3 0 / 1 1 / 0 8 4.625 1 5 / 1 1 / 0 9 9 9 - 2 6 + / 4 . 7 2 -58.82 4.625 3 0 / 1 1 / 1 1 9 9 - 3 1 1 / 4/ 4 . 6 3 39197 -85.71 4.5 1 5 / 1 1 / 1 6 9 9 - 1 9 / 4 . 5 9 -0-111/2/.082 4.625 1 5 / 0 2 / 3 6 1 0 0 - 0 1 + / 4 . 6 2 -0-18+/.072 4.5 3 0 / 1 1 / 0 8 9 5 - 2 8 + / 4 . 7 6 -43.25 4.625 1 5 / 1 1 / 0 9 9 9 - 2 6 + / 4 . 7 2 -58.82 4.625 3 0 / 1 1 / 1 1 9 9 - 3 1 1 / 4/ 4 . 6 3 -85.71 4.5 1 5 / 1 1 / 1 6 9 9 - 1 9 / 4 . 5 9 -0-111/2/.082 4.625 1 5 / 0 2 / 3 6 1 0 0 - 0 1 + / 4 . 6 2 -0-18+/.072 4.5 3 0 / 1 1 / 0 8 9 5 - 2 8 + / 4 . 7 6 -43.25 4.625 1 5 / 1 1 / 0 9 9 9 - 2 6 + / 4 . 7 2 -58.82 4.625 3 0 / 1 1 / 1 1 9 9 - 3 1 1 / 4/ 4 . 6 3 -85.71 4.5 1 5 / 1 1 / 1 6 9 9 - 1 9 / 4 . 5 9 -0-111/2/.082 4.625 1 5 / 0 2 / 3 6 1 0 0 - 0 1 + / 4 . 6 2 -0-18+/.072 9 5 - 2 8 + / 4 . 7 6 4.5 -43.25 Developing India's Corporate Bond Market Finance and Private Sector Development Unit South Asia Region December 2006 The World Bank Developing India's Corporate Bond Market Finance and Private Sector Development Unit South Asia Region December 2006 The World Bank Acknowledgements T his note was prepared by a team consisting of Varsha Marathe (Finance and Private Sector Development, South Asia Region, World Bank), and Christopher Juan Costain (now in Finance and Private Sector Development, Africa Region, World Bank). Li Lian Ong and Pipat Luengnaruemitchai (both from the International Capital Markets Department, International Monetary Fund) provided important inputs and contributions on the international experience. The report benefited from a background note on selected issues in the corporate debt market in India prepared by Susan Thomas and Renuka Sane. The peer reviewers were Anjali Kumar (Financial and Private Sector Development), Anita George, Nicholas Vickery (both from the International Financial Corporation), and Nachiket Mor, Neeraj Gambhir (both from ICICI Bank). The report was prepared under the overall guidance of Sadiq Ahmed (Director, Finance and Private Sector Unit and Poverty Reduction and Economic Management, South Asia Region), Barbara Kafka (Director, Operational and Quality Services), Joe Pernia (former Director, Finance and Private Sector Unit, South Asia Region), Simon Bell (Manager, Finance and Private Sector Unit, South Asia Region) and Priya Basu (Lead Economist, Finance and Private Sector Unit, South Asia Region). The team would also like to acknowledge the inputs and encouragement of the Capital Markets Division, Ministry of Finance in finalizing this note. The team also received helpful comments and inputs from Clemente Luis Del Valle, (Financial and Private Sector Development), P. S. Srinivas (East Asia Finance and Private Sector Unit),Tom Glaessner, Claire Grose, and Thordur Jonasson. Heather Fernandes and Maria Marjorie-Espiritu (Finance and Private Sector Development, South Asia Region, World Bank) designed the report and provided administrative support. Bruce Ross-Larson and his team from Communications Development Inc. edited the report. Currency equivalents As of November 2005, US$1 = Rs. 45.26 Contents Executive summary ............................................................................................................ vii 1. Why does India need a corporate bond market?............................................................1 The size and depth of the debt market................................................................................................... 1 Patterns in emerging market countries...................................................................................................1 Patterns in mature market countries......................................................................................................2 The importance of a corporate bond market ............................................................................................3 India's model of industrial financing......................................................................................................3 India's sources of corporate finance........................................................................................................4 Pressures for change .................................................................................................................................6 A changing, competitive financial sector................................................................................................6 New legislation affecting the debt market..............................................................................................7 New opportunities for financing overseas ..............................................................................................7 Huge infrastructure financing needs......................................................................................................8 Conclusion............................................................................................................................................ 8 2. What is holding back the supply and demand? ...........................................................11 The supply of corporate bonds ............................................................................................................ 11 Government dominance in primary issuance.......................................................................................11 The nonexistent market for high-yield issuance ...................................................................................12 The drivers of demand............................................................................................................................13 High household savings but low retail participation ............................................................................13 Growth of assets with institutional investors........................................................................................13 The obstacles to institutional investing ..................................................................................................14 Banks ..............................................................................................................................................14 Insurance companies...........................................................................................................................16 Pension and provident funds...............................................................................................................17 Mutual funds ......................................................................................................................................20 Foreign institutional investors .............................................................................................................20 Conclusion.......................................................................................................................................... 21 3. What is holding back the development of the market?................................................23 Long and costly issuance process ......................................................................................................... 23 Lack of innovative debt instruments.................................................................................................... 25 Markets for risk sharing ­ securitization and derivatives ......................................................................26 Securitization ......................................................................................................................................26 Credit enhancement............................................................................................................................28 Derivatives ..........................................................................................................................................28 Inadequate secondary market infrastructure........................................................................................ 29 Exchange traded versus over-the-counter systems ................................................................................29 Trade reporting platform.....................................................................................................................31 Clearing and settlement system ...........................................................................................................32 Gaps and overlaps in the legal and regulatory framework .................................................................... 32 Regulatory jurisdiction and coordination ............................................................................................32 Overlap due to `definitions' of terms in the legal and regulatory framework.........................................33 Creditors' rights ..................................................................................................................................34 Provisions of the Companies Act.........................................................................................................34 Taxation..............................................................................................................................................35 4. What does India need to do to develop its corporate bond market?.............................37 Recommended regulatory reforms....................................................................................................... 37 Better access for issuers........................................................................................................................37 Better opportunities for investors ........................................................................................................38 Better regulatory practices ...................................................................................................................39 Recommended market reforms............................................................................................................ 40 Better corporate credit and trade information......................................................................................40 Better market infrastructure ................................................................................................................40 Better choice of products.....................................................................................................................41 Better homogeneity in corporate bond securities.................................................................................41 Conclusion.......................................................................................................................................... 42 Annexes 1. Recommended reforms, by responsible agency........................................................................................43 2. Key reforms and outstanding issues in the government securities markets ...............................................47 3. Statistics on issuers in primary markets....................................................................................................49 4. Restrictive investment policies and guidelines for insurance and pensions ...............................................51 5. Use of financial instruments to increase liquidity.....................................................................................53 6. Report of the High Level Expert Committee on Corporate Bonds and Securitization .............................55 References .....................................................................................................................57 List of Figures, Tables, Boxes and Annex Tables Figures 1.1 Size and composition of outstanding domestic debt markets in selected emerging developing countries, 2004...............................................................................................................................3 1.2 Resource mobilization by the Indian corporate sector, 1970­75 to 1990­95 ....................................................4 1.3 Sources of funds for Indian corporations, 1985­2002 ......................................................................................5 1.4 Debt-equity ratios by sector, 1988­2004 ..........................................................................................................6 1.5 Overseas issuance of equity and debt by Indian corporations, 1992­93 to 2005­2006 US dollars (millions).........................................................................................................................................7 2.1 Investments of life insurance companies, 2004 ...............................................................................................17 3.1 Public and private sector bond issuance through private placements (2001­2006)..........................................25 3.2 Issuance size and number of deals in the securitization market, 2000­06........................................................27 3.3 Securitization in the Indian market, by type, 2002­06 ...................................................................................28 Tables 1 Summary of recommended regulatory and market reform measures ................................................................xi 1.1 Financial depth and share of corporate bond market in India and selected emerging market countries, 2004.....................................................................................................................................1 2.1 Resources raised in the primary markets in India, 1995­2006 ........................................................................12 2.2 Credit ratings for bonds issued by public sector agencies in 2005 ...................................................................13 2.3 Retail participation in Indian debt markets, 2003­06.....................................................................................13 2.4 Assets under management of local institutional investors in India and selected emerging market countries, 2004...................................................................................................................................14 2.5 Investments of scheduled commercial banks, 1997­2006...............................................................................15 2.6 Distortions between the treatment of bonds and loans in bank regulations.....................................................16 2.7 Net investments by foreign institutional investors, 1997­98 to 2005­06........................................................20 3.1 Costs for an issuance of Rs. 1 billion through private placement, 2005 ..........................................................24 3.2 Securitization issuance in India and selected emerging markets, 2001­04 (US$ millions)...............................26 3.3 Turnover in secondary markets .......................................................................................................................30 3.4 Business growth in trades reported at the National Stock Exchanges Wholesale Debt Market.........................30 Boxes 2.1 International experience on regulating investments by pension funds .............................................................18 2.2 International experience with encouraging foreign investment in corporate bond markets..............................19 3.1 International experience with auction systems for bond primary market issuance: experience in Latin America............................................................................................................................23 3.2 International experience on better dissemination of trading information ........................................................31 3.3 Examples of regulatory overlap in the debt market..........................................................................................33 Annex Tables A2.1 Dimensions of the Indian government securities market, 1992­2005.............................................................47 A2.2 Interest rates on various savings instruments end-March 2005........................................................................48 A3.1 Issuers in India and typical issue characteristics...............................................................................................49 A3.2 Selected indicators of debt markets in India, 2002­06....................................................................................49 A3.3 List of top 25 issuers in the year 2005­2006...................................................................................................50 A3.4 Resources raised by banks through private placement (2003­2006)................................................................50 A4.1 Investment guidelines for life insurance companies.........................................................................................51 A4.2 Investment guideline for non-life insurance companies...................................................................................51 Executive summary A well-developed corporate bond market is Why does India need a corporate essential for the efficiency and stability of a country's financial system and the overall bond market? growth of its economy. Issuers and investors' access Corporate bond markets form a crucial part of a to the market provides for financial diversification diversified financial system that ensures efficient and facilitates necessary financing, which benefits allocation of resources. When many emerging not only AAA-rated corporations but also less well markets suffered a sudden outflow of capital in the known, sub­investment grade corporations and late 1990s, one painful lesson was that their financial infrastructure developers. This note examines the systems had relied too heavily on bank lending and state of India's corporate bond market, identifies paid little attention to developing other forms of constraints that inhibit its size and depth, and finance. It has often been argued that, if corporations suggests reform measures that India needs to in Indonesia and Korea had relied more on domestic take to develop its market into a competitive corporate bond markets and less on bank financing, source of financing for a wide range of issuers the magnitude of losses from the banking and and an attractive investment for a wide range of financial crisis of the mid 1990s would have been less investors. Recommendations are based not only on severe. Thus, the corporate bond market has a role an assessment of conditions in India, but also on as an alternative funding source for corporations, relevant international experience. which could act as a buffer in the face of sudden interruptions in bank credit or international capital The corporate bond market in India, with its flows. Policymakers in East Asia have started to pay volume of outstanding debt amounting to 5 attention to developing a local bond market and these percent of gross domestic product, remains efforts have begun to pay-off. underdeveloped compared with other emerging markets that have similar depth in their financial Corporate bond markets play a critical role for sectors. A comparison of the size and composition companies in accessing the long-term financing of the domestic debt market in India and seven needed for growth. The development of a corporate other prominent emerging market countries puts bond market is particularly important, given that India ahead of only Mexico in the size of its Indian corporations today no longer have access corporate bond market. At the end of 2004, the to long-term funding from development financial corporate bond market was 38 percent of GDP in institutions, and banks are more inclined toward Malaysia, 21 percent in Korea, and 11 percent in retail lending, where the risks are much lower. Chile. Furthermore, India's corporate bond market Furthermore, the banks' willingness to make long- represents less than a third of the debt stock on term loans is also limited by the asset-liability issue and mainly comprises issuances with maturity mismatch on their balance sheets. Since a large fiscal of less than five years. Banks, financial institutions, deficit is likely in the near foreseeable future, there public sector undertakings, and state government­ is little flexibility left for banks to provide long term guaranteed instruments dominate most of the funding for infrastructure, industry and agriculture issuance in the corporate bond market. sectors (Mohan, R., 2004b). viii Corporate Bond Market Report Today, companies wanting to borrow long term in local some others, the collapse of other sources of funding led currency to finance expensive investments are faced with to a rise in the issuance of corporate bonds. The principal a dearth of adequate institutional sources. The absence issues on the supply side in India are the dominance of a deep and liquid corporate bond market at the longer of government-owned entities as the primary issuers end of the maturity spectrum causes corporations either of bonds, lengthy and costly primary issuance process togoforrollingshortermaturityborrowings,whichtend and the absence of high-yield issuances in the current to be more expensive, or to go for foreign borrowings, market. The principal issues on the demand side of which pose exchange-rate risks. The growing reliance on the Indian corporate bond market,are lack of a diverse overseas borrowing is already becoming evident with the pool of institutional investors despite the recent rapid increased external commercial borrowings and foreign growth of assets under the management of institutional issuance of bonds by Indian firms. Interestingly, there investors. In part this is due to restricted investment are indications that many lower-rated corporations have guidelines of institutional investors and policy issues also accessed foreign debt in the past two years through related to opening up the pensions sector and allowing the issuance of foreign currency convertible bonds, greater foreign investment in the bond markets. indicating that offshore markets have a greater capacity to finance Indian firms across the credit spectrum as Supply-side constraints compared to the domestic bond markets. Development of an active local corporate bond market would allow The lack of size and depth in India's corporate bond firms to issue debt securities that match the timing and market is associated partly with the lack of depth in the currency of their cashflows better. This would reduce government bond market and the absence of a yield the corporations' costs and vulnerabilities associated curve for government bonds, which could serve as a with balance sheet mismatches and exchange rate risks. benchmark for corporate bonds. India's corporate bond market is also constrained by cumbersome primary Corporate bond markets are a principal vehicle issuance guidelines. Primary market issuance processes for corporations to raise long-term financing for and costs are important factors in the decision of a infrastructure to support economic growth. The corporation to access the corporate bond market. Most growing need for investment in infrastructure and of the bond issuance in India has moved to the private the huge financing gap that already exists imply that placement market, because it affords corporations quick private funding will have to play a significant role. As access to funds at fairly low cost. Recently, regulators infrastructure policy and regulatory frameworks emerge have tried to improve transparency and disclosures in and reforms advance, a better-developed financial the private placement market through requiring listing system, particularly a long-term domestic bond market, of privately placed securities on the exchanges in order canaccelerateaccesstofinancebyinfrastructureprojects. for these to be eligible securities for the institutional If the financial system fails to develop rapidly enough, it investors. However, this has resulted in taking away the will not be able to respond quickly to changing financial advantages of private placement avenues for issuers as requirements, especially for long-term financing, and these securities have now to be listed. Further problems it is likely to slow down reform in infrastructure and remain in streamlining the disclosure requirements economic growth overall. for private placements to the needs of fixed income instruments--making it burdensome for first-time What is holding back the supply issuers and unlisted firms. A related problem is the and demand? nondevelopment of a market for sub­investment grade paper and high-yield securities. India has a strong equity Demand and supply issues have fueled the growth of culture that places onerous demands of market discipline corporate bond markets in many countries. In some (such as requirements for disclosures and corporate countries, such as Chile, the growth of institutional governance) on corporations of all credit qualities. investors fueled demand for corporate debt securities. In Given this culture, the nonexistence of a market for Executive Summary ix high-yield bond issuance is surprising. In comparison, availability of derivative products, which would allow in developed markets, such as the United States, Japan, investors to mitigate credit and interest rate risk. In and the Euro area, the market for sub­investment grade part, the lack of derivative instruments due to regulatory paper is growing rapidly. Deepening of the issuer class restrictions has meant that there is no effective market across the credit spectrum will provide lower-rated for credit risk in India. Enhancements, and the greater borrowers better access to formal finance and lead to a use of derivative products, would broaden market well-diversified financial system. access, as these would enable lower-rated corporations and infrastructure sponsors to tap investments from Demand-side constraints institutional investors. On the demand side, the absence of sufficiently developed What is holding back the long-term investors is a major impediment. While