Indian Corporate Bond Market- Challenges & Way Forward
Posted in Finance Articles, Total Reads: 3780
, Published on 23 September 2012
India is a bank-dominated market and the relative importance of bank assets as a percentage of GDP has continued to grow—partly as banking penetration has deepened with financial liberalization, and partly as a result of the ongoing need for deficit financing. The Indian bond market is, however, less well-developed. While having seen rapid development and growth in size in the government bond market, the corporate bond market remains restricted in regards to participants, largely arbitrage-driven (as opposed to driven by strategic needs of issuers) and also highly illiquid.The article will analyze the challenges faced by corporate bond market and suggest reforms for the same.
Indian Debt Market
Let us compare the debt market of India with other countries.
Source: RBI (as on Dec, 2011)
Indian Debt Market is only 34% of GDP which is very less compared to other nations. India’s government bond market has grown steadily—largely due to the need to finance the fiscal deficit—and is comparable to many government bond markets in the world with around 30% of GDP. The major investors in G-Sec are Commercial Banks and Insurance companies. But the corporate bond market is relatively underdeveloped with only 4% of GDP.The presence of corporate bond market in India is barely perceptible as compared to other economies.
Need for Corporate Bond Market?
The role of a healthy corporate debt market as a channel that links society’s savings into investment opportunities is of vital importance for several reasons. For the issuer it provides low cost funds by bypassing the intermediary role of a bank. Presence of bond funds gives the corporations an alternative means of raising debt capital and thus ameliorates any potential adverse effect that a bank credit crunch may have on the economy. For the investor, there exists a yield premium opportunity in comparison to traditional deposits at banking institutions.
WhyIndian Corporate Bond Market Lags?
Now that we have established there is a need for a vibrant and liquid corporate bond market in India. Let us analyze the reasons that impede its growth.Major factors inhibiting its development are:
Regulatory restriction on institutional investors
They are prevented from investing in unrated debt instrument.
They are also restricted to invest only 10% of their total non - SLR investments in unlisted debt papers.
Further only investment grade securities are eligible for subscription by banks. This prevents banks from investing in bonds of lower rated.
2. Insurance Companies and Pension Funds: Internationally institutional investors like insurance companies and pension funds play an important role in the corporate bond market as the investment time horizon for these institutional investors and the bonds are long. In India, the involvement of insurance companies in corporate debt market so far has been limited. Insurance companies and pension funds have huge potential to play a bigger role and contribute to the sophistication and deepening of the bond market in India.
3. Chicken And Egg Problem: There is a lack of supply of suitable long term bonds which suit the need of insurance and pension firms. Also there is lack of demand due to regulatory restrictions on investment in corporate bonds.
Non Uniform stamp duty: Stamp duties are typically 0.375% for debentures and, as they are strictly ad-valorem, there is no volume discount. The rate of duty varies depending upon location (various states have set their own rates). Currently, if the bond is being sold in one (state) jurisdiction, but the asset has to be securitized in another, then the stamp duty as applicable in the latter is levied.
Majority Issues being Private Placements and not Public Issues: Public issues are bonds offered to a wide range of investors and which conform to the regulatory standards required of public issues of bonds. They require a prospectus approved by SEBI, and have to be open at a fixed price for a month to allow investors particularly retail investors to subscribe. Private placements can be made to a maximum of 50 “Qualified Institutional Buyers” (professional investors).
SEBI in its Annual Report 2010-11 said“Although the year has seen a number of public issues, private placements have also remained as one of the preferred modes of raising debt funds. The rise in funds mobilized could also be possibly attributed to issuers preferring the domestic debt markets as a primary source of corporate debt. The issuers raised an amount of 2,18,785crore by way of private placement during 2010-11 as compared to 2,12,635 crore in 2009-10.”
TDS in Corporate Bonds: In case of corporate bonds, TDS is deducted at source for resident and on non-resident investors as per prevalent tax laws.
