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  • 1. Praxis Business School Indian Bond Market Present Scenario & Future Road Map A report submitted to Prof. Amit Parakh In partial fulfilment of the requirements of the course Fixed Income Securities On 15th October, 2009 By Kaushambi Ghosh (B08012) Nikhil Verma (B08019) Rupesh Agarwal (B08026)
  • 2. INDIAN BOND MARKET Executive Summary We studied the Indian bond market to ensure the following outcomes: 1. Gaining adequate knowledge on the development of bond market 2. Studying the present scenario of the segment 3. Assessing future potential of the same In the pre-independence period restrictions on interest rate long-term loan were very low and so the only kind of bonds that were available was Govt of India securities. In the post independence period realising the need for rapid developments of industrial and need for support to sensitive sectors like agriculture with medium and long term loans govt formed few institutions to mobilise investments to earn interest. Commercial banks were not much into mobilisation of investment since they are aware of the disadvantage of interest regulation plus higher operational cost. Post liberalization of economy cheap capital was available to commercial banks through other means which made such long term lending possible for them and within no time they ate much share of domestic institution since these institution were at a disadvantage of not been able to get cheap capital due to regulations and hence converted them into commercial banks. Since early 2000's trading on exchanges were allowed keeping in mind that 70-80 percent of domestic saving of India is invested in fixed income securities. Till date India Bond markets have had a turnover of one- tenth times that of Equity market in India which ranks third in Asia in terms of turnover compared to U.S. which has one-fifth of the equities market turnover. With the launch of trading of interest rate derivatives this market is going to be bigger and bigger coupled with the above fact since introduction of derivates will allow better risk management mechanism and instruments for investors. There would be an increase in municipal bond market side we have the logic that more than three-fourth of Indian population lives in urban area and it is estimated to increase by almost 8% there is much to be done in urban infrastructure segment to make it at least just sufficient enough to handle the pressure and hence the needs for funds and hence need for municipal bond markets will be there. 2|Page
  • 3. INDIAN BOND MARKET Contents Executive Summary...................................................................................................................... 2 Introduction ................................................................................................................................ 4 Development................................................................................................................................... 4 Debt Market in India ....................................................................................................................... 7 Wholesale Debt Market Growth for past 8 years ........................................................................... 8 Market Segments ................................................................................................................................ 9 Development and Outlook ......................................................................................................... 10 Key Developments ............................................................................................................................ 11 Corporate Bonds ............................................................................................................................... 14 Factors Limiting the Further Development of Corporate Bond Market ........................................... 14 Securitization ............................................................................................................................. 19 Banks and Insurance Companies: Predominant Investors in Securitized Notes .............................. 22 Regulation Hampers Participation .............................................................................................. 24 Measures to Address Bond Market Liquidity.................................................................................... 25 Measures to Develop the Corporate Bond Market .......................................................................... 27 Conclusion ................................................................................................................................. 28 3|Page
  • 4. INDIAN BOND MARKET Introduction Development At the time of its independence in 1947 India had only the traditional commercial banks, all with private sector ownership. Like the typical commercial banks in other parts of the world, the banks in India were also not keen to provide medium and long-term finance to industry and other sectors for their fixed asset formation. The banks were willing to fund basically the working capital requirements of the credit-worthy borrowers on the security of tangible assets. Since the government was keen to stimulate setting up of a wide range of new industrial units as also expansion/diversification of the existing units it decided to encourage setting up of financial intermediaries that provided term finance to projects in industry. Thus, there emerged a well-knit structure of national and state level development financial institutions (DFIs) for meeting requirements of medium and long-term finance of all range of industrial units, from the smallest to the very large ones. Reserve Bank of India (the central banking institution of the country) and Government of India nurtured DFIs through various types of financial incentives and other supportive measures. The main objective of all these measures was to provide much needed long-term finance to the industry, which the then existing commercial banks were not keen to provide because of the fear of asset-liability mismatch. Since deposits with the banks were mainly short/medium term, extending term loans was considered by the banks to be relatively risky. The five-year development plans envisaged rapid growth of domestic industry even in the private sector to support the import substitution growth model adopted by the national planners. To