the volume of assets under management of institutional development of the market? investors is growing, institutional investors in the The microstructure of primary and secondary markets debt market are found to be "too restricted" or for corporate bonds--such as issuance methods, trading "homogeneous." They mainly hold "safe" paper, such as mechanisms, dissemination of transaction information, government securities, government-guaranteed paper, and the role of intermediaries--critically affect market and highly rated corporate paper. Banks, insurance development. In India, the crucial issues involved in companies, and pension and provident funds are all developing the corporate bond market are facilitating constrained by regulatory and investment guidelines speedy and cost-effective primary issuances without that require a large portion funds to be invested compromising transparency and disclosure, elongating in government securities. They are allowed little the maturity of corporate bond issuances, and flexibility to invest in nongovernmental, private sector improving the liquidity in secondary markets. Moreover, corporations, particularly lower-rated corporations. because the corporate bond market functions within Existing restrictions have discouraged mutual funds a larger legal and regulatory framework, developing from holding lower-rated, relatively illiquid bonds, as the market requires developing that framework as fund managers are unwilling to invest in instruments well, by clarifying administrative responsibilities and that may have to be redeemed at any time. Foreign improving coordination among the various oversight institutional investors have the risk appetite to invest in authorities, by facilitating aggregation and disclosure bonds across the credit spectrum. However, investment of information about transactions, and by modernizing caps on their debt investments in the country deter laws on creditors' rights, bankruptcy, and corporate them from holding larger portfolios. Internationally, governance. particularly in mature markets, pension funds and insurance companies have greater flexibility to manage Market microstructure issues their portfolios and do not have explicit ceilings on debt securities in which these funds can invest. Their The microstructure of a viable corporate bond market investments also include foreign assets. provides trading platforms that allow efficient price discovery, efficient clearing and settlement mechanisms, Current restrictions on investors' bond market investments adequate credit information, and speedy and efficient do not augur well for innovations in instrument types. enforcement laws relating to default proceedings. The Indian bond markets have seen very limited innovations, absence of market infrastructure to support India's and most of the issuance tends to be plain vanilla fixed- secondary market for trading bonds is one of the biggest rate coupon bonds. In contrast, the Latin American impediments to improving liquidity in that market. markets have used several different structures with Furthermore, liquidity is constrained by the narrow relatively long maturities. Lack of these innovations range of financial instruments on offer. New financial has also stifled third-party enhancement and limited instruments, such as credit derivatives and interest rate x Corporate Bond Market Report hedging tools, would help to attract investors to the they can develop the right attitudes and abilities in an corporate bond market. For credit derivatives, the main enablingenvironment.Whilemacroeconomicstability,a constraint is the absence of enabling guidelines from the well-functioning money market, a government securities Reserve Bank of India; for hedging tools, the constraint market, and an effective legal and regulatory framework is the absence of a suitable money market index for all provide a critical foundation on which to build the interest rate swap market to develop (although corporate bond markets, many of the elements of an indications are that this is now beginning to develop). enabling environment are interdependent and normally must be developed or reformed in conjunction with Another barrier to active trading and pricing in the one another. It must also be cautioned that there is no corporate bond market is the paucity of information on general agreement on which conditions are "necessary" transactions. No one knows exactly how much debt is for corporate bond market development, and there is outstanding on any given date. Data on bond issues, certainly no "one-size-fits-all" recipe. size, coupon, latest credit rating, underlying corporate performance, information on secondary trading and In India, some of the enabling measures relating to default histories of companies are sparse and usually not government securities market are already in place or available from one source. arebeingimplemented.Forinstance,arelativelyliquid benchmark yield curve of up to 20 years already exists Weaknesses in regulation for government debt. Furthermore, ongoing efforts to improve the liquidity of the repurchase market-- Weaknesses in regulation, including poor coordination much of which is currently focused on the overnight among the various agencies involved in corporate bond market--are also important for the corporate bond market regulation, also fail to support the development market. Moreover, although local securities markets of India's corporate bond market. In the debt markets, can provide an alternative source of funding to the the Ministry of Finance, the Reserve Bank of India, banking sector, especially during banking crises, a and the Securities and Exchange Board of India all sound and well-regulated banking system can be a have regulatory and supervisory roles that are not necessary complement to the development of local sufficiently delineated. The overlap in regulation and bond markets. the different focus of each authority tends to inhibit the introduction of new products and the needed Reform strategy innovations in market design. The High Level Expert Committee on Corporate Bonds The lack of a bankruptcy code and institutional and Securitization, appointed by the Ministry of Finance mechanisms to deal with business failure in a way that to look into the legal, regulatory, tax, and market design is fair to bondholders have also crimped the ability of issues in the development of the corporate bond market, corporations to issue bonds based on expectations of recommended several measures to strengthen the market future cashflows. infrastructure and the legal and regulatory framework. Recommendations in this note are intended to build What does India need to do the enabling environment in which the corporate to develop its corporate bond bond market can flourish. The proposed measures are grouped into two main categories: regulatory reforms market? and market microstructure reforms. For issuers, investors, and intermediaries alike, participation in India's corporate bond market is not Regulatory reforms likely to take off until they recognize clear economic benefits, often in the form of better costs, lower risks, Recommendationsareproposed(a)todevelopagrowing or better market performance than the status quo, and and diverse set of issuers by streamlining procedures Executive Summary xi and reducing costs of issuance, (b) to encourage Market reforms local institutional investors, such as banks, pension fund managers, and insurers, to participate in the To strengthen the corporate bond market itself, corporate debt market by making investment policies recommendations focus on improving the and regulatory guidelines sufficiently flexible for these comprehensiveness and access of information about entities to choose an appropriate risk-return profile issues and issuers, the efficiency and reliability of within fiduciary constraints, and (c) to strengthen the market infrastructure, the range of products available, legal and regulatory framework by clarifying oversight and the homogeneity of corporate bond securities. The responsibilities among the various regulatory agencies accompanying table summarizes the suggested reform and modernizing laws governing creditors' rights and measures and the responsible agency (a more detailed corporate governance. version of this table is in annex-1). Table 1 Summary of recommended regulatory and market reform measures Reform measure Responsible agency Regulatory reforms Reforms affecting issuers Streamline procedures for public issuance of debt. Shelf Securities and Exchange Board of India, Ministry of registration should be extended for all types of corporate Company Affairs borrowers. Strengthen the debenture trustee system by providing protection Securities and Exchange Board of India from default by the company in timely payment of interest. Rationalize the stamp duty among different classes of investors Ministry of Finance, state governments, Reserve Bank and states. of India Reforms affecting investors Relax and amend regulations for permitting pension and Ministry of Finance, Income Tax Department, Ministry provident funds to invest in corporate debt. of Labor, Employee Provident Fund Organization, Modify the investment guidelines for insurance companies Insurance Regulatory and Development Authority to allow investment in instruments with a rating of less than AA with adequate safeguards to protect the soundness of the investor. Relax regulatory caps on banks' investments in unlisted corporate Reserve Bank of India, Ministry of Finance bonds (currently limited to 10 percent of their total non-SLR investments) as well as the minimum rating requirement needed for investments in corporate bonds (minimum investment grade, i.e., AA and above). Provide capital for the interest rate risk in the entire balance Reserve Bank of India, Ministry of Finance sheet, as opposed to just the marked-to-market portion of the book. This would ensure that bonds and loans are given similar treatment from the interest rate risk perspective. Remove the artificial distinction between investments and Reserve Bank of India, Ministry of Finance advances in the current regulatory regime. Guidelines and rules should be similar for a given credit whether it is held as a loan or as a bond. Further raise the current corporate bond ceiling for foreign Ministry of Finance, Reserve Bank of India, Securities institutional investors in corporate bonds. As a first step, the cap and Exchange Board of India could be relaxed for longer term investment in corporate bond debt markets (over 3 years) xii Corporate Bond Market Report Table 1 Summary of recommended regulatory and market reform measures Reform measure Responsible agency Professionalize fund management services. The authorities Securities and Exchange Board of India, Insurance need to ensure that pension and provident funds and insurance Regulatory and Development Authority , Employee companies have access to professional fund management services Provident Fund Organization and put in place adequate risk management systems to preserve the soundness of these investors. Reforms affecting the legal and regulatory framework Improve existing regulatory practices. The regulation of the High Level Committee on Capital Markets, Ministry corporate debt market should be put under the ambit of one of Finance, Reserve Bank of India, Securities and regulator. Exchange Board of India Enforce recently amended bankruptcy laws that clearly define Ministry of Company Affairs, Ministry of Finance, creditors' rights and borrowers' responsibilities, the promotion of Reserve Bank of India, Securities and Exchange Board adequate corporate governance practices, and timely and accurate of India and SEBI public disclosure of financial information. Market microstructure reforms Improve comprehensiveness and access to corporate credit and Securities and Exchange Board of India, Ministry of trade information. Company Affairs Secondary responsibility: credit rating agencies, National Stock Exchanges, Clearing Corporation of India, Ltd. or Fixed Income Money Market Dealers Association Improve trading and settlement systems. Efficient systems are Securities and Exchange Board of India, Reserve critical for providing liquidity, efficient price discovery, and an Bank of India, National Stock Exchanges, Clearing exit route for debt investments in infrastructure. Corporation of India, Ltd., Ministry of Finance Develop new product structures (e.g., credit enhancement, bond Securities and Exchange Board of India, Reserve insurance) and hedging mechanisms. Bank of India, National Stock Exchanges, Clearing Corporation of India, Ltd., Ministry of Finance, self- regulatory organizations such as Fixed Income Money Market Dealers Association, Association of Mutual Funds of India, Primary Dealers Association Permit short selling in government securities, because it will help Reserve Bank of India, Ministry of Finance in refining the pricing mechanism for corporate bonds and help investors hedge their risks effectively. Remove differential tax treatment between different classes of Ministry of Finance, Central Board of Direct Taxes corporate bonds. A plan for action Improving the primary issuance process, through streamlined disclosures and adoption of a shelf To put these recommendations into action, it is useful registration process for all corporate issuers, which to distinguish measures that can be implemented first will enable them to file one consolidated document and begin to yield benefits immediately from more for several offerings with the regulator. complex measures that would require implementation Relaxing investment guidelines for banks and over a longer term. key institutional investors such as pension funds, and insurers. Investment policies and regulatory guidelines for insurance companies, pension First steps funds, mutual funds, banks, and other financial In the immediate term, reforms relating to the key institutions need to be sufficiently flexible for these entities to choose an appropriate risk- supply and demand side issues identified in the note return profile within fiduciary constraints. could be addressed. This would include: These could be modified based on a consultative Executive Summary xiii exercise with the market participants and their (SEBI) impede confidence in the market. In respective regulators. the medium term, the current practice of RBI's being responsible for prudential regulationi Later priorities for market participants in the government securities market should probably continue. The medium to longer-term reforms that require In addition, RBI should continue to provide coordination among various regulatory agencies could the market infrastructure for government include: securities trading,ii although the possibility of conflicts of interest should be minimized. In Improving market infrastructure. On secondary the longer term, these market infrastructure market reforms, improvement in credit and trade services for the government securities market information should be a priority for the regulators should be gradually moved out of the Reserve and self-regulatory organizations. On secondary Bank of India. With regard to regulating the market infrastructure, while the debate on market conduct of the government securities exchange-traded versus over-the-counter methods market, which covers the behavior of market of trading is an important one, centralized order participants and the overall integrity of the flow, reporting, and mitigation of settlement market, the option of moving to a unified risks through appropriate clearing and settlement regulation of the financial markets could arrangements are more critical impediments that be considered when the larger questions of need to be addressed. Lessons can be learned from financial regulatory architecture are resolved. developed market experience with trade execution systems, trading venues, data dissemination, and settlement systems. Conclusion Encouraging a market for innovations and new The list of reforms discussed above is not entirely new products. This will enable institutional investors nor by any means complete. But the message does to invest in a wider range of instruments and bear repeating. Corporate bond markets are important for sub­investment grade corporations and for financial stability as a buffer when other funding infrastructure providers to access financing. sources are affected. The development of a deep, liquid Less regulation of qualified institutional buyers local corporate bond market in India at the longer end and the facilitation of a diverse institutional investor base are an important reforms that will of the maturity spectrum could facilitate a competitive help bring in risk capacity from overseas. source of financing that allows access to a wide range of issuers. It would also benefit the country's infrastructure Adopting a regulatory framework that ensures investments by tapping into the growing pool of long investor protection and market integrity and term funds available with the gradually developing class containssystemicrisk.Keyelementsoftherequired of institutional investors. framework include the enforcement of recently amended bankruptcy laws that clearly define Notes creditors' rights and borrowers' responsibilities, i Such as setting standards (capital requirements, etc.) and supervising the promotion of adequate corporate governance market participants (banks and primary dealers), given that the Reserve practices,andtimelyandaccuratepublicdisclosure Bank of India is entrusted with a variety of functions, including being of information. investment banker to government and formulating and implementing monetary policy, and that RBI needs to be sure that monetary policy is carried out through sound intermediaries (market participants). Improving existing regulatory practices. ii The corporate bond market should be put Such as carrying out the auction system, trade matching system, recording of transactions, and settlement (through the Clearing Corporation of under the ambit of one regulator. Currently, India, Ltd.) etc., as long as the conflict of interest with respect to RBI perceived inconsistencies and conflicts being a provider of services to the government securities market as well as a regulator of that market can be minimized through ensuring that between the Reserve Bank of India (RBI) and these services are provided in a transparent manner and that information the Securities and Exchange Board of India is available to all market participants uniformly. 1.Why does India need a Corporate Bond Market? A well developed corporate bond market is late 2006. The corporate bond market, despite having essential for financial efficiency and stability and reasonable financial depth (India's financial assets were for overall economic growth. Corporate bond about 173 percent of GDP at the end of March 2005) markets form a crucial part of a diversified financial comparable to or better than many other economies at system that ensures efficient allocation of resources similar income levels, attained a level of only 5 percent and financial diversification. A well-functioning bond of GDP and trailed many other emerging markets market also helps to meet the need for financing, not (table 1.1).1 A comparison of the size and composition of only for AAA-rated corporations, but also for less the domestic debt market in India with select emerging well known, subinvestment grade corporations and market countries puts India ahead only of Mexico infrastructure developers. in the size of its corporate bond market (figure 1.1). Government remains the dominant issuer in India with The size and depth of the debt outstanding government securities reaching 34 percent market of GDP in 2004. Notwithstanding the sharp rise of stock market Patterns in emerging market countries capitalization--from less than 33 percent of GDP in 2000 to about 85 percent in 2006--India's financial When many emerging markets suffered a sudden sector has traditionally been dominated by banks and outflow of capital in the late 1990s, one painful lesson bank lending, which were at 37 percent of GDP in was that their financial systems had relied too heavily Table 1.1 Financial depth and share of corporate bond market in India and selected emerging market countries, 2004 Country Corporate bond marketa Government securities Bank credit Stock market capitalization U.S. dollars Percentage U.S. dollars Percentage U.S. dollars Percentage U.S. dollars Percentage (billions) of GDP (billions) of GDP (billions) of GDP (billions) of GDP India 37.2b 5.3 235.0 33.8 253.4 36.5 387.9 55.8 China 195.9 10.1 287.4 14.9 2318.0 120.0 639.8 33.1 Korea 396.7 58.4 171.6 25.2 605.8 89.1 428.6 63.1 Malaysia 61.4 51.9 45.2 38.2 123.3 104.2 190.0 160.6 Thailand 28.7 17.8 36.2 22.4 123.3 76.3 115.1 71.2 Brazil 75.7 12.5 295.9 49.0 166.6 27.6 330.3 54.7 Chile 21.9 23.0 20.0 21.0 57.9 60.9 117.1 123.2 Mexico 23.8 3.5 153.1 22.5 97.2 14.3 171.9 25.3 a.Includes financial institutions and corporate issuers. b.Includes commercial paper issuance and longer term bond issuance. Source: Bank for International Settlements, International Monetary Fund, Merrill Lynch, and World Bank staff estimates. 2 Corporate Bond Market Report on bank lending and paid littleattentionto developing development of a government bond yield curve that other forms of finance. Since the financial crisis in facilitated the pricing of corporate bonds and changes East Asia in the late 1990s, it has often been argued in the bond contracts, together with the growth of that, if corporations in Indonesia and Korea had relied private pension funds and other institutional investors more on the domestic corporate bond markets and (insurance companies and mutual funds). These efforts less on bank financing, the magnitude of the losses have resulted in the growth of corporate bonds as a from the banking and financial crisis would have source of corporate finance. been less severe. The corporate bond market provides an alternative funding source for corporations Structural reforms carried out by authorities in various which could act as a buffer in the face of sudden emerging market countries have also facilitated the interruptions in bank credit or international capital development of the corporate bond market. These flows. Policymakers in East Asia have started to pay included establishing rating agencies and benchmark more attention to developing local bond markets. yield curves, permitting issuance of unsecured bonds, and liberalizingmarketeligibilitystandards.Reformsandpolicy In emerging markets, local bond markets are gradually initiatives to improve the bond market infrastructure have becoming an alternative source of funding for both strengthened trading platforms, clearing and settlement governments and corporations. The authorities' systems, and the regulatory environment. efforts to develop local bond markets, combined with the corporate sector's efforts to diversify away from Patterns in mature market countries refinancing and foreign exchange risks, have contributed to an expansion in local corporate bond markets (with Development patterns have differed among countries the exception perhaps of countries in Central Europe). with mature corporate bond markets. The corporate In Asia and Latin America, the pull-back in bank credit bond market in the United States has been an important during the crisis years has also contributed to the increase source of funds for the private sector for a long time. in corporate bond issuance. In Asia, the dearth of bank The outstanding nonfinancial corporate debt securities financing, as well as the need to restructure balance in the United States amounted to $32 billion (55 sheets, has provided an additional impetus for corporate percent of GDP) in 1932 and have increased steadily debt issuance.2 In Latin America, the rapid growth to about $2 trillion (22 percent of GDP) in 2003. In of local institutional investors, together with large contrast, Canada, Japan, and most European countries refinancing needs of the corporate sector in a difficult have seen their corporate debt markets develop only in external environment, have driven increased corporate more recent decades. Corporate bond markets in most bond issuance. other advanced economies were virtually nonexistent in 1980. Until the late 1990s, the corporate bond market In particular, corporate bonds have become a relevant in some European countries, including Germany, source of funding, accounting for more than 30 percent remained insignificant compared with other sources of of total corporate debt in Korea and Malaysia because corporate financing. of the important structural changes implemented after the financial crisis in 1997. In Korea, the government Institutional structure has played an important role in raised the ceiling on corporate bond issuance from two the differences in corporate bond market development in to four times equity capital and eliminated restrictions thesematuremarketcountries.Therelativeinsignificance on investment in domestic bonds by foreign investors. of the corporate bond market in Europe was mirrored by Malaysia's corporate bond market has grown steadily the corresponding dominance of the banking sector. In due to efforts to streamline the bond issuance process, contrast, in the United States banks play a very small role encourage secondary bond market activities, and relax in financing large companies and face strong competition insurance companies' portfolio limits. The growth of from the corporate bond market even for medium-size corporate bonds in Mexico is more recent, with the companies. In Canada, loan financing by nonfinancial Why does India need a corporate bond market? Figure 1.1 Size and composition of outstanding domestic debt markets in selected emerging developing countries, 2004 60 Korea GDP ofeag Malaysia 40 percenta as Chile 20 Bondse Thailand China Brazil Corporat Mexico India 0 0 10 20 30 40 50 60 Government securities as a percentage of GDP Source: International Monetary Fund, Bank for International Settlements, and World Bank staff estimates. corporations has declined since the early 1980s as bond Now financial intermediaries offer a range of financial and equity financing increased. This new trend coincides services, such as banking, insurance, and securities with the major Canadian banks' expansion into the trading under one roof. brokerage and investment banking business in the 1980s after legislative changes (Calmès 2004). The model of industrial financing in India has evolved from one based on banks and development finance The importance of a corporate institutionstoonebasedonacompetitivefinancialsector, bond market following the economic and financial sector reforms in 1991. By design, the prereform financing model was a Finance is a crucial ingredient for economic growth.3 state-led initiative that emphasized building a financial The reforms of the 1990s in India helped accelerate system with a widespread banking network, not only in economic growth, pushing gross domestic product up termsofthegeographicalspreadandsocioeconomicreach, by 5.9 percent in the 1990s, versus 5.6 percent in the but also in the functional sense, through development 1980s. This section explores the relative importance and finance institutions (DFIs) (Mohan 2004b). In this efficacy of different sources of financing, the change in model of financing, banks catered to short-term working financing patterns over time, and the performance of capital and DFIs catered to medium- to longer-term financial intermediaries. funds for the corporate sector. Since banks had access to low-cost deposits, DFIs were provided concessional India's model of industrial financing sources of finance through government guarantees on their bonds and special access to concessional funds Traditionally, countries have adopted either a bank- from the Reserve Bank. Corporations could supplement based financing model or a market-based financing financing from these sources by tapping the capital model. In the former model the corporation interacts markets, but the corporations' access to those markets with the bank, whereas in the latter, it approaches the was restricted through elaborate approval processes, "public" for finance. However, the distinction between interest rate controls, and limits on the amount of the two models is increasingly becoming blurred, with leverage (the debt-equity ratio) that corporations could an increase in universal banking and conglomeration. undertake (Patil 2002). 