Corporate calling

IFR India Special Report 2011
11 min read

Capital market reforms, especially the introduction of credit derivatives, have raised hopes that India’s rupee bond market will finally live up to its potential – but there is a long way to go.

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The Indian debt markets have demonstrated consistent growth in the last few years, with the government introducing various measures to increase the depth of the market. Industry participants believe the corporate bond segment has reached a turning point and is poised – with a push in the right direction – for rapid expansion.

This optimism stems from various measures in the last couple of years to stimulate the domestic fixed-income market and reduce the burden on the country’s overstretched banks.

Although there has been progress, the Indian bond market remains way behind its regional counterparts, indicating that a consistent push is required to take it to the next level. In 2011 (until mid-August), India’s rupee bond market had registered 318 deals totalling Rs1.14trn (US$25.3bn), according to Thomson Reuters data, roughly on track to match the 2010 full-year figure of Rs2.15trn from 637 deals, up from Rs1.71trn in 2009.

Of this, however, corporate bonds accounted for Rs679.5m so far in 2011, well below the Rs24bn for 2010 and Rs4.9bn for 2009. India’s corporate bond market still lags well behind those of its biggest neighbours – China (US$49.7bn), and South Korea (US$31.1bn). Even Malaysia (US$4.2bn) and Singapore (US$3.2bn) have recorded more corporate fundraisings in 2011 than India.

With the public sector accounting for a vast majority of rupee bond issuance, the onus is on the government to accelerate reforms to address that problem.

“Fixed-income is an enormous opportunity in a growing economy. Unfortunately, the government still dominates this space in India. Clearly, these are great opportunities for all arrangers, but how these are realised remains to be seen,” said Jaideep Khanna of Barclays Capital.

Industry players believe the bigger-than-expected rate hike in late July has prompted many corporate treasurers to look at the rupee bond market as a more viable funding option. The Reserve Bank of India added 50bp to the repo rate on July 26, its 11th hike since the tightening cycle began in March 2010.

Extra documentation

The hike in the key rate has pushed banks’ base rates higher, thus reversing the pricing gap between the loan and bond markets. Some participants estimate that loans are now about 125bp costlier for most corporate borrowers than bonds.

“Base rates have gone up over 1% since the start of this fiscal year, encouraging a lot of companies to look at the bond markets a lot more closely as a funding option,” said Hitendra Dave, head of global markets at HSBC India. Dave added that new issuers would be more than willing to go through the extra documentation in order to benefit from the better pricing in the bond markets.

The base-rate regime, introduced in July 2010, prevents banks from lending beneath their respective levels, many of which now hover above 10%. The rule was designed to stop the popular practice of banks lending below their prime rates, which the central bank feared could add to credit concerns further down the line.

“Post the latest rate hike, there is also more discreet buying from asset managers, who were earlier of the opinion that interest rates would keep going up. However, market opinion is now split with some believing the policy rates have peaked,” Dave said.

India’s domestic bond market is closely aligned with the growth in infrastructure financing. The country has spent billions on infrastructure in the last five years or so and estimates are that it will fork out a further US$1trn equivalent over the next five years ending 2017.

Confined to the domestic banking sector, the rush of lending has inevitably put pressure on India’s banks, and the rupee bond market is being seen as the best way to strengthen the country’s capacity to finance its projects. Many banks are finding it harder to lend to infrastructure projects, having either hit their sector exposure limits or reached concentration levels on lending to particular borrowers.

The bond markets may also be a way of luring more foreign investments to the infrastructure sector – a priority for the government. Yet, past performances here suggest that lawmakers have more to do to attract overseas investors to infrastructure-related bonds.

Traffic moves at busy intersection in New Delhi

Source: Reuters/Adnan Abidi

Traffic moves at busy intersection in New Delhi

As of June 30, foreign institutional investors had used up just US$80m of a US$25bn quota for infrastructure bonds. Even in a rising interest-rate environment, it is a dismal number and one that Manmohan Singh’s government is desperate to address. One of the main reasons cited for the lack of foreign interest – a three-year lock-up period on investments – is already being addressed. Market participants said the finance ministry had decided to halve the lock-up, but much more needed to be done.