encourage investment in industry, a conscious policy decision was taken that the DFIs should provide term- finance mainly to the private sector at interest rates that were lower than those applicable to working capital or any other short-term loans. In the early years of the post- Independence period, shortages of various commodities tended to make trading in commodities a more profitable proposition than investment in industry, which carried higher risk. Partly to correct this imbalance, the conscious policy design was to increase attractiveness of long-term investment in industry and infrastructure through relatively lower interest rates. To enable term- lending institutions to finance industry at concessional rates, Government and RBI gave them access to low cost funds. They were allowed to issue bonds with government guarantee, given funds through the budget and RBI allocated sizeable part of RBI’s National Industrial Credit (Long Term Operations) funds to Industrial Development Bank of India, the largest DFI of the country. Through an appropriate RBI fiat, the turf of the DFIs was also protected, until recently, by keeping commercial banks away from extending large sized term loans to industrial units. 4|Page
  • 5. INDIAN BOND MARKET Banks were expected to provide small term loans to small-scale industrial units on a priority basis. Regulated Financial System Until almost the middle of the last decade the financial system was highly regulated. Although the DFIs were given freedom to extend term loans to projects, which they considered support-worthy based on their rigorous technical and financial appraisal, their interest rate structure was administratively fixed by the RBI along with the other interest rates in the system. The interest rates charged by the commercial banks were appropriately aligned in such a way that the project loans were relatively lower than the loans extended by banks for such purposes as working capital for industrial and other units. Similarly, the rates that the corporate entities could offer on their bonds were fixed by the Finance Ministry which used to regulate the capital markets until the independent capital market regulator viz., Securities Exchange Board of India (SEBI) was set up about a decade ago. The Finance Ministry, however, used to informally consult RBI before it fixed the interest rates on corporate bonds. Usually the interest rates on bonds and the interest rates of the DFIs were such that the corporate units did not have much attraction to raise funds from the market. There were other factors, which also discouraged corporate sector raising funds directly from the market. The debt-equity norms on bond funds were more rigorous than the ones that the institutions allowed in respect of their term loans. While the Finance Ministry did not permit bond issues of companies that would exceed the debt-equity ratio of 2:1, the institutions used to extend loans that would result in a debt-equity of up to 3:1 in respect of highly capital- intensive projects. Further, for the common investors corporate debt was not attractive in view of the absence of a secondary market for corporate debentures. Another highly discouraging factor was the high level of stamp duty that the state governments levied on secondary market transactions in bonds. On account of all these discouraging factors corporate bond market did not develop and the corporate borrowers preferred to raise funds by approaching term lending institutions. Financial Sector Liberalisation The situation has significantly changed after the financial sector policies were revamped and deregulation was introduced after 1991. The DFIs no longer have the comfort of the protective policy climate in which they operated. They no longer have access to concessional sources of finance like government guaranteed bonds or budgetary support. Now they have to compete with commercial banks, whose cost of funds is way below that of the DFIs. With their extensive branch network the banks have access to low cost deposits. The branch network of DFIs is small and RBI has given them limited access to deposits since the DFIs are not subject to the statutory liquidity ratio and cash reserve ratio as in the case of commercial banks. DFIs are finding it difficult to accept the obligations of SLR and CRR on their entire asset base just to have unfettered access to the deposit market. 5|Page
  • 6. INDIAN BOND MARKET Global competition through more liberal imports has negative impact on the profitability of several industrial units assisted by the DFIs in the past. Hence the DFIs are getting saddled with increasing levels of NPAs. Opening up of the Indian economy to comply with WTO requirements has meant more liberal imports and considerable slow down in 3 fresh domestic investments. This has adversely affected fresh business of the DFIs and the demand for term loans has come down sharply. More liberal industrial policy framework has encouraged mergers, amalgamations, restructuring and rationalisation of production capacities, leading to productivity improvements and consequently less demand for creation of additional capacities in various industries. Greater import availability ensures much wider range of choices (and often better quality), has resulted in declining demand for term finance from industry. The DFIs are increasingly realising that their special role as purveyors of development finance is no longer relevant in the deregulated financial system, which has cut off their access to low cost funds. DFIs are finding it difficult to remain viable by raising funds from the market at market related rates and compete with the commercial which have also started project lending in a big way with the help of the low cost deposit funds. DFIs have also found that they are not in a position to raise long maturity funds from the market and have to remain contented with short and medium term maturity bond funds. They cannot afford to get over-exposed to long gestation projects, as it would lead to serious asset-liability mismatches. DFIs have therefore started diversifying their activities into shorter maturity loans. Some of them are seriously toying with the idea of converting themselves into a commercial bank or have reverse merger with one of the commercial banks. Since the DFIs are increasingly withdrawing themselves form project lending it has become imperative for the government to devise suitable policy frame that will encourage emergence of