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Developing the Indian Bond Market- The Way Ahead

Posted in Finance Articles, Total Reads: 4235 , Published on October 24, 2011

Bond Markets or Fixed Income markets, based on the simple concept of time value of money and interest has evolved as one of the most innovative and dynamic financial instruments that has steered the growth and development of most economies. Nevertheless it has also been one of major cause of concern for some of the European countries like cash-strapped Greece that risks default and Italy that is struggling to implement necessary austerity measures and cut debt.


There are two primary types of bond markets – Government bond markets which are liquid, deep, and broad-based market necessary to facilitate optimal government borrowing and Corporate Bond market which is an alternative to the banking finance

Government Bond Market

In case of Government bond market, it is well capitalised, we have state of the art issuance process,  sound depository system , sufficient availability of instruments and Processes , efficient price-discovery mechanism and it is closely intertwined with the monetary and fiscal policies of the Government and. All said and done, the Government bond market is not free of limitations. It is plagued with illiquidity due to Held-Till-Maturity regime for SLR securities, skewed investor base, lack of retail investors and absence of term money market among several others.

Corporate Bond Market

India’s corporate bond market with $200 Bn is one-third the size of Chinese Corporate Bond Market at $614 Bn according to Asian Development Bank Figures. Apart from being small in size, there have been too few public issuances beleaguered with liquidity, mostly because they don’t give proper exit options which dissuade the investor from investing in corporate bond market. Also it is characterised with risk of volatility, manipulation by corporates and unreliable price discovery. Nonetheless, it has increased regulatory focus, availability of the Dematerialised holding option and repo facility, with Secondary market activity on the rise to contain some of the issues cited earlier.

Regulatory changes related to Bond market

Until the middle of last decade, interest rates on corporate bonds were fixed by finance ministry after consulting RBI and they also didn’t allow firms with debt-equity ratio of more than 2:1 to issue corporate bonds although they were allowed to raise loans; not to forget the high level of stamp duty that was charged on the secondary market transactions in corporate bonds. We have overcome all these regulatory restrictions that prevented the development of the bond market and have come a long way since then. But we are still a lot behind the developed economies with efficient bond markets. Below are a few initiatives taken by the Government in this regard.

Government is encouraging bond buyers by introducing a 20,000-rupee tax exemption for investors buying bonds to support infrastructure projects.

Low liquidity in the bond markets is also caused due to numerous variants of bonds with no benchmark for comparison amongst the investor groups. To resolve this issue, around Mar 2010, The Indian and Asian associations of debt market participants came together to bring about standardisation of all corporate bonds which would in turn lower the costs for companies raising debt and also attract the investors.

The FII limit in the bond market has been increased to US$30 billion early this year with FII inflows into the Indian market being approximately US$9 billion (Year-to-Date) as against US$1 billion in 2009. This has had little impact with a lot of uncertainty prevailing in the market (Downgrade of two French banks recently, Euro zone crisis and US debt crisis), FII’s seen investing a measly $650 Mn in the bond markets in August 2011 as against equity markets where they were the net sellers.

Implications of developing Bond Market on the economy

Bond market brings certainty as it provides a lot of stability to the companies issuing them. Especially when the Government plans on increasing the infrastructure with massive investments of around $ 1 Trillion in the span of next 5 years, we need to develop our bond market. Infrastructure projects have long gestation periods of atleast 15 years and bankers are reluctant to lend for such long periods and even if they are, they shall lend at very high interest rates raising the cost of the projects impacting the projects payback period and NAV calculations. Also considering that banks only lend 70% of its total deposit due to reserve requirements and 40% mandatory lending to priority sectors, it is imperative for the Government to encourage private participation and develop the bond market. The Union Budget FY2011-12 would have a significant impact on fixed income markets in 2011. Several factors such as the borrowing calendar of the government along with the fiscal deficit roadmap and the disinvestment plans for 2012 will be the crucial factors that would decide the movement of bond yields.

Challenges facing the Bond Market

Bond markets are confronted with high inflation, Corporate Governance issues, foreign currency convertibility issues; the Indian Rupee bond markets shall not find many takers amongst the foreign investor community in the current times with the increased investor interest in Chinese bonds due to strengthening of Yuan against Dollar. Also with migration to IFRS there shall be implications for valuation and recognition of P & L.

Lastly 11 rate hikes in the last 1 year by RBI have impacted the bond market severely and can be seen in the growth of the credit market which has declined from 18% last year to 15% in this year. Yet another rate hike of 25 basis points can be expected in the near future.

The way forward

In order to improve retail participation in Government bonds it can be marketed as yet another investment product that earn stable and good returns in these uncertain economic times as against a  mandated tax-savings product.

With inflation hovering around 9%, Government can introduce inflation indexed bonds and such other new products like interest rate options to suit diverse investor interest. In order to increase investor confidence, it is imperative for the banks to provide bank guarantee on such issues of corporate debt.

Also caps on foreign investors (pension companies and foreign insurance companies) operating in India should be softened. Also with increased FII participation in bond market the load on domestic investors shall be lifted and would free domestic resources.

The investor base can be widened by fine-tuning the delivery channels so that they have direct access to issuance in the primary market, by fine-tuning the trading infrastructure to gauge direct access to secondary market and lastly by active and concerted market making by banks.

Lastly the post tax bond interest rates have come down and with over 56% of the Emerging market bond issuance categorised in the investment grade, there is a large scope for developing the Indian bond markets especially now with the dwindling interest from developed markets to developing markets.

This article has been authored by Asmita Karanje from SIBM Bangalore

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