the movements of credit rating of all outstanding securities on their websites on half-yearly basis. Market participants have, however, expressed the view that the level of compliance by the CRAs in adhering to these regulatory requirements is not high. Currently, banks furnish loan overdue information to credit information companies (CICs) on monthly basis. Also, CRAs are not eligible to access the information on bank lending to large borrowers under stress from CICs for the purpose of determining the ratings for corporates.
The working group, therefore, recommended CRAs to publish the credit rating transition matrix more frequently. Also, CRAs may take up membership of CICs to access relevant credit information. The working group also opined that RBI may consider whether CRAs may be allowed access to Central Repository of Information on Large Credits.
Integrated Trade Repository
The need of a central repository / database is almost un-argued as it enables investors to get complete information about corporate debt market at one place. Such database will enhance transparency in the market and enable investors to take an informed decision. Though, NSDL and CDSL have created a database for the primary market there is, however, a need to have an integrated Trade Repository (TR)/database so that the information of both primary and secondary markets, such as, issue wise outstanding size, rating, shut period, price, volume of secondary market trades, rating migration, etc. are available at one place. Accordingly, an announcement for introduction of an Integrated TR for primary and secondary market in corporate bond market has been made in the Union Budget 2016-17.
Therefore it is recommended for introducing a centralized database for corporate bonds covering both primary and secondary market segments in two phases, for secondary market trades by end August 2016 and for both primary and secondary market by end October 2016.
Index for corporate bond market
There is a strong need of bond market index in order to cater to the needs of participants who want a platform to act as a benchmark. In view of the same, the working report recommends Stock Exchanges to introduce a corporate bond index on the lines of Nifty 50 and BSE Sensex.
Augmenting partial credit enhancement (PCE) limit on bonds
RBI Guidelines on PCE of INR bonds issued by infrastructure companies restricts the extent of PCE provided by banks to 20% of the bond issue size. For investors desiring a minimum of AA rating on bond, the current PCE seems inadequate to raise ratings for bonds. In order to encourage corporates to avail of this facility, especially by infrastructure companies, during the initial phase the upper limit for PCE by the banking system as a whole may be enhanced to a higher limit with no single bank having exposure of more than 20 per cent. It is also felt that the capital required to be maintained by banks on account of PCE should be lower if the base rating of the project improves. This would incentivise banks to provide PCEs on projects which are expected to perform better with passage of time.
It was therefore recommended for RBI, by August 2016, to enhance the upper limit for PCE to a higher limit with no single bank having exposure of more than 20 per cent of the bond issue size by end August 2016. Also, it was recommended to formulate a separate regulatory framework for providing credit enhancement of corporate bonds by NBFCs engaged in such activities to help bolster bond ratings that can attract investors.
Electronic trading platform
SEBI has prescribed norms[3] for electronic trading platform (screen based trading) in place for trading of bonds; but only 15 of such bonds are available for trading. The reason for such low volume can be attributed to high penalty for short delivery of bonds (currently, 5% of default amount) given the volatility in bonds.
To encourage market participants to start trading on such platforms, the risk management practices of the clearing houses shall be reviewed and a mechanism similar to equity market where the entity involved in delivery failure is given a time period to cover from the market and failing which some penalty is imposed shall be considered.
Encouraging bond financing rather than bank financing
In many of the developed countries bonds are issued without creation of security interest, subject to certain compliances, so as to enable easy of raising of funds by the corporates. But, bank borrowing has been a popular source of funding in India. The reason behind this can be prevalence of the cash credit system where the burden of the cash management of the corporations falls on the banks. The objective is to encouraging alternative sources of funding to bank credit for the corporate sector to finance growth and to de-risk the balance sheets of banks and spur the bond market in India. Also, it was announced in the Union Budget 2016-17 for RBI to issue guidelines to encourage large borrowers to access a portion of their financing needs through market mechanism instead of the banks.
The Working group therefore recommends large corporates with borrowings from the banking system above a cut-off level to tap bond market.
Acceptance of corporate bonds by RBI
As of now, banks can only pledge government securities to borrow from the Reserve Bank of India, and allowing them to pledge corporate bond could spur more buying of the debt by banks. Internationally, many central banks accept corporate bonds as collateral for their liquidity operation. It is not uncommon for central banks to take a lead with a view to developing the financial market.
In order to incentivize banks and PDs to invest in corporate bonds and thereby create demand for corporate bonds, it is recommended to RBI to explore the possibility for accepting corporate bonds for LAF operations with suitable risk management framework including rating requirements
Investor Protection
A robust, timely and effective bankruptcy regime is critical to the development of corporate debt market from investors’ point of view. The recently passed Insolvency and Bankruptcy Code, 2016 is expected to ensure recovery for creditors and address the concerns of investors in corporate bonds by providing new time bound recovery and resolution framework and rules under the Code are expected to be issued shortly. In order to achieve the objective behind the Bankruptcy Code, issues such as early notification of the rules, development of insolvency professionals, tribunal/court infrastructure and information utilities and quick redressal of the transitional problems may be addressed with priority.
Other Recommendations
Credit Default Swaps (CDS)
Pending amendments relating to permitting netting of OTC derivate contracts may be explored expeditiously within the purview of existing legal provisions and banking practices.
Repo in corporate bonds
FIMMDA to consult market participants in order to develop an acceptable market repo agreement for execution among the market participants by end September 2016. Market makers may be allowed to participate in the repo market.
Basel III compliant Perpetual Bonds
EPFO and Insurance companies may be allowed to invest in AT-1 bonds of banks and the maximum investment ceiling of 2% may be reviewed for relaxation.
Rationalization of Stamp Duty
The stamp duty on debentures should be made uniform across states and be linked to the tenor of securities.
Conclusion
The Indian bond market is in for major revamp by the regulators. The continuing spate is for action for different regulators and all of them are likely to facilitate the growth of Indian capitals market. There seems to be a huge drive from the government to integrate financial market in India further with the rest of the world. If everything falls in place as expected, the bond market in India expected to surge and be a much higher part of its GDP. This is expected to bring Indian bond market in line with that of China, Brazil and other developed countries.
For this, the regulators must be lauded for coming up with ways to strengthen the Indian bond market.
[1] https://taxguru.in/sebi/amendment-sebi-issue-listing-debt-securities-regulations-2008-provide-consolidation-reissuance-debt-securities-corporate-bond-market-call-put-options.html
[2] https://taxguru.in/rbi/notification-fema-202000rb-dated-3rd-2000.html – Refer Schedule 5
[3] http://www.sebi.gov.in/cms/sebi_data/attachdocs/1378988180275.pdf
(Author is associated with Vinod Kothari Consultants Private Limited)