alternative supply sources of project finance. In view of the current slackness in overall investment activity in the Indian economy the dwindling sources from the traditional suppliers of project finance are not being felt so explicitly. But once the investment climate improves and demand for long term funds picks up alternative sources of term finance to industry and infrastructure need be to found. The best course of action for the government would be to strengthen the capital market and in particular encourage growth of an active bond market. The capital market can be relied upon to play an effective role provided a suitable policy frame for the development of an active and highly liquid nation-wide debt market is put in place. The need for developing a vibrant debt market that also encourages relatively longer maturity instruments suited for financing infrastructure projects has been effectively highlighted by a high powered committee in “The India Infrastructure Report” submitted by it to the Government of India in June 1996. 6|Page
  • 7. INDIAN BOND MARKET Debt Market in India The debt market in India comprises mainly of two segments viz., the Government securities market consisting of Central and State Governments securities, Zero Coupon Bonds (ZCBs), Floating Rate Bonds (FRBs), T-Bills and the corporate securities market consisting of FI bonds, PSU bonds, and Debentures/Corporate bonds. Government securities form the major part of the market in terms of outstanding issues, market capitalization and trading value. It sets a benchmark for the rest of the market. The market for debt derivatives have not yet developed appreciably though a market for OTC derivatives in interest rate products exists. During 2007-08, the government and corporate sector collectively mobilized Rs. 3,722,501 million (US $ 93,132 million) from primary debt market, a rise of 27.24% as compared to the preceding year (Table 6-1). About 68.77% of the resources were raised by the government (Central and State Governments), while the balance amount was mobilized by the corporate sector through public and private placement issues. The turnover in secondary debt market during 2007- 08 aggregated Rs. 56,495,743 million (US $ 1,413,454 million), 57.04% higher than that in the previous year. The share of NSE in total turnover in debt securities witnessed a decline and stood at 5.71% during 2006-07. 7|Page
  • 8. INDIAN BOND MARKET Wholesale Debt Market Growth for past 8 years All trades Retail Trades Avg. No. of Avg. daily Avg. trade daily active No. of Turnover turnover size (Rs. Turnover Turnove No. of Turnover Turnover Share in total Month/Year Securities trades (R. mn.) (Rs. mn.) Mn) (US $ mn) r (US $) trades (R. mn.) (US $) turnover (%) 2000-01 1038 64470 4285815 14830 66.48 91891 318 498 1318 28.26 0.03 2001-02 979 144851 9471912 32775 65.39 194097 672 378 1094 22.42 0.01 2002-03 1123 167778 10687014 35983 63.7 224990 758 1252 2995 63.05 0.03 2003-04 1078 189518 13160962 44765 69.44 303318 1032 1400 3317 76.45 0.03 2004-05 1151 124308 8872936 30283 71.38 202810 692 1278 4101 93.74 0.05 2005-06 897 61891 4755235 17547 76.83 106596 393 892 3104 69.58 0.07 2006-07 762 19575 2191065 8980 111.93 50265 206 399 1015 23.29 0.05 Apr-07 98 928 171587 9031 184.9 4293 226 12 30 0.75 0.02 May-07 145 1093 174835 8326 159.96 4374 208 18 60 1.5 0.03 Jun-07 143 1065 173352 8255 162.77 4337 207 38 60 1.5 0.03 Jul-07 184 2089 338146 15370 161.9 8460 385 9 30 0.75 0.01 Aug-07 128 1230 214305 10205 174.2 5362 255 8 40 1 0.02 Sep-07 148 169024 169024 8451 180.97 4229 211 27 40 1 0.02 Oct-07 147 1411 254932 11588 180.67 6378 290 10 40 1 0.02 Nov-07 110 1083 177039 8430 163.47 4429 211 7 20 0.5 0.01 Dec-07 117 1585 328654 17298 207.4 8223 433 12 40 1 0.01 Jan-08 144 2359 427242 18576 181.11 10689 465 27 70 1.75 0.02 Feb-08 118 1497 240439 11449 160.61 6015 286 7 20 0.5 0.01 Mar-08 148 905 153615 8534 169.7 3843 214 36 40 1 0.03 2007-08 601 16179 2823170 11380 174.5 70632 285 211 490 12.26 0.02 Apr-08 122 1016 198928 9946 195.8 4632 232 6 21 0.49 0.01 May-08 137 1200 206563 10428 172.1 4809 240 3 4 0.09 0 Jun-08 190 956 182334 8683 190.7 4245 202 106 203 4.73 0.11 8|Page
  • 9. INDIAN BOND MARKET April-June 449 3172 587825 29057 558.6 13686 674 115 228 5.31 0.04 CAGR -0.066 -0.15 -0.05 -0.03 0.12 -0.03 -0.013 -0.101 -0.116 -0.099 -0.049 Market Segments The various segments in debt market in India are discussed below: • Government securities form the oldest and most dominant part of the debt market in India. The market for government securities comprises the securities issued by the central government, state governments and state-sponsored entities. In the recent past, local bodies such as municipal corporations have also begun to tap the debt market for funds. The Central Government mobilises funds mainly through issue of dated securities and T- bills, while State Governments rely solely on State Development Loans. The major investors in sovereign papers are banks, insurance companies and financial institutions, which generally do so to meet statutory requirements. • Bonds issued by government-sponsored institutions like DFIs, infrastructure-related institutions and the PSUs, also constitute a major part of the debt market. The gradual withdrawal of budgetary support to PSUs by the government since 1991 has increased their reliance on the bond market for mobilising resources. The preferred mode of raising capital by these institutions has been private placement, barring an occasional public issue. Banks, financial institutions and other corporates have been the major subscribers to these issues. • The Indian corporate sector relies, to a great extent, on raising capital through debt issues, which comprise of bonds and CPs. Of late, most of the bond issues are being placed through the private placement route. These bonds are structured to suit the requirements of investors and the issuers, and include a variety of tailor-made features with respect to interest payments and redemption. Corporate bond market has seen a lot of innovations, including securitised products, corporate bond strips, and a variety of floating rate instruments with floors and caps. In the recent years, there has been an increase in issuance of corporate bonds with embedded put and call options. While some of these securities are traded on the stock exchanges, the secondary market for corporate debt securities is yet to fully develop. • In addition to above, there is another segment, which comprises of short-term paper issued by banks, mostly in the form of certificates of deposit (CDs). This segment is, however, comparatively less dominant. • The Indian debt market also has a large non-securitised, transactions-based segment, where players are able to lend and borrow amongst themselves. This segment comprises of call and notice money markets, inter-bank market for term money, market for inter- 9|Page
