Question of potential

IFR Asia India Report 2012
11 min read
Manju Dalal

India’s domestic debt capital markets should present tantalising opportunities for underwriters and investors, as an increasing number of companies look to diversify away from bank loans. Progress, however, has been frustratingly slow.

Children climb trees as they play on the outskirts of Srinagar

Source: Reuters/Danish Ishmail

Children climb trees as they play on the outskirts of Srinagar

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Nearly three decades after the first deals, rupee bonds remain little more than a sideshow in Indian corporate finance. Companies have had the run of the bank loan market, while investors have shown little appetite for credit risk.

A series of stalled initiatives to reinvigorate the market are a constant source of frustration for India’s financiers. However, all that may be about to change. The government recently appointed Subhash Chander Kalia, a former banker with Union Bank of India and Vijaya Bank, as an adviser, tasked with getting the market back on track.

In particular, Kalia’s appointment is designed to improve co-ordination between the many different regulators and market participants, and ensure that recommendations of various committees are implemented. Although he sits within the fully state-owned India Infrastructure Finance Co, Kalia reports directly to DK Mittal, secretary, department of financial services.

The mandate sends a message that the government is determined to give India the vibrant corporate bond market needed to meet its huge infrastructure financing needs.

India needs to invest Rs1trn in infrastructure in the next five years to maintain its economic growth. The country reported growth of 5.5% for the April-June quarter, the lowest in three years. To fuel the growth, it is crucial for India to have a flexible financing option at its disposal.

A large part of this infrastructure financing will come from the debt markets. With the banks already full and facing their own capital adequacy pressures, the role of the bond market is poised to grow.

Volumes are indeed growing, but, on a global scale, India’s local bond market is still tiny. It represents less than 4% of the country’s GDP – far less than the average proportion and dramatically lower than developed countries like the US, where the bond markets account for 130% of the country’s GDP.

Rupee bond sales have surged this year to Rs1.8trn from 599 issues, as of September 6. During the same period last year, the industry raised Rs1.3trn from 379 issues.

Liquidity and transparency are the two main hurdles. Traditionally, bond market has been limited to a handful of market players, such as banks, primary dealers and brokers, restricting its expansion.

Bond-market intermediaries end up holding large portions of the deals they execute, which is not the case in the equity markets. With secondary markets also dormant in most tenors, intermediaries often end up holding the bonds to maturity, effectively leaving many banks with a fixed-rate loan on their books.

Efforts, however, are being made to attract more investors, including retail ones, into the market with the introduction of tax-free bonds and also encouraging blue-chip issuers like the State Bank of India to tap this segment. For the financial year ending March 2013, the government has doubled the tax-free bond issues to Rs600bn.

Various committees have recommended measures to expand the range of investors, but, so far, this has remained a pipe dream.

Private placements were introduced as a means to help execute bond deals quicker, but this route has become a bane to the market. Nearly 90% of bonds sold in India are private placements – going to fewer than 49 investors – and a typical private placement goes to 10–15 investors, limiting the chances of secondary trading.

The government is now seriously looking into the possibility of lifting retail participation to improve trading liquidity. Kalia’s office is considering one proposal that will make it mandatory for corporations to tap the bond market for their working capital needs. The move will create more supply and prompt more investors to look at corporate bonds as an investment option.

According to a paper presented to the Ministry of Finance in May 2011, rupee bonds are still not being given priority over other sources of funds. Large firms relied on bank loans for 17.8% of their financing in 2010–11, up from 14.4% in 2000–01. Bond markets accounted for just 3.9% in 2010, and 3.5% a decade earlier.

“Banks are the biggest enemies of the local bond markets,’ said the head of debt capital markets at an investment bank in India. “As they prefer loans over bonds, how do you expect other issuers and investors to follow them?” he asked.

India’s banks appear adequately capitalised, but their balance sheets are heavily skewed towards loan assets, which do not need to be marked to market in the same way as bonds.