4 Corporate Bond Market Report Figure 1.2 Resource mobilization by the Indian corporate sector, 1970­75 to 1990­95 700 600 500 400 billion Rs 300 200 100 0 1970-75 1975-80 1980-85 1985-90 1990-95 Time period DFI Assistance* Private Equity Issues Debenture Issues PSU Bonds Issue PSU disinvestment * Includes only disbursements by the three principal DFIs: ICICI, IDBI, and IFCI. Source: Reserve Bank of India and IDBI. The evolution of the corporate financing strategy over the most important source of funds for corporations, the 1980s and 1990s has been influenced by the fiscal followedbybankfinancing6.Corporationsindeveloping position of the government. As fiscal deficits grew, the countries, in contrast, rely on external finance to a larger financial system began to be geared to funding the extent. For Indian corporations, external finance came government's budgetary needs, thus limiting the ability largely from the DFIs before 1985 (figure 1.2). of the financial system to allocate resources efficiently.4 Thefinancialsectorreformsofthe1990ssoughttoreduce Other sources of external finance, such as equity the role of the government in the allocation of resources issues, were negligible until the mid 1980s. The capital by creating a competitive financial sector. The key markets gained importance in the later half of the features of the postreform model included dismantling 1980s and peaked in the mid-1990s. Both equity and the administered structure of interest rates; gradually debenture issues thrived during 1985­95 as sources of withdrawing restrictions on the assets and liabilities of funds for public and private corporations because of banks and nonbanking financial institutions, enabling the reforms in the primary issuance pricing controls. them to build their portfolio across instruments of However, since 1995, there has been a decline in equity varying risk and tenor; and gradually withdrawing funding and a diversion of corporate debentures to the concessional funding to DFIs (Mohan 2004b). private placement market, reflecting a decline in the importance of capital markets. In fact, nongovernmental India's sources of corporate finance nonfinancial companies have been increasingly relying on internal sources since 1997­­and external financing This section looks at the financing pattern for the has fallen (figure 1.3). The recent shift to internal corporate sector over a period spanning the two models resources in Indian corporate funding, however, appears of industrial financing (1970­2005)5. In most developed to be a short-term phenomenon arising from the recent countries, retentions or internal resources constitute poor performance of primary markets7. Why does India need a corporate bond market? Figure 1.3 Sources of funds for Indian corporations, 1985­2002 80 80 70 70 60 Sources 60 50 50 40 ernal 40 30 30 ExtalotT Banks 20 20 10 10 0 0 -10 1984 1987 1990 1993 1996 1999 2002 1984 1987 1990 1993 1996 1999 2002 Time period Time period 80 80 70 70 60 y 60 50 ionsutitt 50 40 40 Equit Ins 30 30 20 20 10 10 0 Financial 0 1984 1987 1990 1993 1996 1999 2002 -10 1984 1987 1990 1993 1996 1999 2002 Time period Time period 80 70 60 50 ures 40 30 20 Debent 10 0 -10 1984 1987 1990 1993 1996 1999 2002 Time Period Source: Reserve Bank of India. Equity, as a source of funding for nongovernmental 1970s, represented 4 percent of GDP from 1997­98 to nonfinancial public companies, went up from 3.9 2001­02. In contrast, investments by capital markets, percent of funds from all sources (internal and external) which increased from 0.1 percent of GDP in the 1970s in 1984­85 to a peak of 29.6 percent in 1993­94, but to a high of 1.9 percent of GDP from 1992­93 to since then it has been declining. Over the past ten years 1996­97, fell close to the level of the 1970s between it has been hovering around 10 percent. An analysis of 1997­98 and 2001­02. the capital structure of listed companies between 1988 and 2004 indicates that debt financing has grown in Sectoral financing. The pattern of sectoral financing does parallel with the equity market. Except for a couple of not suggest that any Indian industry has been starved of short patches in the mid- and late 1990s, banks and bank credit (Mohan 2004a), with the overall nonfood financial institutions have constituted a steady source gross bank credit increasing from 19.9 percent of GDP of funds, contributing roughly 20­25 percent of the in the 1980s to 21.6 percent from 1997­98 to 2001­02. funding requirements of nonfinancial companies in the There is no indication from the sectoral numbers of a lack private sector (figure 1.3). of bank finance. For example, within individual sectors, the industrial credit as a percentage of the manufacturing Investments by banks and financial institutions, which GDPregisteredanincreasefrom65.6percentinthe1980s represented 2.1 percent of GDP (at current prices) in the to 71.9 percent in the period from 1997­98 to 2001­02. Corporate Bond Market Report Figure 1.4 Debt-equity ratios by sector, 1988­2004 4. 50 4. 00 3. 50 io 3. 00 Raty 2. 50 Equit 2. 00 Debt 1. 50 1. 00 0. 50 0. 00 1988 1990 1992 1994 1996 1998 2000 2002 2004 Year Construction Electricity FFinancial services Manufacturing Mining Source: Center for Monitoring the Indian Economy. Debt and equity. The database of the Center for Financingfromdevelopmentfinancialinstitutions Monitoring the Indian Economy indicates the relative has fallen. contribution of debt and equity financing to companies The rise of equity as a significant source of finance (listed and unlisted) in selected industrial sectors, as for the industrial sector was confined to the period measured through their debt-equity ratios (equity at 1985­95. Corporate debentures grew during this book value) from 1988­2004. There seems to have been period (except for 1993­95), and even as equity some shift away from debt and toward equity in some finance declined in the subsequent years, debt issues sectors, particularly financial services and construction. thrived through the vehicle of private placement. In the manufacturing sector, the average debt-equity ratio declined modestly between 1992 and1997, but Pressures for change this trend reversed after 1997. However, at market value, the manufacturing sector debt-equity ratio declined Many pressures are pushing India toward long-term substantially after 2001 (figure 1.4). financing through a corporate bond market. These include the growth of a changing, competitive financial The broad trends of industrial financing in India can be sector; the new legislation affecting the debt market; the characterized as follows: new opportunities for financing overseas; and the huge infrastructure financing needs. Banksremainamajorsourceoffundsthroughboth conventional credit and investments (commercial A changing,competitive financial paper, corporate bonds, and, to a limited extent, sector equity), although the nature of these institutions has changed radically since the 1990s because of The earlier section showed that the gradual shrinkage of the pressures of liberalization and deregulation of development financial institutions and the gap created interest rates. for long-term financing were the most serious issues in Why does India need a corporate bond market? the flow of resources to industry. The downscaling of operations of DFIs, together with the sluggishness of Figure 1.5 Overseas issuance of equity and capital markets in recent years (between 2001 and 2004), debt by Indian corporations, has created a gap at the longer end of the institutional 1992­93 to2005­2006 financing spectrum. There is a limit to the role of banks US dollars (millions) at the longer end because of the mismatch of assets and 7500 liabilities on their balance sheets.8 It is expected that a 6000 large fiscal deficit will continue in the near future, which will constrain banks from extending longer-term credit to 4500 infrastructure, industry, agriculture and other productive million$ sectors (Mohan 2004a). A more detailed analysis of the 3000 US issues arising from a competitive financial sector and 1500 growth of institutional investors is provided in chapter 2. 0 1990-91 1993-94 1996-97 1999-00 2002-03 2005-06 New legislation affecting the debt Debt Equity market Source: Prime Database. Over the past two decades, sustained budget deficits required the Indian government to make large issuances of government securities. The government, through local currency. However, asset-liability mismatches and the passage of the Fiscal Responsibility and Budget the seeming preference of banks to take interest rate Management Act, is aiming for fiscal consolidation, risk rather than credit risk9 imply that banks frequently which is intended to bring the fiscal deficit down to 3 offer only short-term loans. While loans of longer percent of GDP and the revenue deficit to zero. The maturities may be obtained abroad, such loans are achievement of these targets can be expected to lead to a likely to be in foreign money. An active local corporate significant decline in the share of government securities bond market would allow firms to issue debt securities in the total assets of the financial system. However, after that are a better match for the timing and currency of accounting for inflation and expected real GDP growth, their cash flows. the absolute level of net issuance of government securities may not fall much. The Indian market has been used to Overseas offerings by Indian corporations through rising fiscal deficits and large borrowing programs from equity and debt instruments have been rising since the the government over the years. So it is expected that an liberalization of the Indian economy in 1991. Equity active issuance of government paper will continue in the issuances have more or less been stable. Debt issuances foreseeable future. Banks especially have been investing by Indian corporations have been more opportunistic in government securities much more than the statutory to take advantage of low global interest rates. Spreads requirements. However, as the fiscal consolidation process on emerging market bonds narrowed to historic lows proceeds, resources with financial institutions of different in early 2005 in part because of excess global liquidity. kinds will increasingly become available for investment This led global investors, particularly pension funds in corporate debt for financing productive activities and insurance companies, to invest in emerging market (Mohan, R.,2004c). bonds (figure 1.5). New opportunities for financing Within the category of debt issuances, corporations are overseas increasingly using foreign currency convertible bonds (FCCBs).10 The total FCCB issuance from 1999 to 2004 A company that wants to finance an expensive wasonlyUS$603.1million.In2004­05andthefirsteight investment would ideally want to borrow long term in months of the financial year 2005­06 (April 2005 until Corporate Bond Market Report November 2005) the issuance has been about $3 billion Five-year Plans, government finance--consisting of and $1.9 billion, respectively. In comparison, domestic gross budgetary support to the central plan, allocations debt issuance by Indian corporations through the public to the states, and internal and extra-budgetary resources issuance route constituted $0.9 billion in 2004­05 and of central state-owned enterprises--amounts to roughly no issuance had taken place until December 2005. Most Rs. 13,601 billion for the main six infrastructure of this FCCB issuance was by manufacturing (mainly sectors11 over the period 2001­02 to 2010­11. This, the steel and automobile industries) and infrastructure of course, assumes that the government will be able companies (mainly telecommunications). Many lower- to undertake fiscal adjustment. Even with adjustment, rated corporations have also raised money through India would still face a staggering financing gap of over FCCBs. Overall, even though a wider range of issuers Rs. 5,500 billion for the decade ending 2010­11. This have accessed the domestic market in recent years, it is a huge difference between what the country needs appears that offshore markets have a greater capacity to and what the government can pay. Success in attracting finance lower-rated credits. private funding to help meet this gap will depend on India's ability to put in place regimes, systems, and While the reliance of Indian corporations on long-term practices that consistently encourage private investment foreign financing through the issuance of American and public-private partnerships in infrastructure. This depository receipts, global depository receipts, and would include a well-developed financial system that foreign currency convertible bonds has been increasing, can provide access to long-term debt funding. it constitutes only 2 percent of the total flow of resources to Indian industry in 2004­05. In contrast, As infrastructure policy and regulatory frameworks external commercial borrowings by corporations have emergeandreformsadvance,abetterdevelopedfinancial increased significantly in the past three years and system, in particular a domestic corporate bond market, constituted 20 percent of the total flow of resources canaccelerateaccesstofinancebyinfrastructureprojects. to Indian industry in 2004­05 (RBI Annual Report A less developed financial system is likely to slow down 2005). This analysis remains incomplete, however, reform in infrastructure since it cannot respond as without examining in greater detail the risks that quickly to changing financial requirements, especially could arise from increasing external borrowing in for long-term resources. an environment of hardening interest rates. Another aspect that needs to be examined from the demand Conclusion side (the corporations' side) in greater detail is some quantification of cost of borrowing for the corporate The changing environment that arises from India's sector in the absence of a corporate bond market. economic and financial growth will place significant financing demands on the Indian financial system. Huge infrastructure financing needs Thus, all the segments of the financial system (banking, equity markets, and debt markets), and in particular the With its present state of physical infrastructure, India long-term domestic corporate bond market, will need will find it difficult to sustain an annual GDP growth of to expand their current roles. over 7 percent over the medium term. There is a massive and urgent need to increase investment in power, roads, Thestrategicorientationofthisnoteisthedevelopmentof ports, airports, railways, urban facilities, and rural the domestic corporate bond market as a key component infrastructure. of the overall financial development in India, creating a viable financing vehicle for a wide range of borrowers, Calculations on financing gaps show that finance will including nongovernmental companies. A priority in this become an ever more important constraint for Indian contextistoestablishadeeper,broader,andmoreefficient infrastructure over the medium term. According to the corporatebondmarketthatprovidesacompetitivesource estimates of funding given for the tenth and the eleventh of financing across a wide range of tenors and access to a Why does India need a corporate bond market? wide range of issuers. The development of a deep, liquid 2 The drivers for development of corporate bond markets in Asia (the local corporate bond market in India at the longer end dearth of bank financing, as well as the need to restructure balance sheets) are present in India as well, and yet the corporate bond markets have not of the maturity spectrum could facilitate the country's witnessed similar growth. The note explores these issues in detail in the infrastructure investments by tapping into the growing later sections. 3 pool of long-term funds that would be available with The framework for analysis in this section draws on Mohan 2004a. 4 the gradually developing class of institutional investors The reasons for this inefficiency are well documented and include the combination of an administered interest rate regime and directed credit (private insurance companies, provident funds, and the preventing proper pricing of resources, among other things (Mohan prospective private pension funds). 2004a). 5 Based on India: Role of Institutional Investors in the Corporate Governance of their Portfolio Companies (World Bank 2005). Several preconditions for the development of a corporate 6 Mayer (1988, 1989, 1990), Corbett and Jenkinson (1994) in Pal, bond market are slowly falling into place. Government Partapratim, "Stock market development and its impact on the financing bond markets have developed substantially, although pattern of the Indian corporate sector, Research Paper, NSE, 2001. 7 Following a series of scams and price-rigging incidents in the stock a few issues still need to be addressed to have a better markets during the early to mid-1990s, the Securities and Exchange functioning government bond market. Annex 2 provides Board of India in 1996 instituted strict entry and disclosure norms for an overview of some of the issues. The progress of reform companies accessing the capital markets. This may also have caused a decline in the number of issues and the amount raised in the primary has been much slower in the corporate bond market. market (Handbook of Statistics on the Indian Securities Market, SEBI, In general, the development of local corporate bond 2004). 8 markets has been constrained by the lack of a meaningful The inherent difficulty for a bank to provide long-term funding stems from the fact that the deposit liabilities of the bank tend to be of investor base with developed credit assessment skills, relatively shorter maturity, which could then result in asset-liability the high costs of local public issuance, and the lack of mismatches. 9 liquidity in secondary markets. These constraints are On the assets side, banks hold large volumes of long-term government paper in tradable form, well in excess of the statutory requirement of 25 explored in greater detail in the following chapters. percent. 10FCCBs are bonds denominated in a foreign currency (usually U.S. Notes dollars) that, in addition to offering a return or yield, also offers investors the option of converting their principal investment into 1 Financial depth is measured as the sum of financial assets held by equity at a pre-decided price. The price is decided when the instrument banks, financial institutions, and insurance companies; the amount of is issued. outstanding corporate and government bonds; and the capitalization of 11These comprise roads, power, telecommunications, railways, airports, and the stock market as a ratio to GDP. ports. 2.What is holding back supply and demand? D emand and supply issues have fueled the of the various issuers, instruments offered, and details growth of corporate bond markets in many on the largest issuers in the corporate bond market in countries. In some countries, such as Chile, 2005­06. Only two amongst the top 25 issuers are the growth of institutional investors fueled demand for nonfinancial institutions, the Food Corporation of corporate debt securities. In some others, the collapse India and Indian Oil Corporation, which are state- of other sources of funding led to a rise in the issuance owned. This is not a recent trend­­a similar pattern of of corporate bonds. This chapter analyzes the sources issuance was prevalent even in 1995­96. Amongst the of supply of corporate bonds and gives an overview of financial institutions issuance by banks in the primary the size and nature of the demand for them, as well as market is on the rise mainly to raise Tier II capital to the impediments to greater participation of investors in fulfill capital adequacy requirements.1 corporate bond markets in India. Although there is no single reliable number, the total The supply of corporate bonds outstanding privately placed debt was approximately $43.7 billion, which is ten times the publicly issued The principalissues on the supply side are the dominance debt (McKinsey 2006). The lack of comprehensive of government-owned entities as the primary issuers of data relating to the debt on issue and the outstanding bonds and the absence of high-yield issuances in the stock of debt for corporate issuers is a serious handicap current market. in the Indian market today. While data on public issuances by corporations is available, most of the Government dominance in primary corporate bond issuance over the last few years has issuance been through the private placement market, which has had very little oversight and reporting requirements by About 80 percent of the primary issuance in the issuers and arrangers until about a year ago. Now that bond market is by public sector entities (financial and the reporting of debt on issue by listed companies has nonfinancial). Most of this issuance is raised through been somewhat streamlined, it is expected to improve the private placement market (table 2.1). In 2005­06 gradually. However, data on outstanding debt is still the private placement market witnessed over a 1,000 very hard to compile, as there is no comprehensive deals raising Rs 963 billion. On the other hand, repository of information to track debt issuance by the public bond issuance market was very limited companies through its entire life cycle--that is, from with only two issuances in 2005­06 raising Rs 2.45 issuance until redemption. billion. Interestingly the private placement market has attracted greater number of public sector issuers Unlike equity, where large primary issues have moved over the last five years. The top 25 issuers contributed to a book building process on the exchanges, most to 67 percent of the private placement market in bond issuances today have become part of the private 2005­06, of which two-thirds were public sector placementmarket.Alittleover90percentofallissuances issuers. The largest debt issuers within the public and in the corporate bond market today are through private private sector are financial institutions rather than placement. This strong shift toward a largely privately manufacturing companies. Annex 3 offers a snapshot placed bond market is simultaneously observed across 12 Corporate Bond Market Report Table 2.1 Resources raised in the primary markets in India,1995­2006 Year Public Bond issues (Rs. billions) Total resources Share (percent) of Share (percent) equity issues mobilized private placement in of bonds (Rs. billions) (Rs. billions) in total Public Private Sum of bond (2+5) Bonds Total (5/6*100) issues placements issues (3+4) (4/5*100) (4/6*100) 1 2 3 4 5 6 7 8 9 1995­96 88.8 29.4 100.3 129.8 218.6 77.3 45.9 59.4 1996­97 46.7 70.2 183.9 254.1 300.8 72.4 61.1 84.5 1997­98 11.3 19.3 309.8 329.1 340.5 94.1 91.0 96.7 1998­99 5.0 74.0 387.5 461.6 466.6 84.0 83.0 98.9 1999­2000 29.7 47.0 550.7 597.7 627.5 92.1 87.8 95.3 2000­01 24.8 41.3 524.6 566.0 590.7 92.7 88.8 95.8 2001­02 10.8 53.4 454.3 507.7 518.5 89.5 87.6 97.9 2002­03 10.3 46.9 484.2 531.2 541.6 91.2 89.4 98.1 2003­04 178.2 43.2 484.3 527.5 705.7 91.8 68.6 74.8 2004­05 214.3 41.0 553.8 594.8 809.1 93.1 68.5 73.5 2005­06 273.8 2.5 963.7 966.1 1240.0 99.7 77.7 77.9 Note: Private placements from 2000-01 onward are issues with maturity and optionality of at least a year. Private placements for earlier years include all issues irrespective of maturity or optionality. Source: Prime Database Ltd. all sectors of current issuers and private companies or corporate governance practices and timely and accurate units. The move away from more transparent modes of public disclosure of financial information. In addition, issuance toward private placement might indicate high concerns remain about the efficacy of bankruptcy laws, costs of a public issue. A detailed analysis of the costs of which clearly define creditors' rights and borrowers' issuance is provided in chapter 3. responsibilities. (Legal and regulatory issues impinging on development of a vibrant bond market are examined The nonexistent market for high-yield in chapter 3.) However, in recent years, there has been an issuance increase of bond issuances by Indian corporates overseas, particularly through the route of foreign currency Most of the issuance in the corporate bond market in convertible bonds (FCCBs) as described earlier, possibly India is credit rated, and most of the issuance is rated indicating that the overseas markets have a greater risk AA+ or higher. Large Indian corporations with good bearing capacity for all types of Indian credit. credit rating are able to raise money in international markets (although this may expose them to currency In India, the restriction on institutional buyers by their risk) and domestic markets with relative ease. India respective regulators of only investing in investment has a vibrant equity market and the existence of a grade quality securities has led to the corporate bond strong equity culture that places onerous market market being skewed toward having only "investment discipline demands (for disclosures and good corporate grade" bonds. For example, table 2.2 shows that most of governance) on corporations of all credit qualities. the issuance by public sector agencies in 2005 was with Hence, the nonexistence of a market for high-yield a credit rating of AA+ and above. issuance in India is surprising. In the United States, for comparison, the market for The absence of a market might indicate that lower "A" and higher rated credit is only 43 percent of total rated corporations are not able to meet the required outstanding debt, and "AA" and higher is only 16 What is holding back supply and demand? 