The recent crisis in mutual fund industry has again brought forth the debate on development of corporate bonds market. H.R. Khan’s Report of the Working Group on Development of Corporate Bond Market in India had grouped the aspects related to the development of corporate bond market under 7 “I” framework – Issuers, Investors, Intermediaries, Infrastructure, Incentives, Instruments and Innovations. This article analyses steps that can be taken to increase Investor participation in the market which in turn will increase the liquidity in the market.
A) Foreign Investors:
“When foreign players are not allowed to participate in the local markets, the expertise, risk bearing capacity, and capital they could bring to the market is lost. The volumes they contribute are also lost. Both factors reduce liquidity and efficiency. Indeed, this liquidity can be critical for kick starting a market. For instance, Indian investors have little experience with long-term corporate bonds, while foreign investors have this. The broader participation for foreign investors in that market could allow more attractive debt structures to emerge, greater liquidity, and eventually, more domestic participation also.”
The above extract from CFSR Report aptly explains the value foreign bond investors can bring to Indian markets. Additionally, this capital has much lower correlation to domestic pools of capital thereby providing high levels of diversification to the market. Though FPI participation over the past ten years has increased – the outstanding as on April 30, 2020 was slightly over INR 1.64 lakh crores –it still is less than fifty percent of India’s annual ECB borrowings.
Few changes in regulations can result in increased participation from this important investor class.
- InApril 2018 RBI introduced a regulation prohibiting any FPI from holding more than 50% of any ISIN. The implication of this was borrowers had to find at least one more investor for issuing NCDs to any FPI Investor. This resulted in many foreign investors prefering ECBs over NCDs (considering no such rule exists for ECBs). RBI provided Voluntary Retention Route (VRR) route as an alternative wherein investors could bid for VRR limits and could avail exemption from the regulation of 50% maximum holding per ISIN (and few other regulations) provided it committed to remain invested in India for a minimum tenor of three years. However, the VRR limits are only 40% of the overall FPI limits. Relaxation from this regulation can significantly increase participation of FPIs in NCD market.
- FPIs get a concessional tax rate of 5% if the pricing of NCDs is below SBI’s base rate plus 500 bps (effectively 13.15% as on 1st May 2020). For issuances priced higher than this, the tax rate is 20%. Few changes can be made to the existing framework as provided below:
- Benchmark should be changed to a market driven parameter like G-Sec – Ironically, the ECB regulations are linked to G-Sec while for more liquid NCDs, regulations refer to SBI’s base rate. This anomaly should be corrected.
- Threshold should be substantially increased or alternatively removed – This will significantly expand the issuer base who will be able to tap the bond markets and in parallel increase the participation of foreign investors who have more risk appetite but require higher yields.
Banks in India have traditionally preferred loans over bonds. This is because loans can be carried on the books without being mark-to-market, thus reducing the possibility of unexpected demands on bank capital.The internal organization of the bank also inhibits demand—corporate bond portfolios are managed by the treasury, while loans are managed by credit department thereby creating barriers between the two forms of lending.
In its Nov 2018 circular made it mandatory for “Large Corporates” to raise at least 25% of their borrowings by way of issuance of NCDs. Reserve Bank of India should also mandate wholesale financing above a certain ticket size to be pushed to bond markets. This will force banks to make necessary changes to their internal processes.
The artificial preference of banks for loans should be gradually reduced by subjecting loans and bonds to similar mark-to-market requirements, especially for aspects such as interest rate exposure that are easily measured. This has been a recommendation given by many Financial Reform Committees including the CFSR.
C) Primary Dealers:
Even though Primary Dealers have been allowed to invest in corporate bonds up to a sub-limit of 50 per cent of their net owned funds, their participation in this segment has been limited. Adding high rated corporate bonds to the list of eligible securities while borrowing from RBI will incentivise both banks and primary dealers to invest in the same. This can also give a boost to the Primary Dealer Industry which has been suffering from low ROEs (average ROE for standalone PDs was 5.7% and 5.8% respectively in FY 18 and FY 19) – attacting more players to the industry. This however might require changes to the Reserve Bank of India Act, 1934.
D) Alternate Investment Funds:
Long term capital gains of debt mutual funds are taxed at 20% with indexation benefits while AIF investors are taxed at maximum marginal rate of more than 30%. This taxation arbitrage available to mutual funds have rendered debt focussed AIFs uncompetitive. To compensate for this most of the debt AIFs have been focussing on high-risk high-return segments like real estate and venture debt. Debt AIFs should rather have been deploying the sophisticated capital raised from ultra HNIs, family offices, foreign investors etc in A/BBB/BB rating category exposures. The taxation rate of select categories of debt AIFs should be brought at par with mutual funds – this will ensure that an active market develops for corporate bonds rated A or lower.
The article has covered only investor-focussed reforms. In order for corporate bond market to develop, reforms will be required at multiple levels including market infrastructure, products & issuers as well.