“One of the other factors in the way of growth of the bond markets is limited access made available to participants. The government should look at liberating the access to markets and let investors walk down the credit curve themselves,” said Barclays’ Khanna.

“To attract any investor to the market, the government just has to ensure investors get their prices and also have the flexibility to exit when they want,” said another banker.

It is quite evident that the country has not been able to achieve any of these factors.

In the Union Budget in February this year, Finance Minister Pranab Mukherjee lifted the ceiling for FII investment in bonds infrastructure companies issued to US$25bn from US$5bn.

Pending legislation

The shorter 1.5 year lock-up period is also a feature of the Infrastructure Debt Funds, soon to be introduced through pending legislation. In order to make investments in the product more attractive, policymakers have proposed a reduction in the withholding tax on interest payments on overseas borrowings of the IDFs to 5% from 20%. Corporate bonds, however, will remain subject to the 20% tariff.

IDFs are meant to refinance existing infrastructure loans and free up India’s banks to fund new projects. Even international multilateral agencies, such as Asian Development Bank, have offered to provide partial credit enhancements to infrastructure bonds to make the borrowing cheaper.

Foreign investors will also be allowed to participate in credit-default swaps, set to be introduced – after a long preparation period – on October 24. Here, too, most feel it will take years to develop the sophistication and depth needed for a credit derivatives market to become worthwhile. Participants are happy that foreign institutions will be allowed to take part in the CDS market, albeit only as CDS protection buyers.

Many still feel the regulations need to be tweaked further to draw a better response. “I am not very optimistic that the CDS market will be very popular and liquid because of the limitations in the existing regulations. The RBI should create the same environment as that for the futures market so that CDS, in the true sense, becomes a useful tool for the risk transfer,” said a banker with a foreign bank.

Market players are also quick to point out that the loan market needs CDS-like protection, since over 70% of the credit risk of Indian banks is related to the loan market. Still, many expect a marquee CDS trade to take place soon after the new rules come into force in October.

Government borrowers remain the mainstay of the rupee bond market, issuing nearly 95% of the total volume. As such, many believe the reforms need to start with this segment.

“I want the state-run companies to go electronic in their bidding process, so that there is more transparency and promptness in the process,” said Dave of HSBC.

Surprisingly, India’s state-run companies still believe in calling bids for their paper manually, asking each arranger to be physically present at the time of the opening of the bids. The lowest bidder gets the mandate even if the fees are quoted at zero – an increasingly common feature in today’s market. Others are asked to match the lowest bid if either the others fall in the same coupon range or the issuer wants to raise more money.

While some arrangers feel this five- to 10-minute mandate process is sufficient, as most terms are made known at the RFP stage, others feel this practice puts the arrangers at a distinct disadvantage.

“Many times, the arrangers succumb and book a loss only because they cannot antagonise these big state-run issuers. The public-sector bond market is worse than a fish market,” said Delhi-based banker.

Another anomaly with state-run bodies is the lack of clarity on deal sizes. Typically, issuers indicate only a minimum size for a bond sale, or provide a cap on the overall total. This makes it impossible for an arranger to gauge demand for a particular tranche of the paper – increasingly a problem in volatile market conditions.

“Many times, we go gung ho about the issue, realising only later that the issuer had only a small upsizing plan and our entire bid derails. Sometimes, we have seen a Rs1bn issue end up at Rs10bn. Where in the world can one witness such crazy behaviour?” said another banker.

Also, many believe the practice of allowing state-run bodies to settle bonds after a full two weeks also needs to be curtailed to 48 hours.

“The settlement and securities creation should be predetermined, failing which, the situation should be declared a default,” said another arranger who actively participates in auctions for state-run bonds.

Many strongly believe the buying behaviour of many government entities, including the largest insurer, LIC of India, need to change. LIC still negotiates bilateral deals, hardly participates in syndication and does not trade in secondary.

“Ideally, LIC should be one of the most active traders and it should benefit from the liquidity in the secondary market as the insurer will be able to churn its risk,” suggested another Mumbai-based banker.

However, as one banker put it, the entire thought process of the government is flawed and, as such, one has to be very patient to see a big change in the rupee bond market.

By Manju Dalal, Senior Reporter

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