13 Table 2.2 Credit ratings for bonds issued by Table 2.3 Retail participation in Indian public sector agencies in 2005 debt markets,2003­05 Rating AIFI INF PSUs SFIs SLUs No. of trades Traded value NA 44 4 8 7 (Rs. billions) NR 2 5 10 2003­04 1400 3.32 AAA 71 1 4.9(SO) 2004­05 1278 4.1 AA+ 29 2005­06 892 3.1 AA 7 3(SO) 1(SO) Source: NSE Fact Book, 2006 AA- 1(SO) 1,1(SO) A+ 3 1(SO) High household savings but low A 3 1 4.3(SO) 2(SO) financial savings A- 2 1 1(SO) 3(SO) BBB+ 2 2(SO) 1(SO) Though India's saving rate as a percent of GDP has been LAAA 4 1(SO) consistently higher than that of most other countries with LAA+ 1 comparable income, it has fallen short of the East Asian LAA 2 2(SO) countries (India 28 percent; China 44 percent; Malaysia LA+ 1(SO) 43 percent; Korea 32 percent; Thailand 31 percent; and LA 1 Indonesia 23 percent) (World Bank 2005b). In India PR1+ 1 1 while the household savings are high the level of financial PR1 1(SO) savings are quite low with less than half of household savings invested in financial assets. The main financial Note: AIFI: All India Finance Institutions; INF: Infrastructure; PSUs: Public Sector Undertakings; SFIs: State Financial Institutions; SLUs: State Level instruments popular with the households are bank Undertakings. deposits, provident funds, insurance, income-oriented Source: Prime Database Ltd. mutualfunds,andpostalsavingsschemes.Householdsare averse to directly investing in the markets and rarely play percent (Merrill Lynch 2004). In Japan and the Euro a significant role in the corporate bond market (table2.3). area, as well as Britain, lower-rated credits, particularly This aversion is exacerbated in part by poor liquidity of sub­investment grade, constituted the fastest growing fixed-income instruments in the secondary markets and component of the market. One of the explanations for in part by the high rates offered on small savings schemes the low incidence of high-yield issuance in emerging and the perceived safety of these instruments compared market countries relates to the pattern of corporate with corporate bonds (Patil 2002). development in these countries, which have seen relatively less reorganization and takeovers than in the Growth of assets with institutional United States (De Bondt and Marques-Ibanez 2004). In investors the United States, the spurt in the growth of high-yield issuance has been due to the corporate restructuring in One of the drivers for demand of corporate debt is the 1980s requiring large amounts of debt financing, the rapid growth of assets under the management of which was aided by leveraged buy-outs (IMF 2005). institutional investors, which leads them to look for different avenues to invest. In Latin America, the growth The drivers of demand of pension funds has been one such driver for increased demand for corporate debt. In India, while growth of The principal issues on the demand side of the assets under management of institutional investors is corporate bond market are the low retail participation takingplace,investorsinthedebtmarketarebelievedtobe despite high household financial savings and the "too restrictive" or "homogenous"2 --that is, they mainly recent rapid growth of assets under the management hold high-rated "safe" paper--which limits the investable of institutional investors. universe of corporations to large companies with strong 14 Corporate Bond Market Report Table 2.4 Assets under management of local institutional investors in India and selected emerging market countries,2004 (as a percentage of GDP) Type of institutional investor Indiaa Chile Mexico Thailand Pension fundsb 2 61 42 14 Mutual funds 5.5 13 35 13 Insurance companies 12 20 20 12 Total assets under management of institutional investors 20 91 16 23 a. Figures pertain to end-March 2004 except for pension funds where latest numbers are for 2003. b. Figures pertain only to the corpus of the Employee Provident Fund, as data on other exempt provident funds is not publicly available. Source: International Monetary Fund, World Bank staff estimates. credit fundamentals or government-guaranteed paper. market and the obstacles that impede their participation This observation is supported in the earlier discussion of in the development of a deeper and broader corporate supply side trends, wherein issuance is largely dominated debt market. by public sector issuers and high-rated private corporate issuers. This implies that the buyer market is important Banks as a target for reforms to develop the bond markets in India. In mature markets, the investor base for bonds Investment categories and their relative share to total is generally well-diversified, with banks, mutual funds, investment of banks. Investments by banks comprise hedge funds, pension funds, and insurance companies two broad categories: government and other approved providing a broad demand base for bonds. A diversified securities (SLR investments); and commercial paper, investor base with varied demand requirements, maturity shares, bonds, and debentures issued by the corporate profiles, and risk preference is important to ensure high sector and public sector undertakings (non-SLR liquidity and stable demand in the market. investments). Investments in government securities and other approved securities amounted to a little over 30 The assets under management in India are still relatively percent of assets and 83 percent of total investments small as a percentage of GDP. In Latin America growth of banks at end-March 2005. According to regulation, of pension funds has been a big driver for the demand banks have to invest 25 percent of their net demand for corporate bonds (table 2.4). The small size of the and time liabilities in SLR investments. However, banks pension funds could be explained in part by the delay held as much as 38 percent of their net demand and time in implementation of pension reforms, which would liabilities in government and other approved securities have brought in private sector pension funds with the in 2004­05, as these are perceived as relatively high- flexibility to invest in a variety of instruments including return, low-risk assets. These securities have zero-risk corporate debt.3 While the mutual fund industry in India weighting in calculations of regulatory capital adequacy has grown rapidly over the past decade, it has to compete ratios, which is a significant attraction for banks at a with attractive assured returns from government schemes. time when profitability remains low and banks are This is possibly the single most important impediment to under pressure to raise these ratios (Basu 2005). growth of the industry in smaller towns and in attracting the longer-term individual investor (ADB 2003). Despite significant preemption of investments to government securities, banks remain the largest investors The obstacles to institutional in corporate bonds in India in value terms, with an investing investment of about Rs. 1,137 billion, accounting for about 13 percent of total investments of banks at end- The rest of this chapter discusses the participation of March 2005 (table 2.5). This, however, could also be various types of investors in the Indian corporate bond viewedasaconsequenceofthenarrownessoftheinvestor What is holding back supply and demand? 15 Table 2.5 Investments of scheduled commercial banks,1997­2006 (Rs. billions) Type of investment Mar-06 Mar-05 Mar-04 Mar-03 Mar-02 Mar-97 SLR investments of scheduled commercial banks Government securities 6,919.46 6,840.05 6,391.43 5,362.14 4,317.53 1,588.90 Other approved securities 139.48 162. 91 181.00 192.81 217.53 316.24 Total 7,058.94 7,002.96 6,572.43 5,554.95 4,535.06 1,905.14 Non-SLR investments of scheduled commercial banks Shares and mutual fund investments 229.32 260.49 215.04 165.23 59.14 12.52 Commercial paper 41.66 38.91 37.70 40.07 84.97 6.85 Bonds/debentures 1,054.52 1,136.95 1,123.70 1,131.69 665.89 166.31 Others 0.00 66.33 51.18 45.70 0.00 0.00 Total 1,325.50 1,436.35 1,376.44 1,336.99 810.00 185.68 Memo: Conventional bank credit 15,070.77 11,004.28 8,407.85 7,078.56 5,897.23 na na: not available Source: Reserve Bank of India; Trends and Progress of Banking in India, various issues base in the market and the still early development of portfolio, banks were allowed to shift SLR securities institutionalinvestorsinIndia,asdiscussedsubsequently to the HTM category, and no fresh non-SLR securities in this section. In the case of banks, apart from the were permitted to be included in the HTM category general risk aversion, certain regulations impede greater during the year 2004­05. participation in secondary corporate bond markets. In addition to the differences in regulatory treatment Regulatory differences between bonds and government debt between government securities and corporate bonds, securities and between bonds and bank loans. Indian banks the capital requirement and market valuation norms prefer to give loans to corporations than to invest in debt are not symmetrically applied to loans made to securities. This is partly due to the current accounting corporations. Some banks believe that the requirement norms and partly due to regulatory requirements on to adopt an internal rating system before investing in corporate bond investments. When bonds (government bonds issued through private placement is a deterrent-- as well as corporate) form a significant proportion of the procedures are time-consuming and involve a lot banks' balance sheets, as in India, the question of of approvals and technicalities. Thus, banks prefer to their valuation becomes significant. With financial finance corporations' requirements through loans, since systems becoming largely market-based, there have direct lending has less stringent procedures and capital been increasing requirements for bonds to be marked requirements. Moreover, a bank has full control in to market value, making their apparent worth more setting the terms of a loan to a corporation, whereas volatile. In India, the same bond may be marked to a bond is a more standardized commodity over which market4 if regarded as part of a trading portfolio but the bank has less control. Another issue that skews the valued at cost if held as a long-term investment (and incentive in favor of loans is the credit quality of the many banks often hold bonds to maturity). While corporate that is financed. A bank is required to invest corporate bonds are required to be marked to market, a only in bonds that are of investment grade quality, preferential treatment for government securities allows while loans can be made (and regularly are made) to banks to exceed the 25 percent limit under the Held corporations of varying credit quality. to Maturity (HTM) category, provided that the excess comprises only SLR securities. As interest rates rose in The Reserve Bank of India's recent guidelines restrict the early part of last year and banks faced losses due banks' investment in unlisted non-SLR securities to to large holdings of government securities in their 10 percent and require minimum investment grade 16 Corporate Bond Market Report Table 2.6 Distortions between the treatment of bonds and loans in bank regulations Regulation Bonds Loans Minimum rating criteria External credit rating required. Minimum investment None. grade. Limits on holdings Cannot invest in unrated securities. Limit on holding of None. unlisted securities (10 percent of the portfolio). Accounting treatment Marked to market if in Held-for-Trading and Available- Accrual basis-essentially similar for-Sale category. Hold-to-Maturity category (HTM) to HTM category for corporate does not require mark to market. However, banks are now bonds. prohibited from adding fresh investments in corporate bonds in HTM category. Loan loss provisioning In case of a 90-day overdue for interest or principal, Detailed norms for recognition it is to be classified as a nonperforming investment of asset as nonperforming. (NPI). Provisioning for NPI similar to provisioning for Provisioning guidelines as per the nonperforming assets. This is in addition to marked-to- category of asset, that is, sub- market loss as per market rates. standard, doubtful, and loss. Capital requirement Capital for market risk on investments as per RBI prescribed Capital provision on risk-weighted methodology. In addition capital is to be provided for on a assets. risk weighted assets basis. rating. This prevents banks from investing in bonds of bank market require an interbank index, which does lower-rated corporations (infrastructure companies are not exist in India. To have an active interbank market, typically lower-rated corporations). This also applies to one needs to have heterogeneity among banks, which loans to state governments and to state-level enterprises. only partially exists in India (heterogeneity would allow Until recently, all state government bonds were issued some banks to focus on raising deposits and others as a basket with sovereign credit rating. However, state- on arranging financings, which are then syndicated). level enterprises that had the same credit quality as the Another reason why an interbank market does not exist state government had bonds that reflected the "actual" is because banks mainly lend to the government, and so rating of the state government. If this rating was not "retail" banks have no need to lend to "money center" of investment grade quality, then the bank could not banks or through bonds. invest in the bond. This led to situations where the bank held bonds of the state government, but not Insurance companies bonds of enterprises of the same state government. Therefore, while banks stand ready to make loans to The advent of private insurance companies. Before corporations, they keep away from active participation 2000, India's life insurance industry was a public in the corporate debt market. The distortions between sector monopoly. Life insurance was monopolized by treatment of bonds and loans caused by the regulatory the Life Insurance Company of India (LIC). General regime are summarized in table 2.6. insurance was monopolized by the General Insurance Company of India (GIC) which was split into four Lack of incentives to trade in the market. One of the most subsidiaries in 2000 that were delinked from GIC, interesting issues in the lack of development of the while GIC was converted into a reinsurance company. corporatebondmarketinIndiaistheinabilitytoseparate Since liberalization of entry in 2000, 13 private life interest rate risk from credit risk, thereby limiting the insurers (10 of which have foreign participation) and pool of investors. Even before the advent of interest rate 9 private general life insurers (5 of which have foreign swaps in the developed markets, one of the main ways participation) have entered the market. The Life that banks would participate in the bond market was Insurance Corporation of India is still the dominant through floating rate notes. Floating rate notes for the (nearly monopolistic) entity in the Indian insurance What is holding back supply and demand? 17 sector, with a little over 95 percent of the gross premium underwritten in the life insurance business. Figure 2.1 Investments of life insurance companies, 2004 Restrictive investment guidelines. All over the world, 11% insurance companies are among the largest participants in the corporate bond market. Insurance companies in Chile, Mexico, and Peru, for instance, hold around 50, 28, and 15 percent of outstanding corporate bonds, 25% respectively (International Monetary Fund 2005). In contrast, Indian insurance investment still largely 59% adheres to rigid rules of investment set by regulation. 5% The total investment portfolio of insurance companies in India was about Rs. 3,869 billion at the end of March 2004. Of this amount, about 57 percent was invested in Investment subject Infra and social sectors to exposure norms government and other approved securities, in excess of Investment in Gsec other than approved the prescribed 50 percent by the investment guidelines and other securities investments issued by the Insurance Regulatory and Development Authority. For life insurance companies, out of the low level of "other than approved" investments and the total 35 percent that is earmarked for investments preference for government-owned institutions together based on exposure and prudential norms, investments indicate the low risk-taking outlook of the insurance in "approved" securities are capped at 20 percent. The companies. The guidelines also lay down a minimum remaining 15 percent is the category called "other than credit rating of "AA" for investments in debt paper. approved investments," which typically includes private This automatically excludes investment by insurance sector bonds and equity investments. The approved companies in debt paper of private infrastructure investment category is biased toward investments in sponsors and other lower-rated companies. bonds of state-owned financial institutions and highly liquid treasury bills. For non-life insurers, the limit Recently, some flexibility for investments by insurance on "other than approved investments" is capped at 25 fund managers has been allowed, particularly as applied percent (see annex 4). to the rule of "buy and hold."5 Earlier regulation was biased in favor of the "buy and hold" principle. As The actual investment by life insurance companies a result, fund managers were not able to get out of in "other than approved" securities, which typically holding bonds, even where the entity was clearly include corporate bonds and debentures, was only about headed toward bankruptcy. This encouraged fund 5 percent in 2004 (figure 2.1). For non-life companies managers to stay away from making investments in this category of investments reached only about 12 most corporate debt, other than those that had the percent against the allowed 25 percent. guarantee of either the central or state government. More recently, insurance companies have been more A large number of investments by life insurance active in buying corporate bonds. However, these are companies are in the form of long-dated loans to still done within the constraints of the bonds being industrial estates and development institutions or rated as investment grade. cooperatives in India. Most of the nongovernment securities investments by insurance companies are made Pension and provident funds in bonds issued by state-owned specialized financial institutions, such as the National Thermal Power Until 2004, the mandatory pension system mainly Corporation or the Power Finance Corporation (which consisted of an essentially pay-as-you-go system for have a AAA rating), or in the housing finance sector. The federal and state governments and Employees' Provident 18 Corporate Bond Market Report Box 2.1 International experience on regulating investments by pension funds Many countries still maintain tight regulation over asset allocations by institutional investors to prevent excessive risk taking, but this may be a double-edged sword. In Mexico, factors such as the restrictions and limits placed on pension funds (which sometimes require a corporation to be rated specifically by Standard and Poor's in order to be investable), the lack of high-quality corporations (only about ten local "blue chips" are considered investable), the risk aversion of local investors, and the shortage of interested players have hindered liquidity in the secondary corporate debt market. As a result, the general portfolio composition in the pension industry currently consists of around 85 percent of investments in federal government bonds. That said, states and municipalities, which were previously reliant on development banks for financing, have also been active in the local bond market. This has added breadth to the market and improved the transparency of operations, improving the credibility of, and interest in, these securities. In Brazil, tight regulatory requirements have prevented investors other than local buy-and-hold pension and mutual funds from participating actively in the market, limiting demand for corporate issues. In Chile and other markets, regulatory restrictions that prevent banks from doing repurchases with corporate bonds also represent an obstacle for the development of a liquid secondary market. The corporate bond market in Colombia remains very small, partly because of the lack of demand for lower-rated debt from pension funds. Although pension funds in Colombia are, in theory, able to invest in securities rated A-minus or above, in practice, they tend to require a AAA rating, especially for big issues. As a result, local corporations that are not AAA-rated have been reluctant to issue new securities locally. In Malaysia, life insurance companies, which are important players in fixed-income markets, cannot invest more than 15 percent of their portfolio in unsecured bonds and loans and can only invest in highly rated corporate bonds. In contrast, pension funds in mature market countries have substantially greater flexibility to manage their portfolios. While some developed countries apply minimum requirements on pension funds' investment on government securities, most do not have explicit ceilings on debt securities in which pension funds can invest (see OECD 2004 ) However, pension funds in these countries are required to follow "prudent man rules"--that is, assets should be invested in a manner that would be approved by a prudent investor (Roldos 2004b). Funds for other formal sector employees, with about within the MoF which invests only in government 21 million contributors and over 4 percent of GDP in securities. But when the Pension Fund Regulation assets. The central pension and provident funds invest and Development Authority (PFRDA) is established almost wholly in debt of federal or state governments or to regulate the New Pensions Scheme contributors, public sector enterprises. the design of pension fund management under the proposed defined contribution scheme will include To correct issues related to the fiscal cost of government a centralized administrative structure alongside pensions, the unattractiveness of the Provident Fund competitive fund management.6 Pension fund programs, the limited contribution of the formal managers will be constituted as specialized institutions pension schemes to capital market growth, and the lack that hold assets and provide services on a fee basis, of pension coverage outside the formal sector workers, an approach that will help distinguish their activities the Government decided to set a legal framework for from the parent entity or sponsor, better controlling private, defined-contribution, pension schemes for new potentialconflictsofinterestandfacilitatingregulation government employees and other contributors. and supervision. Currently, reforms in the pension sector have been Thus the pension market in India is still effectively under stalled due to political opposition to moving to a government control. While private provident funds are defined contribution scheme and investing in the allowed, the returns are regulated as the provident funds stock markets. Contributions made by the new have to strictly adhere to the investment guidelines central government recruits (who joined after 2004) prescribed by government. Penetration of pension are being managed through an interim arrangement funds is very low and covers only about 12percent What is holding back supply and demand? 