Innovations of necessity

IFR Asia India Report 2013
11 min read

An employee works on his laptop at the Start-up Village in Kinfra High Tech Park in the southern Indian city of Kochi.

Source: Reuters/Sivaram V

An employee works on his laptop at the Start-up Village in Kinfra High Tech Park in the southern Indian city of Kochi.

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Growing volumes in recent years have offered a hint of the potential for India’s domestic bond market, but investors believe the government needs to do more to promote this vital alternative to bank financing.

The rupee bond market registered deals totalling US$29.3bn-equivalent in the year to September 4, according to Thomson Reuters data. That compares well with the US$46.0bn for calendar year 2011, but a recent slump in deal flow amid turmoil in local interest rates means it is on track to fall short of the US$54.4bn issued in 2012.

This slowdown in bond financing also comes at a time when India urgently needs to relieve some of the pressure on its banking system, where infrastructure commitments and rising non-performing assets have left balance sheets stretched.

To get bond growth back on track, observers are calling for measures like removing certain investment restrictions, enhancing transparency, widening the investor base and tweaking the insolvency regime.

The real challenge, however, remains the development of a deeper market that can provide funding for lower-rated issuers and longer-term assets.

Compared with other countries, India’s local market remains woefully underdeveloped, with rupee bonds equalling just 13% of the country’s GDP. The US bond market, the world’s biggest, is equivalent to around 130% of the country’s GDP, while South Korea boasts a domestic debt market equal to around 80% of GDP.

“The rupee corporate bond market is not growing to its potential because it still remains dominated by a few issuers (and investors), who are highly rated,” said TCA Ranganathan, chairman and managing director of Export-Import Bank of India.

Exim India raises around US$4bn each year across the onshore and offshore debt capital markets.

Changing dynamics

The last few months, however, have seen some pivotal changes in the market. In May, India launched online trading for domestic corporate bonds, a long-awaited service expected to add depth to the market.

The Securities and Exchange Board of India had pushed for an online exchange in January, asking stock exchanges and clearing houses to use online trading for all debt instruments, including corporate bonds, government securities and securitised debt.

The National Stock Exchange, India’s largest bourse, was the first to launch the service in May with the Multi-Commodity Stock Exchange following suit in June.

The use of online-trading technology has put India on par with other advanced global markets that have implemented low-touch exchanges. Still, take-up has been slow, and Sebi is looking at ways, such as improving settlement procedures and introducing standardised documentation, to enhance the trading platform to gain more traction.

Market players also suggest that state-owned banks, the key investors, should be encouraged to participate more actively in the secondary market for corporate bonds, as is already the case in government securities. Banks buy more government bonds as these can be included in statutory liquidity requirements, while corporate bonds have yet to be included in that calculation.

The government has also been encouraging some big public sector entities to issue bonds under a single ISIN code to help to build a yield curve. Indian issuers, typically, shy away from reopening their existing issues because they fear doing so will bunch up the maturities.

However, more importantly, industry experts say pension funds and insurers need to participate in the bond markets more actively.

Take, for instance, the Employees’ Provident Fund Organisation, the largest investor with an investible corpus of approximately Rs5.46trn. (US$84.9bn). Earlier in the year, EPFO revised its investment mandate to enable it to invest in the debt of 15 private sector companies, up from seven earlier, and in longer tenor paper of up to 25 years.

“The new investment norms for insurance companies enable them to invest a greater proportion of their investments in paper rated below Triple A. They can even invest a certain amount in paper rated below Single A,” said Roopa Kudva, managing director and CEO of Crisil, the local arm of Standard & Poor’s.

These measures, she said, would free up an additional Rs1trn that insurers could deploy in corporate bonds.

While everyone waits for big new institutional investors to come to the corporate bond markets, participation from foreign investors and mutual funds is already growing handsomely.

According to Crisil, foreign investment in India’s bond market increased five-fold from Rs18.95bn in 2008-09 to Rs283.34bn in FY2013. Mutual fund investments in corporate bonds have also almost doubled from Rs1.09trn in March 2009 to Rs1.87trn in May 2013, constituting 22% of their investment portfolios.

Participation from foreign investors has increased as Sebi has not only made the auctioning of corporate debt limits more frequent [monthly] and transparent, but the government has also greatly increased the quotas for foreign institutional investors.