  • 10. INDIAN BOND MARKET corporate loans, and market for ready forward deals (repos). Typically, short-term instruments are traded in this segment. • The market for interest rate derivatives like FRAs, IRSs is emerging to enable banks, PDs and FIs to hedge interest rate risks. Development and Outlook The Indian financial system is not well developed and diversified. One major missing element is an active, liquid, and large debt market. In terms of outstanding issued amount, Indian debt market ranks as the third largest in Asia, next only to that of Japan and South Korea. Further, in terms of the primary issues of debt instruments, Indian market is quite large. The government continues to be a large borrower unlike South Korea where the private sector is the main borrower. If we compare the size of the Indian GDP with the outstanding size of the debt flotation, Indian debt market is not very much underdeveloped. The gross domestic savings rate in the Indian economy is reasonably satisfactory at around 23%. According to RBI’s annual studies on savings, about 78% of the aggregate financial savings of the household sector were invested in fixed income assets. The average Indian household has great appetite for debt instruments provided they are packaged properly. The main financial instruments popular with the households are bank deposits, provident funds, insurance, income-oriented mutual funds, and postal savings schemes. However, the share of fixed income instruments that could be traded in the secondary markets is negligible. The main reason for this is the absence of an active secondary market in debt instruments. Investors are not willing to invest in tradable instruments as they lack required liquidity. It is thus a typical case of “chicken and egg problem”. Since there are not enough number of issues and the floating stock in the secondary market is very small there is hardly any trading in them. Currently almost 98% of the secondary market transactions in debt instruments relate to government securities, treasury bills and bonds of public sector companies. The quality of secondary market debt trading is very poor if we compare it with the quality of the secondary market in equities. Debt markets lack the required transparency, liquidity, and depth. With reference to the usual standards or yardsticks of market efficiency the Indian debt markets would not score more than 30% of the marks that the Indian equity markets would score. The US has one of the most active secondary markets in both government and corporate bonds. The trading volume in the US debt market is said to be on an average ten times the size of the equity trading. In India the average daily trading in debt during the last year was about one tenth of the average daily trading in equities. These comparisons bring out the underdeveloped nature of the Indian debt markets. The secondary debt market suffers from 10 | P a g e
  • 11. INDIAN BOND MARKET several infirmities. It is highly non-transparent compared to the equity market. It is highly fragmented since the ownership titles of government securities are fragmented in 14 offices of the RBI, which acts as a depository for the government debt including the treasury bills. A seller from New Delhi cannot trade in Mumbai market since security held in RBI office in New Delhi cannot be easily transferred to Mumbai office of RBI and vice-versa. Since the current small order book stands fragmented city-wise the price discovery process does not throw up the best possible prices. Key Developments Union Budget 2008-09: Finance Minister in his Budget speech of 2008-09 proposed some measures to expand the market for corporate bonds such as: • Take measures to develop the bond, currency and derivatives markets that will include launching exchange-traded currency and interest rate futures and developing a transparent credit derivatives market with appropriate safeguards; • Enhance the tradability of domestic convertible bonds by putting in place a mechanism that will enable investors to separate the embedded equity option from the convertible bond and trade it separately 11 | P a g e
  • 12. INDIAN BOND MARKET  The Finance Minister also announced that supplementing the measures announced in respect of the corporate debt market, it was proposed to exempt from TDS, corporate debt instruments issued in demat form and listed on recognized stock exchanges. The announcement regarding enhancing the tradeability of domestic convertible bonds is yet to be implemented. 12 | P a g e
  • 13. INDIAN BOND MARKET 13 | P a g e
  • 14. INDIAN BOND MARKET Corporate Bonds Factors Limiting the Further Development of Corporate Bond Market In actual fact, although corporate bonds can be issued publicly, most issues in the corporate bond market are not really bonds but private placements, and most issues are not made by corporations. 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). And require much less documentation. The small number of investors makes it relatively easy to renegotiate terms. Typically, for example, a change in interest rates will lead to a renegotiation of the coupon on a placement during the currency of the issue. This makes private placements very flexible. Public issues are rare because of excessive disclosure requirements—new SEBI proposals are designed to simplify the process. Disclosure requirements for public issues are viewed by potential market participants as excessive: • Prospectuses for bond issues are reported to be several hundred pages long. 14 | P a g e