19 of the workforce. All these factors have led to for two reasons. First, once a government security underdevelopment of the pension fund asset base which is subscribed, regulations mandate that it be held to is now at about 4.5 percent of GDP (McKinsey, 2006) maturity. Second, investment guidelines also mandate as compared to international standards (United States that interest received from government securities be 66percent ; Chile: 60 percent; Brazil: 40 percent). reinvested in those securities. Restrictive investment guidelines. The Employees Thus, the investment profile of pension funds is Provident Fund and Public Provident Fund are highly regulated, with a bias toward government also repositories of large amounts of long-term securities. Recently, the investment guidelines for finance. According to regulation, provident funds provident funds have been somewhat liberalized with are required to invest a minimum of 25 percent of the announcement of investment in private sector their incremental accretions each year in government shares and debentures. However, this reform has yet securities, 15 percent in state government securities, to be implemented fully. A survey of pension fund and 40 percent in bonds from public sector investment guidelines in some of the Latin American undertakings, with a maximum of 10 percent in countries suggests that, while significant exposure to rated private sector debentures. Today, a significant government debt is stipulated, there is considerable portion of pension and provident funds are deployed freedom for these funds to invest in a mix of financial in government securities, which remain locked in instruments with varying risk-return profiles. Since Box 2.2 International experience with encouraging foreign investment in corporate bond markets Foreign investors are an important source of demand for local securities, and several emerging markets have opened up their local markets in an attempt to widen and diversify the investor base. Although there may be differences in investment strategies among different types of foreign investors, market participants perceive foreign investors as playing a supportive role in local markets (Roldos 2004a). Furthermore, foreign investors usually impose positive pressure for developing robust market infrastructure and transparent market practices. At this stage, however, foreign participation in local debt markets in Asia and Latin America remains limited, despite efforts to open up their markets to foreign investment. As a result, the investor base for local debt instruments continues to be dominated by domestic institutional investors. International experience suggests that market liberalization alone is insufficient for increasing foreign participation. Colombia's restrictions on holdings by foreign investors had clearly been a barrier to the development of the local corporate bond market. The situation in Korea is less clear. Even though foreigners are allowed to invest in all types of listed bonds in Korea's local market, they currently hold only about 0.4 percent of listed domestic bonds (compared with foreign participation of over 40 percent in the Korean stock market). The situation may be partly due to the lack of a developed repurchase market and hedging instruments. In Brazil, the existence of withholding taxes and the threat of discretionary increases in other taxes, such as proposed in the Financial Operations Tax Act, act as a strong deterrent to foreigners from buying domestic securities. In contrast, foreign interest in Mexico's longer-term government bonds rose sharply in 2004, as the local market started to realize the benefits from ongoing reform efforts--to establish a credible benchmark yield curve, improve transparency, and promote liquidity in the market. Similarly, in Malaysia, foreign investor interest in the local markets has been higher, with the government taking new initiatives to make investments into local markets easier and more attractive and to improve market infrastructure. In most mature markets, there are few restrictions on foreign investment in local bond markets. This openness, together with established market infrastructure and governance, pushed foreign participation rates in local debt markets significantly up in the past decade. For example, in June 2003, 46 percent of long-term U.S. Treasury securities and 16 percent of outstanding corporate debt securities were held by foreigners (U.S. Treasury 2004) These shares have doubled in the past ten years. Similarly, in Australia in 2000, about 45 percent of government bonds were held by nonresidents, up from about 25 percent in 1994. Nonresident holdings of private sector debt are closer to 10 percent. Note: See Burger and Warnock (2004) for a discussion on the determinants of foreign participation in local-currency bond markets. 20 Corporate Bond Market Report Table 2.7 Net investments by foreign institutional investors,1997­98 to 2005­06 (Rs. billions) 1997­98 1998­99 1999­00 2000­01 2001­02 2002­03 2003­04 2004-05 2005-06 Debt 2.7 ­8.3 5.1 ­6.4 6.6 3.5 55.3 17.59 ­73.34 Equity 4.5 ­5.5 100.7 101.4 80 24.8 434.3 441.23 488.01 Source: Center for Monitoring the Indian Economy. the early 1980s, pension funds have become important reasonable terms. This is despite evidence that risk- players in the capital markets of many Latin American adjusted rates of returns of these lower-rated bonds countries because of the radical reforms those countries exceed those of AAA corporations. made to their social security systems. However, pension funds are subject to quantitative restrictions, Foreign institutional investors including a list of authorized assets, diversification rules, conflicts of interest regulation, valuation rules, Foreign institutional investors (FIIs) are required and so on. to allocate their investment between equity and debt instruments in the ratio of 70:30. However, it Mutual funds is also possible for such an investor to declare itself a 100 percent debt FII, in which case it can make Public and private sector mutual funds are a growing its entire investment in debt instruments. In that force among institutional investors, with total assets case, the foreign institutional investors can invest under management for mutual funds reaching Rs. in debentures (including nonconvertible and partly 1,496 billion as of March 31, 2005 (5.5 percent of convertible debentures), bonds (including dated GDP). Two-thirds of these funds are typically debt government securities, treasury bills, and other debt investments (the majority of which are money market market instruments). instruments and gilts). Mutual funds have been the main cause of growth in corporate debt issuance in Foreign corporations and foreign individuals are not the primary market in 2004, and it is estimated that eligible to invest through the 100 percent debt route. The they trade about 30­40 percent of their portfolio, overall investment limit under the 70:30 route in dated which could be an important source of activity in the government securities and Treasury bills is US$1.55 secondary debt market. billion. The FII investments in corporate debt have a ceiling of US$0.5 billion.7 More than 300 FIIs invest Despite the rapid growth of assets under management in Indian equities, while the number of FIIs investing by mutual funds, their overall impact on the corporate in Indian domestic debt is less than 20. The table above bond market is limited because these vehicles shows the share of equity and debt in FII investments mostly focus on liquid assets, such as money market in India since 1997. It is evident that Indian equities are instruments, government securities, Treasury bills, and favored by FII (table 2.7). equities. Existing restrictions have discouraged mutual funds from holding lower-rated, illiquid corporate debt While the appetite of FIIs for securities across the instruments, as fund managers are unwilling to invest in credit spectrum is high, the investment caps act as such instruments, which may be redeemed at any time. a significant deterrent for these investors and pose At this time, mutual funds are only investing in AAA a constraint on the growth of the corporate debt or AA+ debt. There is presently no high-yield bond market. This restriction potentially represents a missed fund of Indian assets, and corporations rated below opportunity to develop the market and facilitate the AA--which constitute the bulk of local companies in financing of the infrastructure sector, as emerging the infrastructure sector--are unable to issue debt on market debt spreads continue to compress and What is holding back supply and demand? 21 investors search for yield in local markets (box 2.2). regulatory regimes should accommodate changes such Thus far, anecdotal evidence from market participants as new forms of funds or asset classes while providing indicate that the demand for Indian corporate bonds a clear legal basis for fund operation and regulation, so by FIIs far exceeds the cap of US$500 million. Market that the growth of the industry is not hindered. Finally, analysts believe that the opening of the corporate for foreign institutional investors who have the appetite bond market to foreign investors would generate a and ability to bring in risk capital that is needed for high degree of interest, similar to that already seen in better economic growth, the current absolute ceiling the local equity market. on investments in the corporate bond market could be further increased with future limits being fixed as Conclusion a percentage of gross issuance in the previous year and with relaxations for longer term investment in corporate A broader base of investors is a key component for bond debt markets (over 3 years). deepening securities markets. Continuing pension system reforms, which if implemented successfully can Notes play an important role not only in resource mobilization 1The Basel Capital Accord introduced in 1998 sets minimum capital and providing longer term income security, but also, requirements for banks at 4 percent tier I capital and 8 percent total capital (tier I and tier II capital) in relation to risk weighted assets. Tier in expanding the institutional base to support the II capital is supplementary capital which consists of undisclosed reserves, development of long-term savings instruments and general loan loss provisions, and hybrid instruments that combine deepen the capital markets. Similarly, the insurance characteristics of debt and equity and are available to meet losses and unsecured subordinated debt. industry can also participate more actively in the capital The total amount raised by banks through the primary issuance market markets by increasing penetration ­ 80 percent of was Rs. 105.52 billion in 2004­05 and Rs. 66.23 billion in 2003­04 India's population is without any insurance coverage. (details in annex 3). 2Based on discussions with a subset of investment bankers, brokers, and These reforms should be coupled with changes in corporations. investment policies and regulatory guidelines to make 3Pension reforms currently envisaged in India will be based on the these sufficiently flexible for insurance companies and establishment of a defined contribution scheme with members offered a variety of investment options, including the equity market, fixed-income pension funds to choose an appropriate risk-return instruments, and so on. The current asset allocation of existing provident profile within fiduciary constraints. funds is heavily biased toward central and state government securities. 4The Reserve Bank of India regulation requires that at least 75 percent of the investment portfolio should be marked to market. Banks value their To sustain the rapid growth in assets of mutual funds portfolios according to a model for valuation that is prescribed either by and to attract a diverse set of retail investors, mutual the RBI or the Fixed Income and Money Market Dealers Association, funds will need to offer a wide range of mutual fund FIMMDA. The market values of bonds have to be estimated at a regular frequency to ensure that the correct capital is set aside in keeping with the products with different investment objectives and current risk management principles. strategies (for example mutual funds could offer 5Once a security is subscribed to, regulations mandate that they be held to products that cater to different risk-return and liquidity maturity. 6Although political opposition to private fund managers could mean that needs through investments in liquid securities, or the initially the pension system will be managed only by state-owned fund through investments in illiquid assets such as real estate, managers. or high-yield issuances). The key point being that as 7The investment ceiling on foreign institutional investors has been increased from $0.5 billion to $1.5 billion, as announced in the 2006 financial markets innovate constantly, mutual fund Union Budget Speech. 3.What is holding back the development of the market? T he elements of the microstructure of primary and since they then opt for bank loans, which tend to be secondary markets--such as issuance method, cheaper given the high liquidity in the banking system, trading mechanisms, dissemination of transaction although the liquidity is now reducing due to high credit information, and the role of intermediaries--are growth in the last year. Raising debt through a public important for market development. In India, the crucial issuance in India entails substantial costs associated with issues involved in developing the corporate bond market regulatory compliance, advertising, and intermediation are:facilitatingspeedyandcost-effectiveprimaryissuances costs to brokers and underwriters. without compromising transparency and disclosure, ways and means of elongation of maturity of corporate Raising debt is also a lengthy process--the minimum bond issuances, improving the liquidity in secondary time for clearance of offer documents by the regulator is market, and improving institutional mechanics. This 21 days. In contrast, approval by the regulator takes just chapter focuses on the process and costs of bond issuance, five days in Korea (for secured and guaranteed bonds). the types of instruments issued, the nature and liquidity Furthermore, shelf registration,1 which facilitates of the secondary market, and the legal and regulatory frequent and quick issuance of debt securities, is not framework for corporate bond markets. available to all corporate issuers in India, but only to specially designated public financial institutions. The Long and costly issuance process primary market for equity in India has developed highly efficient screen-based on-line auction mechanisms for The high costs associated with corporate debt issuance, the sale of shares. The corporate bond market does such as the costs of meeting new disclosure laws and not yet use these transparent and low-cost procedures, direct issuance costs, have deterred market development. which help to reach investors all over the country. Latin Ineffect,thehighissuancecostshindersthedevelopment America, in contrast, has moved toward auction systems of local corporate bond markets by discouraging the in which corporate bond offerings are executed in a fair, supply of bonds, particularly from smaller corporations, open, and transparent manner (box 3.1). Box 3.1 International experience with auction systems for bond primary market issuance: experience in Latin America The use of underwriting and auctions for corporate bond issues differs by region. Bond issues in Asia are underwritten and distributed by an investment bank or a syndicate of brokerage houses, similar to the traditional process used in the U.S. domestic and Eurobond markets. Historically, the issuance process was similar in Latin America, but has now migrated to an auction-based system, patterned after government bond auctions. Under this procedure, corporations choose a lead manager (placement agent) for the offering, and institutional investors make direct bids for specific amounts of bonds at various prices. Under a "Dutch auction" mechanism, all bonds are awarded to bidders at a single cut-off price that gives the borrower its desired volume of issuance. Under these auction-based systems, there is no need to form syndicates to spread underwriting risk or to assist the lead manager in the selling effort. Lead managers have been forced to accept this issuance methodology by a concentrated, powerful group of institutional investors who want to ensure that corporate bond offerings are executed in a fair, open, and transparent manner (IMF 2005c). 24 Corporate Bond Market Report International experience in reducing bond issuance in the issuance process and lowered the cost of bond costs varies across emerging market countries--with issuance to below that of bank loans. Not surprisingly, only some countries like Chile or Malaysia being bond issuance has dominated bank lending as a source successful in streamlining processes and reducing costs. of funding in Malaysia since 1997 (IMF 2005c). In Brazil, bringing an issuer to market is relatively expensive. The costs of local issuance (encompassing Unlike the public issuance of corporate bonds, the fiduciary agents, lawyers, registration, rating agencies, private placement market in India offers competitive and bank fees) make it prohibitively expensive to issue rates and quick access to the market with relatively less debentures in amounts lower than 50 million reais regulatory interface (table 3.1). As a result, this segment ($20 million). In contrast, the cost of placing debt in accounts for over 90 percent of debt placement in India.2 Chile's local market is one seventh of that paid for a However, recent guidelines that require compulsory placement in international markets (see Cifuentes, listing of all privately placed debt on the stock exchange Desormeaux, and Gutierrez 2002). Bond issuance costs and detailed listing agreements with the exchange in each category (for example, investment banking fees, have greatly increased the disclosure requirements and regulatory fees, or legal fees) tend to be higher in Mexico costs for private placement, mainly affecting first-time than Chile; however, Mexico does not impose issuance issuers. For large corporations, which either have an tax on securities. equity listing or are frequent issuers in the bond market, the main costs pertain to incremental disclosures, rating In Poland, a number of regulatory and cost obstacles fees, and arranger fees. In India all debt issuances for make private placements the only cost-efficient way to Rs.1 billion or larger have to be rated. Even smaller issue corporate bonds. For example, a prospectus has issues have to be rated if the securities are to be placed to be issued for each bond issue, ruling out medium- with institutional investors, such as banks, insurance term notes programs. Prospective issuers must wait a companies, and pension fund managers. The cost of the long time for the approval of the authorities, in addition rating is roughly ten basis points (or 0.1 percent--one to paying high fees for issuances. Similarly, the cost of basis point is one-hundredth of a percentage point) of public issuance in Hong Kong SAR is estimated to the size of the issue rated. Stamp duty on the issuance of be four times that of a private placement. In contrast, debt securities varies depending on the type of investor. Malaysia's Securities Commission introduced a series Furthermore, stamp duties vary between different states of measures to streamline the capital-raising process. in the country depending on where the charge for the These have minimized the time and work required mortgage is created. The total cost for a frequent issuer Table 3.1 Costs for an issuance of Rs.1 billion through private placement,2005 (in Rs.) Type of cost One-time cost Annual cost Rating 1,000,000 100,000 Listing (National Stock Exchange) 7,500 50,000 Trustees 50,000 50,000 R&T agent 25,000 25,000 Arranger fees 2,500,000 - Stamp duty on secured debentures (assuming mortgage in Mumbai)a 1,000,000 - Total cost 4,582,500 225,000 Percentage of total value of issuance 0.46 0.02 a. In case of unsecured debentures the stamp duty would be 0.375 percent of the amount issued. The stamp duty also varies depending on the state in which the mortgage is created. Note: The above costs are indicative. All costs other than stamp duty are subject to negotiation. Source: World Bank staff estimates based on interviews with investment bankers What is holding back the development of the market? 25 for an issue size of Rs. 1 billion is a little under 50 basis Large private corporations in India prefer to borrow points, which apart from being speedier than public money from international debt markets because of issuance is also cost-effective. more rapid processing and lower costs of financing. When corporations do borrow from the market, One of the most commonly cited deterrents against the mode of issue of debt is in the form of private a public issuance route is the amount of time elapsed placements rather than a public issue of debt. between the decision to source public funding and Theaveragesizeperissuehasgrownsincethe1990s. the actual receipt of the funds, which increases the This shows that the market is willing to absorb a uncertainty of pricing. Most market participants larger amount of debt per issue now. Nonetheless, estimate that it takes two to three months to obtain the number of private corporations accessing the financing. A private placement is much faster, but does domestic market for funds, witnessed a drop in not compare favorably with international markets, 2003­04, before recovering. Interestingly, over the where the time from making a decision to obtaining past five years the number of public corporations funds can be as little as 48 hours. tapping the privately placed bond market has seen a growing trend (figure 3.1). An interesting feature of recent primary issuances has been the ability of issuers of all credit quality to raise Lack of innovative debt funds through foreign currency convertible bonds (FCCBs). This route has become attractive in terms of instruments both lower price (because of the low overseas interest A well-developed debt market like that in the United rates and a relatively strong rupee last year, although States, Euro area has a variety of debt instruments. this trend has now been somewhat reversed) and These include convertible bonds, fixed-rate bonds, easier terms (because of the low cost of arranging the floating-rate bonds, high-yield bonds, zero-coupon issuance and the avoidance of rating and cover charges). bonds, inflation-indexed bonds, securitized bonds (such Furthermore, FCCBs can also be raised within a month, as asset-backed securities, mortgage-backed securities, while pure debt takes longer to raise in India. collateralized bond obligations, collateralized loan obligations, collateralized mortgage obligations, and Thus, these features characterize the primary issuance collateralized debt obligations), subordinated bonds, market for corporate bonds in India: and perpetual bonds, also called annuities. Figure 3.1 Public and private sector bond issuance through private placements (2001­2006) 600 500 400 billion 300 Rs 200 100 2001­02 2002­03 2003­04 2004­05 2005­06 Public sector bond issuance Private sector bond issuance Source: Reserve Bank of India. 26 Corporate Bond Market Report The Indian debt market today tends to issue mostly picked up only after 2000.4 Indian securitization fixed-rate coupon bonds. In the past, convertible bonds began with the ring-fencing of a portfolio of auto loans were issued on a small scale by Indian companies as zero- and has been predominantly an asset-backed market.5 coupon bonds, although these are no longer available Issuance has been predominantly of AAA rated notes, as the pricing guidelines for conversion prescribed by as investor appetite for lower-rated tranches is almost SEBI do not make these attractive for investors. While non-existent. The market is characterized by a limited bonds of varying maturities have been issued (there is a investor base, comprising of a mutual funds and a 30-year government bond), Indian corporations issue few private sector banks. While the securitization debt securities having maturities of five to seven years market in India is growing significantly, it is still on average. There are also bonds that are issued with a way behind the securitization issuances in Korea and 15-yearmaturity,however,withcouponresetseverythree other developed countries where securitization issues years. In contrast, in other emerging Latin American cover a wide spectrum of instruments ranging from markets several different structures are used, including the traditional asset-backed and mortgage-backed floating rate notes and bonds with interest and principal securitization to collateralized loan obligations, payments. Latin American corporations issue coupon collateralized mortgage obligations, and collateralized bonds for maturities extending to 30 years, which in debt obligations (table 3.2). some cases is longer than the maximum tenor of local government securities. There are a number of reasons for the slow growth of the Indian securitization market. In the initial stages Markets for risk sharing-securitization of development of the securitization market, the and derivatives Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 intended India generally lacks innovative debt instruments. With to promote securitization did not have its intended the right policy and regulatory environment, derivatives effect, perhaps as the Act sought to cover three disparate and securitization instruments and mechanisms for risk areas:securitization,securityenforcement,andcorporate transfer and sharing can offer substantial benefits for the reconstruction. The Act did not allow a special purpose long-term financing needs of infrastructure developers. vehicle to be set up for a single transaction and instead Annex 5 provides a comparison of the availability of such required a securitization company to be registered with instruments in India and other developing countries. Reserve Bank of India with provision of minimum capital. Setting up a separate company entailed costs Securitization and made securitization transactions unviable. Although the first securitization deal took place in the The "bankruptcy remoteness" of the securitization Indian market in 1991,3 the market for securitization company was lost (which was the main aim of the Act), Table 3.2 Securitization issuance in India and selected emerging market,2001­04 (US$ millions) Country 2001 2002 2003 2004 Korea 30,230 26,783 26,356 19,247 Malaysia 1,412 751 266 350 Thailand 0 141 20 38 Chile 421 40 343 775 Brazil 1,050 1,150 2,025 1,070 India 562 304 1,138 2,456 Note: Data include domestic and international securitization issuances. Source: IMF, Prime Database, ICRA estimates. What is holding back the development of the market? 