Absence of sub-investment grade securities:In developed markets like USA, UK, Japan there is a vibrant market for sub investment grade securities. While in India regulatory restrictions prevent institutional investors from investing in such securities. This limits issuance of lower rated bonds.
Low Retail Participation:Indian retail investors have not shown interest in the corporate bond market. This may be due an illiquid secondary market and the low confidence (low risk appetite) in the corporate world. Retail investors prefer PF and Post Office schemes and other alternate investment avenues. Less investor knowledge and awareness about such products may be one of the reasons for their low participation.
Absence of Market Makers: There is a need for general market for corporate bonds to be developed for the market participants. Market Makers can address the issues of price discovery and liquidity in the corporate debt segment.
How it can be improved?
There is a need for developing an efficient and vibrant corporate bond market. To meet the needs of firms and investors, the bond market must therefore evolve. The policy recommendations should focus on designing a self-sustaining ecosystem for investors, issuers and market makers.
The following reforms are recommended:
Life Insurance Co.’s: Minimum investment required in respect of approved securities (GOI, State Government & Securities granted by either GOI or State Government) should be reduced. Minimum investment requirement should be investment grade only i.e. BBB –which is followed in United Kingdom. IRDA (Insurance Regulatory And Development Authority) should allow insurance funds to trade in Govt. securities (currently they are required to hold until maturity) to improve liquidity and depth to secondary bond market.
Pension Firms: In order to accelerate the flow of pension funds into infrastructure, Upper limit for investment in Government securities or Government guaranteed securities or gilt funds be reduced. PFRDA should allow pension funds to trade in Govt. securities (currently they are required to hold until maturity) to improve liquidity and depth to secondary bond market.
Foreign Institutional Investors: Income Tax Department, Ministry of Finance should do away with or decrease withholding tax rate to encourage investments in bonds. Same has been done to attract off-shore funds into IDF (Infrastructure Debt Funds) by reducing withholding tax on interest payments on the borrowings from 20% to 5%. Republic of Korea had also scrapped this tax leading to threefold increase in FII investment.
Rationalizing Stamp Duty: There should be a uniform low rate across all states and that the maximum amount payable should be capped. Fix stamp duties based on tenor and issuance value to encourage public offerings of corporate debt. Department of Revenue (DOR) and State Govts need to act on it.
Removal of TDS on Corporate Bonds: TDS was viewed as a major impediment to the development of the Government securities market and was abolished when the RBI pointed out to the Government how TDS was making Government securities trading inefficient and cumbersome. Same could be done for corporate bonds as also been suggested by CII.
Creation of Market Makers in Corporate Bond Market: There is a need to set up institutions that will perform the function of buying/ selling bonds. (By creating a network of dealers which provide two-way quotes). As India already has an established system of Primary Dealers, it should utilize the same for good corporate bond. Dr. C. Rangarajan, Chairman PMEAC has also suggested that there is need to set up dedicated institutions like DFHI and Securities Trading Corporation for the purpose of development of corporate bond market.
Risk Mitigation Steps: To address the risks associated with investment in corporate bonds, GOI had introduced CDS (Credit Default Swaps), IRF (Interest Rate Futures) and Repos on corporate bonds but they have not taken off. Initiatives should be taken to popularize these instruments.
A vibrant bond market can ease financing constraints both in terms of cost of funds as well as ease of access to funds. Considering the size of Indian market, India’s proportion of corporate bonds is insignificant. Policy and regulatory measures need to be taken to increase the breadth and depth of corporate bond market in India. Measures need to be taken for domestic insurance and pension firms and Foreign Institutional investors to invest in corporate bonds. There should be uniformity in the stamp duty levied across the states.
Initiatives should be taken to encourage public issues and not private placements.Risk management tools like Interest rate Futures, Credit Default Swap and Repo in Corporate bonds should be popularized. A liquid corporate bond market can play a critical role in supporting economic development as it supplements the banking system to meet the requirements of the corporate sector for long-term capital investment and asset creation.