  • 15. INDIAN BOND MARKET • Against international practice, disclosure requirements are identical, irrespective of whether the company is already listed or not. • There is no provision for shelf registration—whereby a program of tranches can be covered by a single prospectus. The issue process is reportedly slow, taking several months, which, with high marketing and other costs, makes public issues very expensive. The slow process also makes issues risky, as the price is fixed throughout the offer period. In contrast, documentation for private placements is minimal, although requirements have been increased in recent years. Placements can be issued quickly with book building and pricing usually completed within a day. In line with recommendations of the Patil report, SEBI has agreed new listing agreements with stock exchanges—in August 2008 they were issued for public comment. Key features include: (i) Companies publicly-listed on an Indian exchange would be required to make only minimal additional disclosures for a public issue or a private placement (ii) Unlisted companies would be required to make more substantial disclosures, though less than those required for an equity issue Private Placement Issues are Small Private placement issues are generally quite small, averaging about USD20 million. Because private placements are quite small, corporate issuers tend to make several separate placements, sometimes on the same day. Because there are a limited number of investors available, the separate issues will all, practically speaking, go to the same lender, usually under similar terms. The result is that many of the “bonds” are actually syndicated loans—as the largest investors for private placements are banks. Corporate bonds are usually issued by the private sector, banks, and public companies. Issuance in 2006–07 was USD35 billion over 1,678 issues. Public entities accounted for 42% of the value and 8% of the number of issues. They were also relatively large, averaging USD107 million. Private financial companies—largely banks raising money for lending purposes— represented 35% of the value and 39% of the volume. Private, nonfinancial corporate issuers represented only 23% of value, but 53% of the volume, indicating an average value of only USD10 million (Figures 16, 17). Private sector and nonfinancial issuers—normally major participants in other corporate bond markets—are only a small proportion corporate bonds in the Indian market, in terms of value. Private placement issues are generally quite small, averaging about USD20 million. Because private placements are quite small, corporate issuers tend to make several separate placements, sometimes on the same day. Because there are a limited number of investors available, the separate issues will all, practically speaking, go to the same lender, usually under similar terms. The result is that many of the “bonds” are actually syndicated loans— 15 | P a g e
  • 16. INDIAN BOND MARKET as the largest investors for private placements are banks. Corporate bonds are usually issued by the private sector, banks, and public companies. Issuance in 2006–07 was USD35 billion over 1,678 issues. Public entities accounted for 42% of the value and 8% of the number of issues. They were also relatively large, averaging USD107 million. Private financial companies—largely banks raising money for lending purposes— represented 35% of the value and 39% of the volume. Private, nonfinancial corporate issuers represented only 23% of value, but 53% of the volume, indicating an average value of only USD10 million (Figures 16, 17). Private sector and nonfinancial issuers—normally major participants in other corporate bond markets—are only a small proportion corporate bonds in the Indian market, in terms of value. 16 | P a g e
  • 17. INDIAN BOND MARKET Corporate demand is limited for genuine bond finance (as opposed to loans disguised as bonds). Traditionally companies have borrowed from banks to meet financing needs. Bank credit continues to dominate corporate funding, accounting for 90% of financial assets, with state-owned banks representing 70%—a declining but still dominant share. The main source of finance for smaller companies is from former “development banks,” which have emerged from state-owned development banks but are now private and profit- oriented. They finance themselves not through deposits—from which they are generally barred—but through debt issues. Development banks are active in the private placement market, borrowing wholesale to lend to smaller corporations. Private placements have dominated debt issuance and banks—even a single bank—will often absorb an entire issue. The decision as to whether to issue a bond or take a loan is determined by tactical, not strategic, factors: • At various times the RBI has prohibited banks from lending at rates below their published lending rate—but the prohibition did not apply to investments in private placements. Therefore, a bank that wanted to offer a very tight rate to a highly rated corporate borrower would present the loan as a bond. • Interest rate expectations may influence the choice—when rates are falling, as they have been for several years, borrowers will prefer a variable rate loan and lenders a fixed-rate bond. 17 | P a g e
  • 18. INDIAN BOND MARKET • Large bank loans are required to pass an internal approval process, usually by the board or a board committee. Private placement investments are not subject to the same scrutiny (or delay), again, giving banks an incentive to grant loans but present them as bonds. • Loans are not subject to stamp duties, whereas bonds are, making loans desirable for tax sensitive borrowers. • Loans may be preferable for banks because they are not marked-to-market—this will change under Basel II rules, which are due to begin implementation in 2008. Bonds not held- to-maturity are marked-to-market. But, in the absence of reliable secondary market prices; there is scope for manipulation and window dressing. Similarly, corporations tend to regard loans and bonds as interchangeable. This occurs to some extent in most markets. But in India there is a strong focus on managing or arbitraging micro features. The level and complexity of stamp duty encourages the arbitrage-based approach to corporate finance so decisions are often tax-driven rather than strategy-driven. There is a stated, but as yet unscheduled, intention to reform the stamp duty, probably by introducing a standard national rate with a maximum rate, as recommended in the Patil report. The distribution of corporate bonds issued by rating indicates that the number of sub- investment grade issues is minimal and the proportion below AA is small—7.5% by value in 2007–08. Only the largest corporations are likely to achieve an AAA rating. Others are thus excluded from the bond market and obliged to rely on bank finance. Recent figures suggest the proportion of lower-rated bonds may be increasing in particular the proportion of sub- investment grade bonds following the SEBI’s relaxing its rules relating to lower-rated bonds. 18 | P a g e