27 as the asset being sold down would be linked to the bankruptcy of the securitization company and other Figure 3.2 Issuance size and number of deals in portfolios purchased by the securitization company the securitization market, 2000­06 instead of the originator. Therefore while the Act has 375 been used for non-performing assets by way of selling billion) 300 these assets to asset reconstruction companies, it has not (Rs 225 provided the solutions to issues faced in securitization Size 150 of standard assets, as result of which, most securitization 75 transactions for standard assets are carried outside the uances (Is 0 purview of the Act. 2000 2001 2002 2003 2004 2005 2006 Year Moreover, ambiguity over the status of pass-through 150 certificates issued in securitized transactions has 120 prevented investment by most of the large investors, deals 90 such as provident funds, and nationalized banks. of 60 Because these certificates are not recognized as No. 30 securities, these are not listed on the exchanges, 0 thereby limiting the tradability of the certificates. The 2000 2001 2002 2003 2004 2005 2006 Year government is now considering an amendment to Source: ICRA 2006. the securities law to classify pass-through certificates issued by special purpose vehicles as "securities." This Amongst the various types of securitization provides pass-through certificates with the same legal transactions, the ABS market has seen the largest standing as debt instruments and will make these growth with issuances of about Rs. 223 billion eligible for inclusion in the approved list of securities in FY05, almost three times the volume in 2004 for provident funds, charitable trusts, and many (figure 3.3). The mortgage backed securities market statutory bodies. has not seen as much growth over the last few years, despite significant expansion in the underlying housing In addition to these structural reasons, issues relating finance business, due to various legal and regulatory to taxation (stamp duty), and foreclosure laws need to barriers.6 The market for corporate loan securitization be addressed to increase the interest of issuers as well and other pooled structured finance products is still as investors. The difference in stamp duties across in a nascent stage in India. As the pool of investors in states and the lack of clarity relating to incidence on structured finance products are limited to a handful of stamp duty on the transfer of certain types instruments institutional investors who have a lower risk appetite have limited the market towards certain states (who (due to a variety of reasons discussed in the note), have reduced stamp duties proactively) and to those investment decisions of investors are often influenced receivables that do not incur onerous stamp duty costs. by the "base rating" of the underlying corporate Foreclosures in India are time-consuming and costly. exposures in a collateralized debt obligation pool and While banks and financial institutions have been not on the rating that the instrument achieves. provided avenues for speedier recovery of assets in the event of a default, special purpose vehicles set up for In February and October 2006, the Reserve Bank securitization transactions do not enjoy the same benefit, released guidelines for the securitization of standard thereby rendering the recovery process time-consuming assets. The guidelines codified a number of prevailing and costly. Notwithstanding the difficulties in carrying market practices with some stringent requirements on out securitization transactions under the provisions of capital and profit recognition. While the immediate the Act, the securitization market has been witnessing a impact of the guidelines slowed down the market, in healthy growth over the past three years (figure 3.2). the long run these are a move in the right direction. The 28 Corporate Bond Market Report Figure 3.3 Securitization in the Indian market, by type, 2002­06 100% 80% 60% 40% 20% 0% FY02 FY03 FY04 FY05 FY06 ABS MBS CLOs PG Others Note: ABS: asset-backed securitization; MBS: mortgage-backed securitization; CLOs: collateralized loan obligations; PG: partial guarantee. Source: ICRA. new guidelines are also expected to pave the way for Currently, there are no institutions that provide such mezzanine investors in the securitization which would credit guarantee products in India. In more developed be a welcome development. markets, credit guarantee services tend to be provided by specialized credit guarantee companies. Credit enhancement For example, in the United States, four major credit guarantee companies called the "monolines" Credit enhancements play an important role in mainly provide credit guarantee facilities. The credit enhancing financial intermediation by bridging guarantee market has been recording a substantial the gap between borrowers--especially those with growth in the last two decades in the United States. inadequate credit ratings--and certain investors In India, third-party credit enhancement has not who would only be allowed or interested in developed because of the lower maturity of the investing in bonds with a higher credit rating. market, the lack of market intermediaries such as the Third-party credit enhancement or credit guarantee monoline insurers (which have deep financial ability (also known as bond insurance) by a third party for and risk capital to provide such services), and the issuers with non­investment grade rating provides lack of reliable credit default histories (which is at an important avenue for lower-rated issuers to tap a very nascent stage of development in India today) the market.7 From the point of view of the issuer, needed to appropriately price credit guarantee credit guarantee would help lower funding costs and products. Even if a lower-rated borrower were to broaden market access and the investor base.8 From use this product, it would not be economical for it the investors' perspective, credit guarantee provides to do so unless the savings resulting from reduced additional comfort or protection against default interest cost exceed the cost of guarantee. There have risk and can also enhance liquidity in the secondary been very limited instances of credit-enhancement market. Furthermore, with a credit-enhanced rating, for bond issuances in India, mainly in municipal many issuances are able to qualify under the financing with bilateral or multilateral funding (from guidelines of pension and insurance funds and othe the U.S. Agency for International Development, for conservative investors. example, or the World Bank). What is holding back the development of the market? 29 Derivatives actively traded derivative. The absence of a suitable money market index for the interest rate swap market The development of financial instruments, such as is also another constraint in developing the market credit derivatives and interest rate hedging tools, (although indications are that this is now beginning to to increase liquidity in the secondary markets has develop). also been constrained in India. Globally credit derivatives are among the fastest growing products, In 2003, an attempt by the securities regulator to and especially credit default swaps which make up a start exchange-traded interest rate futures failed to majority of credit derivatives. Credit default swaps take off. The reason for this being that commercial more than doubled to US$ 26 trillion in the first banks, which are by far the largest players in the half of 2006 from a year ago. In the Indian context, bond market, can use exchange-traded derivatives although derivative instruments were introduced in only for hedging. Since banks hold a large stock of July 1999 in the money/foreign exchange market government securities in their portfolio, they need in the form of forward rate agreements and interest to be able to take trading views for a vibrant market rate swaps, credit derivatives are yet to be introduced to develop. With only hedging positions allowed by as the Reserve Bank of India has not yet issued the the Reserve Bank of India, they could have only sold enabling guidelines.9 the derivative contracts, thus making the market extremely one-sided, and as a consequence the market Derivatives can be traded on organized exchanges never took off. However, banks are permitted to take or in over-the-counter markets. Typically, given the trading positions in the over-the-counter derivative variety of needs and specifications in fixed income market, indicating the lack of a level playing field derivatives, these tend to be traded over the counter, between the OTC and ETD markets.11 although recently benchmark securities have helped standardize these products on exchanges as Inadequate secondary market well. Globally, 26 percent of the US$ 53 trillion exchange-traded derivatives were fixed income infrastructure derivatives (both on short-term interest rates and The infrastructure to support the secondary debt long-term government bonds) in 2004. In India, market, in which bonds are bought and sold after after introduction of interest rate derivatives in their initial issuance, includes trading systems, which 1999, banks could undertake simple forward-rate allow efficient price discovery, and reliable clearing agreements and interest rate swap contracts for their and settlement arrangements. Although market own balance sheet management and for market- liquidity is hard to measure, the liquidity of corporate making purposes, provided they ensured adequate bonds in both developed and emerging markets is infrastructure, risk management systems, and relatively low. internal control systems. Exchange-traded versus over-the- The interest rate derivatives market has grown counter systems significantly in the last few years and is predominantly an over-the-counter market, with the outstanding notional In many countries, the majority of bonds are traded amount at around Rs. 6.4 trillion in 2004.10 However on over-the-counter markets. An over-the-counter the interest rate derivatives market is still considered market refers to a decentralized market where securities in its early stages in terms of depth and sophistication. are typically traded over the telephone, facsimile, or Participation in this market remains limited mainly to electronic platform, as opposed to an exchange, which about 15 select foreign/private sector banks and primary is an organized market and may be either floor-based dealers and the market is predominantly an inter-bank or electronic. Organized markets usually have more market with overnight index swaps being the most disclosure requirements (IMF 2005c). 30 Corporate Bond Market Report Table 3.3 Turnover in secondary markets As of December 1, 2003, the exchange had registered Issuer Turnover in secondary market (Rs. billion) 75 trading members on the Wholesale Debt Market. 2002-03 2003-04 2004-05 2005-06 Table 3.4 shows the business growth on the Wholesale Debt Market. Most of the trade data here pertains to Government 19,557 24,334 21,894 25,804 government securities trading, which has witnessed a Corporate/ 360 423 417 227.14 nongovernment steep fall over the last three years since the introduction of Total 19,917 24,757 22,311 26,031 a competing platform called `Negotiated Dealing System' set up at the initiative of the Reserve Bank of India. Source: Reserve Bank of India, Securities and Exchange Board of India Secondary corporate bond trading in India, like in most At a more conceptual level there is a need to think other markets, is done through over-the-counter trading through the secondary market microstructure issues. between the counterparties directly or intermediated by As debt markets are very different in nature from brokers, although the securities are listed on exchanges. equity markets there is a need to examine feasibility The quantum of trades carried out through the exchange of setting up inter-dealer electronic broking platform. is negligible, despite attempts by the Securities and The primary limitation seen today with secondary debt Exchange Board of India (SEBI) to mandate trading of market is that the current framework is in essence an corporate bonds through the exchange. In any case about equity framework that puts emphasis on the need for an 98 percent of the secondary trading is in government exchange trading environment. But for the debt market, securities (table 3.3). there is a need to recognize that due to the illiquid nature of corporate bonds,12 it requires the active participation Once trades are executed, they are reported for of dealers not only to provide liquidity but to act as the information disclosure. Since most of the dealers main source of distribution. This then requires a more in the corporate debt market are also members of decentralized micro-structure, with over the counter the Wholesale Debt Market of the National Stock market transactions making up for an important part of Exchange--a platform originally set up for reporting the secondary market activity. However, the limitations trades in government securities--trades are reported on thatarisesinthiscontextisaratherundefinedrecognition that platform. of over the counter transactions within the current Table 3.4 Business growth in trades reported at the National Stock Exchanges Wholesale Debt Market,1995 to 2006 Year No. of trades Avg. daily volume Avg. trade size (Rs. billions) (Rs. billions) 1994­95 1,021 0.3 0.06 1995­96 2,991 0.4 0.03 1996­97 7,804 1.5 0.05 1997­98 16,821 3.8 0.06 1998­99 16,092 3.6 0.06 1999­2000 46,987 10.3 0.06 2000­01 64,470 14.8 0.06 2001­02 144,851 32.8 0.06 2002­03 167,778 36 0.06 2003­04 189,518 44.8 0.07 2004­05 124,308 30.3 0.07 2005­06 61,891 17.55 0.08 Source: NSE Fact Book, 2006 What is holding back the development of the market? 31 securities regulatory framework, makes it very difficult methodology that can also be applied to mutual funds. for such dealer structure to develop. There is a need to In other countries, institutional investors use either prices address this issue to develop a market microstructure supplied by their regulators, self-regulatory organizations for the corporate debt market, that will be acceptable (Thailand, India), or average quotes from securities to majority of the participants in this market, that is, companies (Malaysia) (IMF 2005c). institutional investors. Trade reporting platform A number of emerging market countries are trying to encourage more exchange-based trading of bonds Over the counter trading often makes trading data more because exchange trading is seen as being more difficult to aggregate and report publicly. The United transparent and allowing a wider range of investors States is an exception, where over-the-counter trading better access to the market, some countries encourage data on all secondary bond transactions are collected investors to trade bonds on the exchange to promote and disseminated through the National Association of competition in the secondary market. For example, Securities Dealers' centralized reporting system TRACE in Peru, the government encourages trading on the (Transaction Reporting and Compliance Engine). The exchange by exempting interest income tax for fixed- information is made available to the public on a variety income securities traded there. In some countries, of websites. A variety of other countries with mature institutional investors (for example, private pension or emerging bond markets are developing similar or funds) are restricted to trading securities only on the alternative methods to improve the dissemination of exchange because of the better transparency. However, it trading information. is still quite early to determine the success of exchange- based trading of corporate bonds. Although there is no single reliable number, the total outstanding privately placed debt in India was The existence of a large number of illiquid corporate approximately $43.7 billion, which is ten times the bonds poses a challenge to institutional investors that are publicly issued debt (McKinsey, 2006). The lack of required to evaluate their portfolio holdings at current comprehensive data relating to the debt on issue and market prices. Some securities are not traded for extended the outstanding stock of debt for corporate issuers periodsoftime.InMexicoandKorea,thesystemsof"price is a serious handicap in the Indian market today. vendors" are established. Institutional investors "purchase" While data on public issuances by corporations is thepricequotesfromthesepricevendorswhoprovideprice available, most of the issuance over the last few years quotes for all securities using their pricing methodologies. has been through the private placement market, In Chile and Peru, the pension fund regulators produce which has had very little oversight and reporting their own "price vectors" for the valuation of portfolios, requirements by issuers and arrangers until about a and there are increasing pressures to have a standardized year ago. Now that the reporting of debt on issue by Box 3.2 International experience on better dissemination of trading information Corporate bond market microstructure plays an important role in determining market liquidity. The market microstructure includes trade execution systems, trading venues, trading commissions, disclosure of contracted price and volume information, and market regulations. Robust and efficient trading, as well as proper data dissemination systems, promote market integrity and improve the liquidity and efficiency of the price discovery process (Madhavan 2000). In most emerging markets, information about transactions on the exchange is well disseminated. Transparency requirements for listed bonds traded on the over-the-counter market differ across countries. With some exceptions, information is made publicly available with delays ranging from minutes to a day. For example, information is provided to regulators in Malaysia; to the stock exchange and subsidiaries in Mexico; and to self-regulatory organizations in Korea (KSDA), Thailand (Thai BDC), Japan (JSDA), and the United States (NASD) (see IOSCO 2002 and 2004. 32 Corporate Bond Market Report listed companies has been somewhat streamlined, it Inthecaseoftheequitymarket,theclearingcorporations is expected to improve gradually. of the national stock exchanges stand as the central counterparty and absorb the credit and settlement risk. Nevertheless, data on outstanding debt is still very hard For settlement of the securities in the trade, the clearing to compile, as there is no comprehensive repository corporation is linked to the securities depositories which of information to track debt issuance by companies take care of the book-entry settlement of trades and for through its entire life cycle, that is, from issuance until settlement of payments between the trade participants, redemption. As a result, investors lack sufficient, timely, the services of participant banks are used to complete and reliable information on bonds. Data on bond the transaction. issues, size, coupon, latest credit rating, underlying corporate performance, secondary trading experience, However, secondary corporate bond trades in India and default histories of companies are sparsely available are bilateral, which means that each counterpart to the and are usually not available from one source.13 This trade takes on counterparty credit risk and settlement has muddied the corporate debt market and created risk. Securities settlement is effected directly by barriers to active trading and pricing. participants through their securities depository. A positive aspect of the settlement system is that most One of the recommendations of the High Level bonds are held in dematerialized form as a consequence Committee on corporate bonds and securitization, set of regulatory requirements that institutional investors up by the Ministry of Finance pertains to establishing a and banks hold all new issuances of corporate bonds system to capture all information related to trading in in dematerialized form. Dematerialization has meant corporate bonds as accurately and as close to execution a huge reduction in costs to both corporations and as possible, and disseminate it to the entire market in buyers of corporate bonds, in terms of the costs of real time. The committee also recommended that it moving paper and the risk of fraud or other loss. would be cost effective to use the existing infrastructure However, bonds that were issued prior to 2000 can available with the national exchanges for dissemination still be held, traded, and settled in physical form for of information related to trading in corporate bonds. counterparties other than banks, which adds to the The Committee favored creation of multiple reporting risks of settlement. The lack of a central counterparty platforms to cater to the needs of the various kinds to mitigate these risks is viewed as one of the major of market players--institutional, retail, and so on-- deterrents to increased secondary bond trading in with SEBI taking the responsibility of approving the India. On the other hand trades in government reporting platforms and ensuring coordination among securities carried out or reported on the Negotiated such multiple reporting platforms. However, in a recent Dealing System get the benefit of a delivery versus decision, SEBI seems to have preferred a monopoly payment mechanism and a settlement guarantee trade reporting platform with one of the exchanges system since a dedicated clearing and settlement being chosen to perform the aggregating and reporting corporation with links to the NDS and, more recently, function of corporate bond trading. the real time gross settlement system, exists. Clearing and settlement system Gaps and overlaps in the legal Robustclearingandsettlementsystemsareacrucialelement and regulatory framework to bond market development because they help enhance Weaknesses in regulation, including poor the efficiency of bond trading and reduce their associated coordination and overlapping jurisdiction among risks. In addition, bond market liquidity is closely linked the government's various regulatory agencies, and to the reliability of bond clearing and settlement systems. weaknesses in laws concerning creditors' rights Investors will only trade bonds if they are confident of the and corporate governance all come in the way of settlement of their trades (IOSCO 2002). developing a corporate bond market. What is holding back the development of the market? 33 Regulatory jurisdiction and of new products and innovation in the design of debt coordination markets. RBI (Government Securities Market) and SEBI (Corporate Bond Market) sought to clarify In the debt markets, the Ministry of Finance, the the demarcation of their responsibilities following Reserve Bank of India (RBI), and the Securities and an amendment to the securities legislation in 2000. Exchange Board of India (SEBI) all have regulatory However, some amount of market fragmentation and supervisory roles that are not sufficiently remains because regulatory jurisdiction is still based delineated. The overlap in regulation and the different on the maturity of debt instruments. RBI regulates focus of each authority tend to inhibit development the issuance of money market instruments, and Box 3.3 Examples of regulatory overlap in the debt market Definitional issues The authority to regulate transactions in corporate debt instruments has been clearly left within the purview of the Securities Contract Regulation Act and the Securities and Exchange Board Act. These legislation are silent as to the authority of the SEBI to regulate repo transactions however the SCR Act does include within the definition of the term "securities" the ability to regulate "rights and interest in securities"--which could, in a broader sense, be taken to include repo transactions. Now that the RBI Act has been recently amended to specifically confer on the RBI the authority to regulate repo and reverse repo transactions in corporate securities in addition to the regulation of such transactions in government securities, it would appear that RBI also has the authority to regulate repo and reverse repo transactions of banks and financial institutions in the context of corporate debt securities. The RBI Act defines securities to mean government securities and confers on the RBI the power to "regulate all agencies" dealing with government securities. However, under the SCR Act, the term "securities" has been defined to include government securities. This creates a potential conflict of authority between the RBI and the SEBI as they are both empowered to regulate the same type of security. In order to ascertain whether or not there is an effective overlap of jurisdiction, the applicability of these definitions needs to be ascertained. The proviso to Section 45W(1) of the Reserve Bank of India Act clarifies that directions of the Reserve Bank relating to securities, derivatives, money market transactions, and so on. shall not relate to the procedure for the execution or settlement of trades on stock exchanges recognized under the SCR Act. In the SCR Act, the term has been included in the list of securities that can be traded on a SEBI regulated exchange. Thus the SEBI has the authority to prescribe rules and regulations as to the manner in which government securities are to be traded on one or more of its exchanges. This authority therefore relates to matters pertaining to exchange trading in defined securities. The RBI Act and in particular Chapter IIID seems to have a broader import. Under this Chapter the authority of the RBI to regulate securities has been granted with a view to appropriately empower the RBI to regulate these types of securities in the larger interests of the financial system of the country. In scope this seems to be a larger mandate. However in practice there appears to be an overlap between the ability of the RBI and the SEBI to regulate securities. Unless this is resolved by clearly establishing each entity's scope of regulation, it is likely that considerable confusions as to the extent of what each entity can legitimately regulate will continue to exist. The exchange-traded secondary debt market. Included in the general powers of the SEBI is the power to regulate all stock exchanges and other securities markets. This is a wide power that would ordinarily enable SEBI to regulate any securities trading platform whatsoever. The RBI has established a separate trading platform with order-matching facility for trading money market instruments and government securities--the negotiated dealing system or NDS. Since the NDS is a securities market in itself, it would appear that the SEBI would have the right to regulate the NDS. This, however, is not the case and the regulation of the NDS is left entirely to the RBI. The powers recently conferred on the RBI under the newly introduced Chapter IIID support this position but the uncertainty as a result of the overlap between the power of the RBI and SEBI need to be addressed and resolved. Further, the negotiated dealing system is restricted to those entities that hold current accounts and securities with RBI (banks, primary dealers, financial institutions, and so on). Currently, market participants, such as brokers and provident funds, who play an active role on the National Stock Exchange's Wholesale Debt Market are not yet part of this system. This results in fragmentation and inefficient price discovery. 