This accounting breather gives banks more leeway to manage their loan portfolios, but only to a point: India’s slowing economy is forcing them into a growing number of debt restructurings that will eat into that capital. These changes are prompting banks to look at refinancing their loan advances with bonds.

The government is also keen to resume work on invigorating municipal bonds, which may help stimulate the secondary markets. India has seen some activity on this front, but, for the last decade or so, the market has lain dormant. The lower credit ratings on municipal bonds kept investors away in the past, while municipal bodies were able to leverage relationships to secure loans to meet their funding requirements.

Although the investor base remains limited, even the few institutions that are big buyers of corporate bonds complain of the lack of supply.

Insurance companies and pension funds – among the key investors in rupee bonds – are restricted in their investment activity as regulations limit them to top-rated paper. Insurance companies and pension funds must have 75% of their portfolios in Triple A rated bonds, although, in reality, most have 90% in the top-rated category.

The MoF is said to be holding serious discussions with the insurance and pension fund regulators to remove some of these restrictions. These investors also prefer long-dated paper to match liabilities, but the bond market is unable to meet such requirements.

“Banks and corporations rarely issue long-dated paper beyond 10 years, which leaves us with very little choice,” said SP Prabhu, vice president and head of fixed income at IDBI Federal Life Insurance.

Most long-dated bonds are now concentrated in the tax-free segment, which offer lower yields over straight, long-term bonds. “As our income is not taxable, the tax-free bond investment does not suit our requirements,” Prabhu said.

The lack of lower-rated issuers is another longstanding problem in the rupee bond market. While lower-rated bonds provide higher yields to investors, they also help companies diversify their funding sources beyond the banking sector.

In March, Crisil conducted a study of 500 companies it rated Single A and concluded that these were attractive investment opportunities. Crisil said these issuers had maintained good credit quality through economic cycles and had displayed healthy financial performances with low defaults and high stability rates.

Stability rates indicates the probability that ratings will remain unchanged over a given time horizon.

The risk-adjusted returns on these Single A rated instruments were also superior to those available from products in higher rated categories, the study found.

The rating agency’s analysis showed that a credit-risk premium of about 104bp for a three-year Single A rated bond over the risk-free return was sufficient to cover potential losses from companies in that ratings category.

Meanwhile, because Indian investors favour companies rated AA– and above, the agency found that the market offered an average credit risk of 204bp for a three-year Single A security.

Here, the government is also stepping up its efforts to make things better. State-run India Infrastructure Finance Co, together with multilateral agencies, such as the Asian Development Bank, are offering credit enhancements so that lower-rated issuers can obtain partial guarantees to enhance their credit profiles in the bond markets.

A stronger backbone

India’s weak legal system has also been blamed for the slow progress of the country’s bond market. Resolving the uncertainty surrounding the chances of recovery and speeding up restructurings in the event of default will go a long way towards boosting investors’ confidence in rupee debt.

The MoF is also looking at ways to rationalise stamp duty across a country where every state has a different structure.

For better transparency, a dedicated platform for rupee bond trading may also lift confidence. ICAP India, a subsidiary of the world’s largest inter-dealer broker, recently applied to Sebi to set up an exchange for corporate bonds and fixed-income derivatives – primarily to cater to institutional investors.

“Trading platforms, proper benchmarks and a defined role of arrangers are a must to tame and grow the rupee bond market. On the government-securities side, the central bank has ensured these three basic requirements are met, but this is totally absent for corporate bonds,” said the DCM head of a foreign bank in India.

“The very idea of having a corporate-bond market is to distribute risk, which now tends to get concentrated on the books of the arrangers. On the pricing front, too, issuers resort to twisting the arms of arrangers, who sometimes give in to tightest price levels for league table and relationship purposes,” he added.

Another banker pointed out the gap that, unlike in the G-Sec market, where the Reserve Bank of India closely monitored the pricing of bonds in the secondary market, there was no such supervision on the corporate bonds side. This led to lot of mispricing and distortions in the yield curve, he said.

The government’s appointment of Kalia is one reason for hope. If his debt market cell can Identify and address these – and other – issues, India Inc may finally get the bond market it so desperately needs.