  • 19. INDIAN BOND MARKET Securitization Securitisation is a form of financing involving pooling of financial assets and the issuance of securities that are repaid from the cash flows generated by the assets. It is a financing tool involving creating, combining and recombining categories of assets and securities into new forms. Assets, loans, receivables, etc. from multiple originators and often from more than one seller, are pooled and repackaged, underwritten and sold in the form of asset-backed or other securities. Securitisation allows banks and financial institutions to keep these loans off their balance sheets, thus reducing the need for additional capital; provides them with alternative forms of funding risk transfer and a new investor base. Further, it facilitates better matching of assets and liabilities and the development of the long-term debt market. Funding costs are lowered as a result of movement of investments from less efficient debt markets to more efficient capital markets through the process of securitisation. There is considerable potential in the securities market for the certificates or instruments under securitisation transactions. The development of the securitised debt market is critical for meeting the humungous requirements of the infrastructure sector, particularly housing sector, in the country. In India, the market for securitised debt remains underdeveloped. Despite two major initiatives, namely, the amendment of the National Housing Bank Act, 1987 (NHB Act) in 2000; and enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act), the market has not picked up mainly because of lack of facility of trading on stock exchanges. This is because securitisation transactions under the NHB Act are not covered under the definition of “securities” in the SCR Act. As a result, buyers of securitised financial instruments have few exit options. India began securitization early among Asian markets, with transactions going back to the early 1990s. Growth accelerated from 2000, reaching INR580 billion (USD12.5 billion) in fiscal 2007/08. However, the securitization market has not yet taken off. Volumes tend to be low and asset types limited. Volumes appear to be mainly influenced by tax or regulatory arbitrage considerations rather than by underlying financial factors. The market is also subject to regulatory, legal, and tax uncertainties. Auto loans were the mainstay of the securitization market in the 1990s. Since 2000, residential mortgage backed securities (RMBS) have also contributed to market growth, though RMBS activity has slowed significantly during the last 2 years, as a focus on asset-backed securities (ABS) has claimed the biggest share of the market— in FY2007 accounting for 63%, followed by CDO/CLO at 32%. In 2007/08 there was a further shift toward CDO/CLO issues— representing 54% of the total. Together with ABS (45% of the total) these two asset classes made up 99% of 19 | P a g e
  • 20. INDIAN BOND MARKET securitization volumes. Credit card securitization has been limited, partly because of stamp duty costs, but also because the credit card market in India—while showing rapid growth— remains small. There have also been limited future flow securitizations, such as toll receipts, and some infrastructure financing. Demand for infrastructure financing in India is now recognized and it is expected that securitization of receivables from those projects should expand rapidly. Accordingly, after extensive consultations with major institutional participants and market experts, the Budget 2005- 06 proposed to “amend the definition of ‘securities’ under the SCRA so as to provide a legal framework for trading of securitized debt including mortgage backed debt”. In pursuant to this, the Securities Contracts (Regulation) Amendment Bill, 2005 was introduced in the Lok Sabha in December, 2005 and referred to the Standing Committee on Finance. The Committee submitted its report in May, 2006. Based on recommendations of the Committee, a revised Bill was introduced and passed by the Parliament in May 2007. The Securities Contracts Regulation Amendment Act, 2007, providing for legal framework for trading of securitized debt, was enacted on 28th May, 2007. The amendment, inter alia, provided for: • Including securitization certificates or instruments under the definition of “securities” in clause (h) of section 2 of the SCRA; • A disclosure based regulation for issue of securitized certificates or instruments and the procedure therefore. The objective of the amendment was to provide a trading platform for securitized instruments under the regulatory purview of SEBI. Now that the securitized debt are “securities” under the SCRA, the entire institutional, supervisory and regulatory architecture of securities law is applicable to these instruments also. As the nature of the securitized assets suggests, originators have mainly been banks and nonbank financial institutions. The originators include former development banks that have been privatized and which have become major players in the consumer lending market, and housing finance companies. ICRA estimates the top five originators account for about 80% of issuance. There has also been some securitization of corporate loans, again with substantial credit enhancement. These have included single loan securitizations. The preference for asset-backed securities (ABS) in India mirrors the pattern in Korea and the Philippines. Mortgage-backed securities (MBS), which are more significant in Malaysia and Singapore, have been less significant in India. 20 | P a g e
  • 21. INDIAN BOND MARKET Securitization was generally small in emerging East Asian markets in 2001, amounting to less than 0.2% of GDP, including India. By 2006 a number of the region’s economies—Korea, Malaysia, Philippines, and Singapore—had expanded securitization levels considerably to between 1.5% and 4.0% of GDP). In t Korea, Philippines, and Malaysia, they did this through policies designed to recapitalize the banking sector. In India, reasonable growth brought securitization volumes to roughly 1% of GDP. 21 | P a g e