34 Corporate Bond Market Report SEBI regulates the issuance of longer-term corporate to ensure that the terms used to describe the scope of debt instruments. Such a division prevails in many authority are distinct in order to avoid confusion. countries. Oversight of mutual funds (normally under SEBI's purview but coming under RBI's A few other examples of this overlap, which result in control as they offered money market investments) diffusing regulatory authority and uncertainty for was subject to regulatory overlap until 2000, when market participants, are provided in box 3.3. it was decided that money market mutual funds would be regulated by SEBI. Some of the regulatory That said, there is a recent example of better interagency confusion also arises due to the fact that while SEBI coordination in rule setting. For instance, SEBI recently is the primary regulator of the markets, the primary issued guidelines on the issuance and trading of investors (banks) and primary dealers are regulated privately placed corporate debt, which were prepared in by RBI. Consequently, the various regulations and consultation with RBI. RBI, in turn, issued investment stipulations relating to banks' participation in the guidelinesforinvestorssuchasbanksandprimarydealers corporate debt market as required by the Reserve Bank to complement SEBI's actions on regulating the private of India on these controlled entities has a significant placement market. This coordination in rule setting was impact on the market. The specific regulation and meant to encourage more transparency in the issuance stipulations have been discussed in the earlier chapter of privately placed corporate debt. This coordination relating to demand issues. Overlaps and jurisdictional was achieved through the Technical Subcommittee of issues will increase as financial markets become more the High Level Committee on Capital Markets and complex and open, thereby increasing the challenge through RBI participation in SEBI committees set up of regulating and supervising them. to examine issues in the debt markets.14 Overlap due to`definitions'of terms in Creditor's rights the legal and regulatory framework A key legal weakness of the corporate bond market is There appears to be considerable overlap in the payoffs obtained by bondholders in the event of applicability of terms such as "securities," "repos," default. In industrial countries, an extensive bankruptcy "bonds," "derivatives," and so on that have been used code exists, with well-functioning institutions. When in multiple legislations. Furthermore, it is evident that, a company fails to pay out cashflows on time, the particularly where there are multiple authorities that management team of the company is displaced, the have the ability to regulate a similar space, the practice company is sold off, and the residual value is given to of defining terms inclusively leads to lack of clarity. the bondholders. Such processes do not exist in India. An examination of the entire legislative landscape is Bondholders have to plan for near-zero recovery in the warranted, and once the legislators have a clear idea of event of default. the manner in which the regulatory jurisdiction needs to be carved up between the SEBI and the RBI, it is The Securitization and Reconstruction of Financial Assets important that appropriate amendments be made to and Enforcement of Security Interest (SARFAESI) Act, the definitions of the various terms that have been 2002, has made some progress on rapid repossession of used loosely across statutes. If possible, the same term collateral for secured credit. However, this is a narrow should not be used to define instruments over which concept, which does not address the deeper issues multiple authorities have regulatory jurisdiction of the bankruptcy code. In a modern setting, bond unless absolutely necessary and in such event a clear issuance should be a senior claim on the cashflows of the hierarchy of control could be laid down in order to company and not associated with specific assets. One avoid overlaps of jurisdiction. If possible, where two of the key weaknesses of SARFAESI is that it is focused authorities exist with similar power over different on the interests of institutional bondholders. It does not segments of the debt market, care should be taken adequately address the claims of individual bondholders. What is holding back the development of the market? 35 The lack of a bankruptcy code and institutional remove restrictions on corporate bond development, the mechanisms to deal with failure in a way that is fair to Companies Act needs to be examined more thoroughly, bondholders has crimped the ability of corporations to which is beyond the scope of this policy note. issue bonds based on expectations of future cashflows. The low recovery rates of the present institutional Taxation arrangements have served to exacerbate credit spreads and have led to credit rationing for most corporations. Finally, the heterogeneous tax treatments across different debt securities (issued by the same Provisions in the Companies Act corporation) create financial distortions and make it difficult for investors to price different instruments. The Companies Act governs the ways and means An added complication from the investors' side is with- through which companies can source funds. There are holding tax (tax deduction at source). With-holding several aspects of the Companies Act that have a direct on corporate bonds is deducted on accrued interest influence on corporations accessing debt, either as loans at the end of the financial year according to prevalent or as securities: tax laws. A with-holding tax certificate is issued to the registered owner at the end of the fiscal year end Every new loan can be made only after a No- with interest payment made on the interest payment Objection Certificate is obtained from the date, to the registered holder, after deducting the earlier lender. Furthermore, every loan has to be with-holding tax due. When multiple trading takes registered with the Registrar of Companies within place in a corporate bond, physical exchange of cash 30 days. needs to take place to account for the with-holding Today, no single creditor has the right to call tax. Investors who are subject to with-holding find for a change in management despite evidence of oncoming bankruptcy. This requires a change in it difficult to sell the bond to those investors who are company law. not subject to such a tax. In 2000, in an effort to encourage secondary trading of government securities A ceiling is imposed on the coupon rate that a corporation can issue on a bond. These ceilings a similar with-holding tax which was prevalent at are decided as part of "deposit rules" (which is that time, was abolished. Similarly, there is a need a part of the Companies Act) jointly with RBI. to exempt interest payments on corporate bonds Technically, the Companies Act has primacy in and securitized assets from the requirement of with- this matter. These ceilings have been changed holding tax to encourage a deeper and liquid bond three times since 1975. If these ceilings are set market in India (Patil Committee Report, 2005). such that the difference between the corporate bond coupon rates and the government bond Notes rates do not match the investors' perception 1Shelf registration in India is allowed through an umbrella prospectus, of credit risk of the corporation, then the whereby a company files one consolidated offer document with the investors would have a disincentive to purchase securities market regulator for the entire amount it proposes to raise over the next 12 months, allowing the company to make more than one the corporate bond. This disincentive can be offering within the stipulated period. exacerbated by nontransparency about corporate 2In most jurisdictions, while extensive disclosure guidelines tend to apply bond prices and the high cost in obtaining to public issuances, private placements are usually exempt from such knowledge about the interest rates and credit stringent rules. In the United States, many issuers prefer to use Rule 144A for placing securities privately to "qualified institutional buyers," which premiums for corporations. exempts them from registration, detailed disclosures, and costs related to preparing financial statements, according to the U.S. Generally Accepted Accounting Principles. In sum, although corporate law in India provides a 3The first transaction in India of around Rs. 200 million of car receivables certain degree of control in determining the rights of was placed by Citibank with GIC Mutual Fund. 4The section on securitization draws on the analysis carried out by Fitch creditors in India, many uncertainties continue. To Ratings and ICRA in their special reports on securitization transactions. further understand the changes that need to be made to 5Asset categories frequently being securitized now include auto loans, two- 36 Corporate Bond Market Report wheeler loans, commercial vehicles, construction equipment, residential being some pre-conditions for development of the credit derivatives mortgages, and credit products (single loan sell-downs, and CDOs/ market in India. CLOs) (Fitch Ratings 2006). 10Between end-March 2002 and end-March 2006, contracts and derivatives 6Apart from stamp duties and other registration charges levied on the transactions of the banking system increased at an annual compound value of underlying assets, ineffective foreclosure laws and provisions growth rate of 55.5 percent. Consequently, the share of contracts and of the Income Tax Act, 1961, and the Transfer of Property Act render derivatives (notional principal) in total off-balance sheet exposures of the securitization transactions unfeasible to a large number of investors. banking system increased from 82.5 percent to 92.7 percent during the 7Although credit insurance is important for the overall bond market, credit same period. The combined share of the 15 banks active in this market insurance for financing infrastructure projects has been more difficult and in total off-balance sheet exposures steadily increased from 73.8 percent has been used in a few developing countries (such as in Chile for the in March 2002 to 82.3 percent in March 2006 (Trends and Progress in toll road program) and often in conjunction with official insurers, such Banking, 2005­06). as the Multilateral Investment Guarantee Agency or the Inter-American 11Rajwade, 2006 Development Bank. 12Non-fungible in nature, small size of issuance series, and so on. 8The issuer enhances its creditworthiness by purchasing a credit guarantee 13 and receives the credit rating, usually AAA, of the credit guarantee However, it is also recognized that the corporate debt market worldwide company. Unless the savings resulting from the reduced interest costs has historically suffered from limited disclosure and lack of credit rating exceed the cost of the guarantee, this form of credit enhancement is not information. Only in recent years has some transparency been introduced (for useful for the issuer. example, in the Eurobond market and, very recently, in the United States). 14The Technical Subcommittee included representatives from RBI and 9The Reserve Bank of India, in its recent report on the Trends and Progress of Banking in India, sees factors such as depth of the bond SEBI. The High Level Committee on Capital Markets was established by market, new regulations seeking risk weightage commensurate with the Ministry of Finance in 1992 in an effort to improve regulatory and credit ratings, and further consolidation of the banking industry as supervisory coordination among all the major financial regulators (RBI, SEBI, and IRDA). 4.What does India need to do to develop its corporate bond market? P articipation in India's corporate bond market to broaden and improve the liquidity of the repurchase cannot be forced or declared, but it can be market--much of which is currently focused on the encouraged by an enabling environment overnight market--are also important for the corporate (Harwood 2000). For issuers, investors, and debt market. Moreover, although local securities markets intermediaries alike, an enabling environment has can provide an alternative source of funding to the several key components: banking sector, especially during banking crises, a sound and well-regulated banking system can be a necessary Recognized economic benefit, often in the form complement to the development of local bond markets. of better costs, lower risks, or better market performance than the status quo. As part of its market reform strategy, the Securities Positive attitude toward participation, which for Exchange Board of India has set up a committee to look issuersincludeswillingnesstodiscloseinformation into the development of the bond market. Additionally, and for investors includes willingness to take risks the High Level Expert Committee on Corporate and trade, because of perceived benefits from Bonds and Securitization, which was appointed by the being in the market. minister of finance to look into the legal, regulatory, Ability to participate, because all participants tax, and market design issues in the development of the have the skills and the right industry structure to corporate bond market, has submitted its report. The engage in market activities. Government has accepted the report and is in the process of implementing the recommendations (annex 7). The development of an enabling environment for the corporate bond markets also requires a few necessary Withthesestrategicassessmentsinmind,thispolicynote "preconditions." Macroeconomic stability, a well- draws together a variety of recommendations that could functioning money market, a government securities facilitate a `Roadmap' for developing India's corporate market, and an effective legal and regulatory framework bond market. The recommendations are grouped into provide a critical foundation on which to build corporate two main categories: those involving regulatory reforms bond markets. That said, many of the elements of an and those for market microstructure reforms. enabling environment are interdependent and normally must be developed or reformed in conjunction with Recommended regulatory one another. It must also be cautioned that there is no general agreement on which conditions are "necessary" reforms for corporate bond market development, and there is Three types of regulatory reforms are proposed to affect certainly no "one-size-fits-all" recipe. the issuers, the various classes of investors, and the laws and regulations governing the corporate bond market. In India, some of the measures relating to the government securities market are already in place or are being Better access for issuers implemented. For instance, a relatively liquid benchmark yield curve for government debt, of up to 20 years, already A growing and diverse set of issuers with both the size exists. Furthermore, ongoing efforts by the authorities and credit quality necessary to appeal to institutional 38 Corporate Bond Market Report investors is needed for the sustained growth of the protection from default by the company in timely corporate bond market. A variety of measures can payment of interest.2 This could encourage retail encourage more corporations to enter the bond market investment in corporate bonds. as issuers: Rationalization of the stamp duty among different classes of investors and states. Stamp duty is Medium-size and small corporations should adopt usually a deterrent for primary issuance of bonds high standards of transparency and corporate and other securitization transactions and needs to governance to strengthen their credit ratings and be streamlined to make it uniform across different facilitate market access. states. From the regulator's side, the procedures for public issuance of debt should be further streamlined, drawing on lessons from countries such as Korea, Better opportunity for investors where regulatory approval takes just 5 days Local institutional investors, pension fund managers, (against 21 days in India). insurers, as well as banks should be encouraged to play Another area that needs to be revisited is the a major role in the development of the corporate debt definition of private placements, which focuses market. Investment policies and regulatory guidelines on the number of investors1 rather than on for insurance companies, pension funds, mutual their quality and capacity to demand the type funds, banks, and other financial institutions need of information and performance indicators from to be sufficiently flexible for these entities to choose issuers. By formally recognizing a QIB (Qualified an appropriate risk-return profile within fiduciary Institutional Buyer) market as the primary target for private placements and secondary trading, constraints. This will also help professionalize fund the regulator could feel comfortable in providing management. In parallel, the authorities need to much more flexibility on the standards of address shortcomings in the accounting methodology, disclosure and corporate governance, and allow as well as the low level of skills in fund management those elements to be more of a contractual nature in some pension and provident funds. The following between investors and issuers. measures could be considered for institutional investors: Extendingshelfregistrationtoalltypesofcorporate issuers would also facilitate quick, timely, and Regulations for permitting pension and provident cost-effective access of issuers to the markets. funds to invest in corporate debt should be Such an arrangement is widely used in developed relaxed and amended. This will help lengthen debt markets, such as the United States, United the maturity of corporate debt. Furthermore, Kingdom, Korea, and Singapore. For example, the move toward a private pension system and a regulators could consider an extension of shelf defined contribution scheme would give pension registration of prospectuses to all companies that fund managers greater flexibility in investing offer debt instruments to qualified institutional their funds. Ideally, the longer-term investment buyers, rather than only to public financial horizon of pension funds should help fulfill the institutions. Alternatively, the regulators could funding needs of the infrastructure sector. adopt practices similar to those in the Eurobond market. Issuers who tap the market frequently are The investment guidelines for insurance permitted to use a short-form listing agreement companiesshouldbemodifiedtoallowinvestment and are given regulatory approval as a condition in instruments with a rating of less than AA. At to an offer closing. As a result, an issue could be present these investments are counted toward launched more easily with the documentation "unapproved" investments. Such a modification, and approvals to follow. in conjunction with development of credit enhancement products, should enable insurance Over the medium term, the debenture trustee system needs to be strengthened by providing companies to invest in a wider range of credits. What does India need to do to develop its corporate bond market? 39 Given the early stage of market development, institutional investors in corporate debt. As a first where long-term institutional investors are step, the cap could be relaxed for longer-term not yet active, the banking system could play investment in the corporate debt market (over an important role in the development of the three years). corporate debt market. Regulatory caps on banks' The liberalization of limits on mutual fund investments in unlisted corporate bonds could investments to allow the development of closed- be relaxed (currently limited to 10 percent of the ended fund products. This would encourage total investments permitted outside their statutory investments down the corporate debt spectrum. liquidity ratio), as could the minimum rating Existing restrictions on lower-rated instruments requirement needed for investments in corporate could be relaxed. This could perhaps encourage bonds (currently AA and above). development of high-yield bond fund of Indian assets and corporations rated below AA, which As discussed in the earlier sections, the regulatory regime for banks puts onerous requirements if a constitute the bulk of local companies in the corporate credit is held as an investment (that is, infrastructure sector. as a tradable security) instead of as a loan. Market The authorities need to ensure that pension and participants feel that the regulations should provident funds and insurance companies have recognize the advantage of holding of corporate access to professional fund management services credit assets as investments because of their and put in place adequate risk management tradable nature. Two measures would be helpful systems to preserve the soundness of these in this regard: investors. Capital for market risk should be provided for the overall interest rate risk in the balance sheet, rather than just the marked-to-market Better regulatory practices portion of the book. This would ensure that Better regulatory practices are crucial for market bonds and loans are given similar treatment development. The principal recommendation on from the interest rate risk perspective. regulatory practices is to clarify oversight responsibilities The artificial distinction between investments among the various agencies that are now involved in and advances in the current regulatory regime regulation. needs to be removed. Guidelines and rules should be similar for a given credit, whether it The regulation of the corporate debt market should is held as a loan or as a bond. be put under the ambit of one regulator. Currently, Competitive pressures are likely to force banks and perceived inconsistencies and conflicts between the other financial intermediaries to develop diverse Reserve Bank of India (RBI) and the Securities and instruments to address the needs of investors and Exchange Board of India (SEBI) are seen as important issuers.Increasedemphasisonbetterriskmanagement impediments to building confidence in the market. and the adoption of the new Basel Accord over the An examination of the entire legislative landscape is medium term are likely to cause banks to economize warranted, and once the legislators have a clear idea of their capital by providing instruments as alternatives to extending and warehousing loans. Measures that the manner in which the regulatory jurisdiction needs facilitate banks' move to the investment banking to be carved up between the SEBI and the RBI, it is and brokerage business are likely to both help important that appropriate amendments be made to improve banks' profitability and contribute to the the definitions of the various terms that have been development of securities markets, particularly used loosely across statutes. If possible, the same term corporate bond markets. should not be used to define instruments over which multiple authorities have regulatory jurisdiction unless The current corporate bond ceiling needs to absolutely necessary and in such event a clear hierarchy be further raised for investments by foreign of control could be laid down in order to avoid overlaps 40 Corporate Bond Market Report of jurisdiction. If possible, where two authorities exist Recommended market reforms with similar power over different segments of the debt market, care should be taken to ensure that the terms To strengthen the corporate bond market itself, used to describe the scope of authority are distinct in recommendations focus on improving the order to avoid confusion. comprehensiveness of and access to information about issues and issuers, the efficiency and reliability of market In addition, for effective functioning of the bond infrastructure, the range of products available, and the markets, the authorities must adopt a regulatory homogeneity of corporate bond securities. framework that ensures investor protection and market integrity, while containing systemic risk. Key elements Better corporate credit and trade of the required framework include the enforcement of information recently amended bankruptcy laws that clearly define creditors' rights and borrowers' responsibilities, the Information plays a critical role in corporate debt market promotion of adequate corporate governance practices, development. More effort needs to be put into collecting and the timely and accurate public disclosure of financial and disseminating data on the size, coupon, and latest information. credit rating of bond issues, as well as the underlying corporate performance and default history of companies In the short run, RBI's responsibility for prudential and the scope of secondary trading (particularly pre- regulation3 of the government securities market should trade information on investors' access to best quotes probably continue, given that RBI is also entrusted with and post-trade information dissemination). This could being investment banker to government, formulating be undertaken either by a specialized agency or one of and implementing monetary policy, and ensuring the self-regulatory organizations in the capital market. that monetary policy is carried out through sound However, to kickstart the process, the regulators (SEBI intermediaries (market participants). In addition, RBI and the Ministry of Company Affairs) could require could continue to provide the market infrastructure for listed and unlisted companies to provide certain government securities trading, such as carrying out the minimum information on all outstanding securities by auction system, the trade-matching system, the recording these issuers to the National Stock Exchanges, Clearing of transactions, and settlement (through the Clearing Corporation of India Limited, or Fixed Income Money Corporation of India, Ltd.). However, inherent conflicts Market Dealers Association. This information should of interest should be minimized with respect to RBI's then be made accessible to the public through a being a provider of services to the government securities frequently updated Website. market as well as a regulator of that market. To achieve this result, RBI will need to ensure that its services are Better market infrastructure provided in a transparent manner and that information is available to all market participants uniformly. Efficient trading and settlement systems are critical to provide an exit route for debt investments in In the medium term, these market infrastructure infrastructure. India needs to upgrade its trading and services for the government securities market should settlement systems. Several Asian and Latin American be gradually moved out of RBI. With regard to market markets have adopted sophisticated settlement systems conduct regulation of the government securities, which and put in place mechanisms for recourse (through covers the behavior of market participants and market guarantee funds or compensation funds) in settling integrity issues, these functions should be moved to transactions, and their experiences could provide some SEBI. In the longer run, as the larger questions of usefullessons.4 Inparticular,amechanismthatwillallow financial regulatory architecture are resolved, the option both listed and unlisted bonds to be cleared and settled of moving to a unified regulation of the financial markets by a central system could be explored. This will help could be considered. improve order flow and reduce market fragmentation. What does India need to do to develop its corporate bond market? 