The limit for FIIs in corporate bonds has been hiked to US$51.5bn in June 2013 from US$40bn in August 2011. Withholding tax for FIIs in rupee debt has been reduced to 5% from 20% for bonds with three-year tenors.

“The key issues that remain to be addressed include low trading volumes in the secondary market, concentration of issuers and continued weakness in the securitisation market.”

India’s nascent high-yield bond market is also showing signs of growth. According to Crisil, 200 companies rated below Triple A issued bonds and 55 firms rated below A1+ issued commercial paper during FY13.

“The greatest hurdle to building the sub-investment-grade bond market is the uncertainty on the insolvency regime. We have come a long way from early 2000 to date in terms of Sarfesi Act and other legislation, but this is still far from ideal”, said Atul Joshi, managing director and CEO of India Ratings & Research.

“In the US sub-investment-grade market, 2012 saw a 30-day post-default weighted average recovery rate of approximately 50%. It is similar certainty on timeframe for resolving a default and a trend line of recovery that is necessary to build up a sub-investment-grade high-yield bond market in India. This will simply increase the confidence level of foreign institutional investors.”

Innovation inspires

Despite the heightened volatility in the market since talk of the end to the US monetary stimulus triggered a wave of foreign selling, the Indian market has produced a number of innovative deals.

In May, engineering and construction group Larsen & Toubro issued the first corporate bond linked to inflation.

L&T placed a Rs1bn 10-year linker to a single investor, a local insurance company, on May 14, and paid an annual coupon of 1.65%, plus inflation. The principal increases according to the wholesale price index.

The principal is linked to the moving average of 12 months, with a lag effect of four months, so that revisions in the inflation index are captured.

Not only did the borrower save on cost, but it provided a template for other corporate issuers.

Soon after, in the first week of June, the government issued its own first batch of linkers, ending a gap of 15 years. India sold Rs10bn of linkers at a real yield of 1.44%.

The Reserve Bank of India holds monthly auctions of these 10-year linkers, which form part of a total Rs120bn–Rs150bn related programme for the fiscal year ending March 2014.

In his inaugural statement on September 4, incoming RBI governor Raghuram Rajan also announced that the central bank, together with the government, would issue inflation-indexed savings certificates linked to the CPI New Index to retail investors before end-November 2013.

These offering were followed in June with the country’s first Basel III-compliant bond from state-owned United Bank of India. With AA+ ratings local agencies, the Rs5bn 10-year Tier 2 bond was sold directly to state-insurer Life Insurance Corp of India with a coupon of 8.75%.

Indian banks will have to raise around Rs2trn before March 2018 to meet Tier 2 capital requirements under Basel III, putting pressure on the bond markets to develop new products that can help these lenders meet regulatory requirements.

In July, Mahindra & Mahindra settled a Rs5bn 50-year bond, the longest bullet paper from an Indian corporate issuer. With ratings of AA+ from Crisil and Icra, the bonds pay a coupon of 9.55%.

Earlier in May, the country’s first infrastructure debt fund, India Infradebt, received a Triple A rating for its Rs5bn debenture issue.

Pending agenda

These instruments bring variety to both investors and issuers, but a deeper market requires greater levels of secondary trading and the participation of a more diverse range of investors and issuers.

“The key issues that remain to be addressed include low trading volumes in the secondary market, concentration of issuers and continued weakness in the securitisation market. While annual trading volume in the secondary market increased to Rs7.38trn in FY13, it’s still very low,” said Crisil’s Kudva.

Frequent state-owned issuers, such as the Rural Electrification Corp and Power Finance Corp, still dominate bond volumes. According to Crisil, the top 10 issuers account for almost half of total issuance.

For all the challenges, however, India’s local bond market offers tantalising potential – just as it was true for other debt markets at an earlier stage of development.

“Global experience indicates a tipping point when bond markets take off. For instance, the US bond market limped along for four decades before taking off in the early 1980s. Corporate debt issuance in the US increased sharply from very low levels until the late 1970s to US$129bn in 1986 and, thereafter, rose exponentially to reach US$1.55trn in 2012. Bond markets in Europe saw a tremendous expansion in the 2000s after the single currency was introduced,” Kudva said.

“Only time will tell if what we are witnessing (in rupee bond markets) is truly the stirring of a wakening giant or merely a turning over in continued slumber.

Innovations of necessity