  • 22. INDIAN BOND MARKET Banks and Insurance Companies: Predominant Investors in Securitized Notes Insurers are subject to restrictive investment mandates, and thus securitized assets are structured to achieve very high ratings and, often, to minimize prepayment risk. To gain these ratings, successful issues require very substantial levels of credit enhancement. Methods of enhancement have included: (i) direct recourse to the originator (often structured as put options); (ii) originator or third-party guarantees; (iii) over-collateralization; (iv) cash collateral and reserves. Until recently, securitizations with subordinated tranches were not offered in India and remain a rarity. This is because there is: (i) little investor demand for such lower-rated notes; (ii) There was no capital penalty for originating banks retaining the first-loss tranche. RBI guidelines have removed the latter reason and the market is now seeing some use of subordinated tranches. 22 | P a g e
  • 23. INDIAN BOND MARKET India currently does not have credit insurance or an active market for credit derivatives, meaning these risk management tools are unavailable for structuring deals and the use of credit default swaps to create synthetic securitizations is impractical. Regulatory responsibility within the securitization market is unclear. But the strong involvement of banks means that the RBI’s regulatory actions will have a significant impact. For example, RBI recently published regulations on the capital provision required for securitizations by banks. These are similar to, but stricter than, Basel II requirements. There are several distinguishing features of India’s securitization market: • As a common law jurisdiction, India does not require specific legislation to permit the formation of special purpose vehicles (SPVs). • This gives considerable flexibility, but at the same time means that many features are left unclear until decided by case law. • For tax reasons, SPVs are set up as single-purpose trusts, rather than corporate entities as is common in other jurisdictions. • Arbitrage considerations are regarded as crucially important and the tax and regulatory environment helps decide whether to securitize, far greater than in other markets. As an example, the recent RBI rules on capital provision led to a number of direct assignment deals (that is, transfers of cash flows but without an SPV) since the new rules specifically applied only to transactions involving an SPV. 23 | P a g e
  • 24. INDIAN BOND MARKET Regulation Hampers Participation Regulatory responsibility in India’s bond markets is fragmented—and there is the perception among market participants that they are also at cross-purposes. Corporate bonds are regulated by SEBI, which is responsible for authorizing the public issue prospectus and for setting standards regarding private placements. It also regulates some of the participants— the brokers (who have all but disappeared from the market) and mutual funds. Other participants are subject to different regulators. Banks and primary dealers are regulated by the RBI, insurance companies (including the Life Insurance Corporation of India) by the Insurance Regulation and Development Agency and provident/pension funds by their own regulator. The bankruptcy system is time-consuming and inefficient, although the law is based on United Kingdom law and, as such, is judged to be reasonably clear. There are, however, (i) Significant political pressures against declaring enterprises insolvent; (ii) Serious delays in the court process—several years are the quoted time for resolution of insolvencies. In practice bankruptcy is hardly an issue in the corporate bond market because (i) Very few issues are rated below AA; (ii) The terms of the private placement (and the small number of investors) mean it is easier to renegotiate terms if necessary, rather than to go through the legal processes for insolvency. Banks, life insurance, and pension funds are required to hold a minimum of 25% of their time deposit liabilities in government securities—the Statutory Liquidity Requirement (SLR). Only holdings in excess of the SLR requirement can be traded and repurchased. Bank holdings have declined as a proportion of total government bond issuance over time as interest rates have fallen and loan demand has risen. However, in absolute terms, 2006 was the first year in which banks’ holdings of government bonds fell. 24 | P a g e
  • 25. INDIAN BOND MARKET Measures to Address Bond Market Liquidity Deep and liquid bond markets provide a safety valve when access to bank credit tightens— by providing an alternative source of financing. To address the lack of bond market liquidity, authorities could: (1) Relax exchange controls on bonds to facilitate investment by foreign investors and broaden the domestic investor base; (2) Ease investment mandates on contractual savings institutions that encourage funds to hold bonds to maturity; (3) Develop exchange and OTC derivatives and swap markets; (4) Consolidate the outstanding stock of government bonds. 1. Relax exchange controls on bonds to facilitate investment by foreign investors and broaden the domestic investor base: The restriction on foreign holdings of bonds is anomalous, in that it is more onerous than the corresponding restrictions on foreign investment in equities, on foreign direct investment, and on foreign investment in derivatives. The potential benefit achieved by allowing more foreign interest—especially trading interest—would encourage greater liquidity and investor diversity in the government bond market. Recently the RBI has repeatedly relaxed the restrictions during 2008 substantially increasing the aggregate holdings permitted for foreign investors. However, indications are that foreign investors have not taken up the allowances of corporate debt available to them. The limitations and distortions in the market have forced some Indian corporate issuers with a global presence who want access to foreign investors have to issue in the Euro market or elsewhere rather than domestically. This contributes to further fragmenting already limited liquidity. 2. Ease investment mandates on contractual savings institutions to hold bonds to maturity: Banks are active traders of government bonds but the SLR limit means that a considerable part of their stock of assets cannot be traded. The result is to reduce the profitability of the banking system. Institutional investors are the main support for 25 | P a g e
  • 26. INDIAN BOND MARKET corporate bond markets in most jurisdictions. Life insurance and pension sector institutions are subject to strict investment mandates, which means their ability to invest in non-government debt instruments is limited. To avoid the risks of a too-rapid easing of investment mandates, relaxation should be controlled and phased. 3. Develop derivatives and swaps markets: Bond market liquidity is not necessarily about trading itself, but in using risk management tools to alter the risk profile of a portfolio. However, tools such as derivatives, bond lending and borrowing, repurchase agreements (repos) and swaps, as well as OTC credit derivatives and credit insurance, are not available in the bond market. Developing derivatives and swap markets is a critical measure for broadening the investor base and for increasing liquidity in both government and corporate bond markets. It is also crucial to funding massive infrastructure investment needs and providing corporations with the tools they need to manage the risks associated with India’s financial globalization. These markets allow a wider dispersal of risk as derivatives and swaps help reduce costs, enhance returns, and allow investors to manage risks with greater certainty and precision. Derivative and swap markets also help address exchange and interest rate risks. The development of these markets needs to be underpinned by improving regulatory, legal, and infrastructure frameworks. Discussions about reintroducing exchange-traded derivatives have focused on the technical aspects. It has been proposed that bond indexes—both corporate and government—be created and futures and options on the same be introduced along the same lines of what has been permitted in equity. The possibility of introducing exchange traded single bond futures and exchange traded credit derivatives is also being explored. In the February 2008 budget speech, the Finance Minister proposed to develop derivative markets by: • launching exchange-traded currency and interest rate futures; • developing a transparent credit derivatives market with appropriate safeguards. However, sentiment in India has been moving against derivative markets—restrictions on commodity derivative markets and recent events in global credit derivative markets will probably reinforce that sentiment. 4. Consolidate the outstanding stock of government bonds: Despite some passive consolidation especially at the long end the government market remains fragmented with many relatively small stocks. There is now a budget provision to finance the consolidation of the outstanding stock of government bonds. RBI should thus move away from its policy of passive consolidation (which has not led to significant improvements in the number and size of issues) to a more active but market-driven 26 | P a g e
  • 27. INDIAN BOND MARKET retirement of small issues, with the aim of creating a limited number of large benchmark issues along the yield curve. Measures to Develop the Corporate Bond Market Reforming stamp duty and disclosure for public offers are additional measures that can help develop the corporate bond market. 1. Reform the stamp duty: The stamp duty is a significant barrier to the development of both the corporate bond and securitization markets. 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). Recently official comments have suggested that individual states have agreed to waive stamp duties but this has yet to be announced as official policy. Rates also vary with the nature of the issuer; and with the nature of the initial purchaser (for example, promissory notes bought by commercial and some other banks are subject to only 0.1% duty, compared with 0.5% if issued to other investors). Interest payments are taxable as income and capital gains are taxable. Plans are being drawn up to ensure a uniform low rate across all states and to cap the maximum amount payable, but the timescale is unclear. 2. Reform disclosure for public offers of corporate bonds: Issuers consider the current process expensive and risky. Existing regulations could be reformed to allow for disclosures that are appropriate for public issues into a largely professional market by entities that are already well-known to the investment community. Regulations could also be changed to allow techniques such as shelf registration. The public issue process is also unduly long to allow for postal submissions—a recent proposal by the RBI to allow online applications might help by shortening the time an issuer is on risk. SEBI proposals, when implemented, should address some of the burdensome nature of issuance by rationalizing disclosure requirements especially for companies already listed. 27 | P a g e
  • 28. INDIAN BOND MARKET Conclusion As markets develop, there is a lot to be learned from sharing experience with other financial centres. While this is widely practiced in equity markets information sharing needs further development in the bond markets. Every capital market has unique features derived from history, culture, and legal structures, but increasingly they also have common features. Equity markets, for example, now almost all follow some version of an electronic order display and execution system. But too often, in learning from others, developing markets try to mimic the more advanced markets of Europe and North America. Structures that suit vast and complex markets in developed countries with greater variety of instruments and investors are less appropriate (or excessively expensive) for less-developed markets. There is thus a strong case for looking to neighbouring emerging markets at similar stages of development for guidance. Doing so may suggest innovative solutions to problems that have been tried successfully in similar markets, provide support for local market innovations based on their success elsewhere, and allow markets to avoid other’s mistakes. India has developed a number of unique features in its bond market—for example its CBLO system and the successful electronic trading platform—which could usefully be studied by its neighbours, many of which suffer from limited repo markets or which have (like India) tried unsuccessfully to move bonds on to electronic platforms. At the same time, in the development of its corporate bond market, India can no doubt learn from its neighbours’ disclosure policies, bankruptcy processes, consolidation of government benchmark issues, and regulatory structures. Bond market associations are also less well-developed than their equity market counterparts, which benefit from international gatherings and regional associations like the World Federation of Exchanges. The Asian Bond Markets Initiative could play an instrumental role in helping address this shortfall. 28 | P a g e