41 In developed markets it is common for bond issues to a legal framework. However, the asset-backed securities be listed on an exchange, which allows for transparency market is expected to grow strongly with expanding and disclosure, but trading occurs off the trading floor pools of assets, such as mortgages, lease receivables, credit in the over-the-counter market. The chief reason that card receivables, and consumer loan receivables. More bond market trading is concentrated in over-the- important, the proposed amendment to the Securities counter markets is that the diversity of debt securities-- Contract Regulation Act that makes pass-through in maturity, coupons, and credit risk--tends to result in certificates amenable to listing and trading will provide a limited trading of most corporate debt issues, and thus a much-needed boost for securitization activity. dealership trading system can improve liquidity. Banks could play an innovative role in project financing Better choice of products through longer-term credit enhancements, take-out financing, special purpose vehicles, and guarantees of Government should encourage financial intermediaries corporate bonds. A typical long-term project faces the to offer new product structures (for example, credit highestriskininitialyears,andcashflowsusuallystabilize enhancement, bond insurance) that enable sub­ after five to seven years. The initial risks could be taken investment grade corporations and municipalities by banks and financial institutions through medium- to access financing. RBI and SEBI should consider term lending, and as cashflows become secure, the loans regulatoryreformsthatwouldhelpdevelophedgingtools could be securitized and sold to institutions that have for investors and traders, for example, credit derivatives, a longer-term liability structure. Packaging and selling bond futures, and options. The development of fixed- a mix of loans involving all kinds of assets (including income derivative instruments is very important for loans to relatively small and medium-size enterprises) the debt market. The liberalization of the investment is another type of securitization that would be a useful regime for financial institutions to take positions in innovation for improving access to finance. A necessary derivatives--subject to strict risk management and condition for this process of asset securitization is the reporting requirements--would improve liquidity evolution of a deep and liquid corporate bond market. in the market and encourage the development of a broader range of instruments. Presently, while financial Better homogeneity in corporate bond institutions such as insurance companies and banks are securities only allowed to use derivatives for hedging purposes, investment by financial institutions in rupee assets can Currently, there is a lack of homogeneity across be hedged through the currency market only up to the corporate debt securities. While foreign investors are market value of the investment. interested in the local corporate debt, it is difficult for them to make adjustments for regulatory risk when Short selling, an often suggested reform measure for the determining relative value. For instance, different taxes Indian debt market, needs to be allowed in government may apply to different debt instruments issued by the securities, as it will help in refining the pricing same corporate. As a result, debt of the same tenor issued mechanism for corporate bonds and help investors by one company could have very different yields before hedge their risks effectively. For example, investors could adjusting for regulatory effects, making comparisons hedge the interest rate risk more effectively by locking very difficult. Some degree of standardization and in the credit spread on a corporate bond by going short homogeneity in bond contracts would facilitate the on a government bond with similar maturity. pricing of credit risk, with regulations implemented to ensure a minimum set of guidelines for such contracts. ThemarketforsecuritizationinIndiaholdsgreatpotential From the investors' side, there is a need to exempt and should be tapped for infrastructure projects.To date, interest payments on corporate bonds and securitized the growth of this market has underperformed, largely assets from the requirement of with-holding tax to because of high stamp duties and the previous absence of encourage a deeper and liquid bond market in India. 42 Corporate Bond Market Report Conclusion Notes The list of reforms discussed above is not entirely new 1Private placements are defined under the Companies Act as issuing nor by any means complete (a matrix of recommended programs targeted to less than fifty investors. reforms,highlightingactionableareas,isinannex1).But 2The debenture trustee has a fiduciary responsibility to protect the interest of the debenture holder and is expected to enforce security in the event of themessagedoesbearrepeating.Corporatebondmarkets default by the issuer company to the bondholders. are important for financial stability as a buffer when 3Setting standards (for example, capital requirements) and supervising other funding sources are affected. The development of market participants, such as banks and primary dealers. 4 a deep, liquid local corporate bond market in India at Similar settlement guarantee for secondary trades is provided in India, although it is limited to trades that are struck on the exchange trading the longer end of the maturity spectrum could facilitate system. As most corporate debt trades are negotiated over the phone, the a competitive source of financing that allows access to a settlement guarantee does not extend to such trades, thereby increasing the settlement risk in the corporate bond market. wide range of issuers. It would also benefit the country's infrastructure investments by tapping into the growing pool of long-term funds available with the gradually developing class of institutional investors. Annex 1. Recommended reforms,by responsible agency Reform measures Responsible agency Regulatory reforms (a) LegalandRegulatoryFramework Improve existing regulatory practices for market development. Ministry of Finance, Reserve Bank, and Securities and The regulation of the corporate debt market should be put under Exchange Board of India the ambit of one regulator. Currently, perceived inconsistencies and conflicts between the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) are seen as important impediments to building confidence in the market. Adopt a regulatory framework that ensures investor protection Ministry of Company Affairs, Ministry of Finance, and market integrity, and contains systemic risk. Key elements Reserve Bank, and Securities and Exchange Board of of the required framework include the enforcement of recently India amended bankruptcy laws that clearly define creditors' rights and borrowers' responsibilities, the promotion of adequate corporate governance practices and timely and accurate public disclosure of financial information. (b) PrimaryIssuancerelatedreforms Streamline procedures for public issuance of debt, drawing on Securities and Exchange Board of India lessons from countries like Korea, where regulatory approval takes just 5 days (against 21 days in India). Distinguish regulatory requirements applying to the wholesale Securities and Exchange Board of India market ­ such as qualified institutional buyers (QIBs) ­ from those applying to the retail market. Similarly, disclosure requirements for privately placed debt could be differentiated based on the whether it is a new issuer or an existing issuer company. Extend shelf registration to all types of corporate issuers to Securities and Exchange Board of India, Ministry of facilitate quick, timely and cost-effective access of issuers to Company Affairs the markets. Regulators could consider an extension of shelf registrations of prospectuses to all companies that offer debt instruments to qualified institutional buyers, rather than only to Public Financial Institutions. Strengthen the debenture trustee system by providing protection Securities and Exchange Board of India from default by the company in timely payment of interest. This could encourage retail investment in corporate bonds. Rationalize the stamp duty among different classes of investors Ministry of Finance, State Governments, Reserve Bank and states. Stamp duty is usually a deterrent for primary issuance of India of bonds and other securitization transactions and needs to be streamlined to make it uniform across different states. 44 Corporate Bond Market Report Reform measures Responsible agency (c) Investorrelatedreforms Relax and amend regulations for permitting pension & provident Ministry of Finance, Income Tax Department, Ministry funds to invest in corporate debt. Need to expedite the move of Labor, Employee Provident Fund Organization towards a private pension system and a defined contribution scheme would give pension fund managers greater flexibility in investing their funds. Modify the investment guidelines for insurance companies to Insurance Regulatory and Development Authority allow investment in instruments with a rating of less than AA with adequate safeguards to protect the soundness of the investor. Relas regulatory caps on banks' investments in unlisted corporate Reserve Bank of India, Ministry of Finance bonds (currently limited to 10 percent of their total non-SLR investments) as could the minimum rating requirement needed for investments in corporate bonds (minimum investment grade, i.e. AA and above). Provide capital for market risk for the overall interest rate risk in Reserve Bank of India, Ministry of Finance the balance sheet as opposed to just marked-to-market portion of the book. This would ensure that bonds and loans are given similar treatment from the interest rate risk perspective. Remove the artificial distinction between investments and Reserve Bank of India, Ministry of Finance advances in the current regulatory regime. Guidelines and rules should be similar for a given credit whether it is held as a loan or as a bond. Facilitate banks' move to the investment banking, brokerage Reserve Bank of India, Ministry of Finance business. In light of various competitive pressures and adoption of the Basel Accord in the medium term, such measures are likely to both help improve banks' profitability and contribute to the development of securities market, in particular, corporate bond markets. Raise the current corporate bond ceiling for FII Investments Ministry of Finance, Reserve Bank of India, Securities in Corporate Debt. As a first step, the cap could be relaxed for and Exchange Board of India longer term investment in corporate debt market (over 3 years). Liberalize mutual fund investments to allow the development of Securities and Exchange Board of India closed-ended fund products. Existing restrictions on lower rated instruments could be relaxed. Professionalize fund management services the authorities need to Securities and Exchange Board of India, IRDA, EPFO ensure that pension/provident funds, insurance companies have access to professional fund management services and put in place adequate risk management systems to preserve the soundness of these investors. 3 Market microstructure reforms Improve corporate credit and trade information. More effort Securities and Exchange Board of India and needs to be put into collecting and disseminating data on bond the Ministry of Company Affairs. Secondary issues, size, coupon, latest credit rating, underlying corporate Responsibility: Credit Rating Agencies, National Stock performance, information on secondary trading (particularly pre- Exchanges, CCIL, or FIMMDA trade information related to investors having access to best quotes as well as post-trade information dissemination) and default histories of companies. Annexure 45 Reform measures Responsible agency Make trading and settlement systems more efficient to provide Securities and Exchange Board of India, Reserve Bank, for liquidity, efficient price discovery, and an exit route for debt Stock Exchanges, CCIL, Ministry of Finance investments in infrastructure. Develop new product structures (e.g., credit enhancement, bond Securities and Exchange Board of India, Reserve Bank, insurance) and hedging mechanisms. Stock Exchanges, CCIL, Ministry of Finance, Self- Regulatory Organizations like FIMMDA, AMFI, PDAI etc. Allow short selling in government securities as it will help in Reserve Bank of India, Ministry of Finance refining the pricing mechanism for corporate bonds and help investors hedge their risks effectively. Remove the tax differential between different classes of corporate Ministry of Finance, Central Board of Direct Taxes bonds. Annex 2. Key reforms and outstanding issues in the government securities markets 1992: Introduction of auction system for price 2000:IntroductionofLiquidityAdjustmentFacility(LAF) discovery to manage short-term liquidity mismatches 1993: Introductionof91-dayTreasurybillsformanaging 2002: Operationalization of Negotiated Dealing System liquidity and benchmarking (NDS) and CCIL. Trade data on NDS made available on RBI website for transparency 1994: Issuance of zero-coupon bonds 2003: Introduction of trading of government securities 1995: Primary dealer (PD) system set up; DvP on stock exchanges, permitting nonbanks to settlement system introduced; floating-rate participate in repurchase market; exchange- bonds issued traded interest rate futures introduced 1997: Technical Advisory Committee set up, 2004: Introduction of the Real Time Gross Settlement permitting repurchase in government securities. System, which facilitates liquidity management; Allowing foreign institutional investors to invest DvP III mode of settlement enabled to permit net in government securities; system of ways and settlement of both funds and securities leg (the Means advances introduced for government of DvP III mode of settlement has also permitted India; capital-indexed bonds introduced the rollover of repurchases); Market Stabilization Scheme introduced, which has expanded the 1999: Introduction of over-the-counter interest rate instruments available to the Reserve Bank for derivatives, like IRS/FRAs, managing the surplus liquidity in the system. Table A2.1 Dimensions of the Indian government securities market, 1992­2005 Item 1992 1996 2002 2003 2004 2005 Outstanding stock (Rs. in billions) 769 1375 5363 6739 8243 8953 Outstanding stock as ratio of GDP (percent) 14.68 14.20 27.89 27.29 30.09 28.94 Turnover/GDP (percent) ­ 34.21 157.68 202.88 87.78 72.99 Average maturity of the securities issued during the year (in years) ­ 5.70 14.90 15.32 14.94 14.13 Weighted average cost of the securities issued during the year (percent) 11.78 13.77 9.44 7.34 5.71 6.11 Minimum and maximum maturities of stock issued during the year N.A. 2­10 5­25 7­30 4­29 5­30 (in Yyears) PD share in the turnover A. Primary market 70.46 65.06 50.84 36.02 B. Secondary market ­ 22.04 21.72 24.25 26.7 * CCIL: Clearing Corporation of India, Limited. Note: Turnover is the total of outright (volume*2) and repurchase (volume*4) turnover. Sources: RBI, Report on Currency and Finance, various issues; RBI (2003) [not cited]. 48 Corporate Bond Market Report Outstanding issues in the Table A2.2 Interest rates on various savings development of a government instruments end-March 2005 securities market Saving Instrument Rates (%) Absence of a robust benchmark yield curve for Postal Savings 6.25­7.5 government bonds: While the government has issued National Saving Scheme 8.5 long term securities, the relatively small average size EPF 9.5 of each benchmark securities issuance coupled with PPF 8.0 limited trading activity has meant that there is really G-Sec 4.69­5.73 no risk-free benchmark reference rate to peg the longer T-bill 4.36­4.37 tenor section of the yield curve. To create a reliable Note: Rates for 1 to 5 years duration except EPF; as of Dec 2004 government bond benchmark yield curve, the size of Source: Reserve Bank of India, State Bank of India, National Stock each benchmark security needs to be sufficiently large, Exchange and Department of Posts usually a significant multiple of the average transaction size. Starting in 2003, the Reserve Bank of India (RBI) interest rates on small saving schemes offered by has made efforts to consolidate issuances with the aim of Government which are not explicitly linked with the concentrating liquidity in a small number of benchmark market determined risk free curve. Retail investors issues. However, more active steps need to be taken for prefer to invest in instruments such as postal savings consolidation. and provident funds where returns are artificially pegged at much higher rates (see Table 12 below), The government debt market is wholesale in nature; than to invest in the debt market, especially given the limited trading that does take place is done the lack of awareness on the risk-return profile of bilaterally over the telephone through brokers, or on the Government securities and the relatively higher the Negotiated Dealing System (NDS). This results in cost of trading in the retail segment of Government a non-transparent market with poor-price discovery securities. where only the parties to trade have information about the trade. The lack of trading in the government Notes debt market may be attributed to two other factors. 1 While the size of the gross borrowing requirement is large, the market's First, institutional investors such as pension funds absorptive capacity is small and this puts constraints on the size of individual issues leading to a number of small issuances of benchmark and insurance companies are mandated to hold securities. This in turn affects liquidity of the benchmark securities. Government securities until maturity, thus hindering 2 Recently, the National Stock Exchange (NSE) in its Wholesale Debt active trading. Second, while interest rates in India Market segment has come up with an innovative formula to devise a 20- year yield curve. While it functions as the only "quasi-reference" rate for are largely deregulated, certain structural rigidities long term corporate paper, it has not sufficed to trigger a more active bond hinder efficient price discovery in various markets. market for long tenor debt securities. This inflexibility can be explained by regulated 3 NSE does provide a platform for trading, but it is mainly used for reporting deals which have been executed and thus it remains a negotiated market. Annexure 49 Annex 3. Statistics on issuers in primary markets Table A3.1 Issuers in India and typical issue characteristics Issuer Instruments Maturity Investors Public sector units Bonds, Structured 5­10 years Banks, Insurance Companies, Provident Obligations Funds, Mutual Funds, Individuals, Corporates Corporations Debentures 1­12 years Banks, Mutual Funds, Individuals, Other Corporates Corporations, primary Commercial Paper 15 days to 1 year Banks, Financial Institutions, Mutual dealers Funds, Individuals, Corporates, FIIs Scheduled commercial Certificates of Deposit 15 days to 1 Banks, FIIs, Corporations, Other Corporates, banks, select financial year, whereas Trusts, Associations, FIs, NRIs, Individuals, institutions (under for FIs it is 1 Mutual Funds umbrella limit fixed by year to 10 years RBI) Public sector units Municipal 0­7 years Banks Corporations, Trusts, Funds, Associations, Bonds FIs, NRIs, Individuals, Other Corporates Source: Indian Securities Market, A Review, 2004, National Stock Exchange Limited (NSEL). Table A3.2 Selected indicators of debt markets in India, 2002­06 (Rs.billions) Issuer Amountraisedfromprimarymarket 2002­03 2003­04 2004­05 2005­06 Government 1,820 1,982 1,456 1,600 Corporate/nongovernment 531 527 595 966 Total 2,351 2,509 2,051 2,566 Source:Prime Database, Reserve Bank of India (RBI), National Stock Exchange (NSE), Securities and Exchange Board of India (SEBI), World Bank staff estimates. 50 Corporate Bond Market Report Table A3.3 List of top 25 issuers in the year 2005­2006. Company Issuance Rs billion Industrial Development Bank of India 68.5 Power Finance Corporation Limited 56.7 Housing Development Finance Corporation 55.2 Rural Electrification Corporation 52.2 Food Corporation of India 45.8 ICICI Bank Ltd. 39.7 National Bank for Agriculture and Rural Development 33.3 State Bank of India 32.8 Export-Import Bank of India 28.6 Indian Oil Corporation 22.3 Power Grid Corporation of India Ltd. 20.0 National Housing Bank 19.1 Infrastructure Development Finance Company 18.5 Housing and Urban Development Corporation 16.1 Small Industries Development Bank of India 15.2 Citicorp Finance (India) Ltd. 14.2 Gas & Power Investment Company Limited 13.1 Indian Railway Finance Corporation Ltd. 13.0 Mahindra & Mahindra Financial Services Ltd. 12.1 HDFC Bank 12.0 National Highways Authority of India 11.9 LIC Housing Finance Ltd. 11.0 Syndicate Bank 10.0 UTI Bank 10.0 CitiFinancial Consumer Finance Ltd. 10.0 Total 641.3 Source: Prime Database Table A3.4 Resources raised by banks through private placement (2003­2006) Category 2003­04 2004­05 2005­06 No. of issues Amount raised No. of issues Amount raised No. of issues Amount raised Private sector banks 63 2,895 44 6,180 24 7,834 Public sector banks 16 3,728 43 9,039 73 22,317 Total 79 6,623 87 15,219 97 30,151 Source: RBI Trends and Progress Report, 2005, 2006 Annex 4. Restrictive investment policies and guidelines for insurance and pensions Table A4.1 Investment guidelines for life insurance companies S.No Type of Investment Percentage i) Government Securities 25%, ii) Government Securities or other approved securities (including (I) above) Not less than 50% iii) Approved Investments as specified a) Infrastructure and Social Sector Not less than 15% b) Others to be governed by specified Exposure/Prudential Norms Not exceeding 20% iv) Other than in Approved Investments to be governed by specified Exposure/Prudential Norms Not exceeding 15% Source: Insurance Regulatory and Development Authority (IRDA) Table A4.2 Investment guideline for non-life insurance companies S.No Type of Investment PercCentage i) Central Government Securities being not less than 20% ii) State Government securities and other Guaranteed securities including (i) above being not less 30% than iii) Housing and Loans to State Government for Housing and Fire Fighting equipment, being not 5% less than iv) Investments in Approved Investments as specified in Schedule II a) Infrastructure and Social Sector Not less than 10% b) Others to be governed by specified Exposure/ Prudential Norms Not exceeding 30% v) Other than in Approved Investments to be governed by specified Exposure/ Prudential Norms Not exceeding 25% Source: Insurance Regulatory and Development Authority (IRDA) 52 Corporate Bond Market Report Table A4.3 Investment guidelines for pension funds S.No Investment Pattern Percentage amount to be investment i) Central Govt. Securities; and/or units of Mutual Funds which have been set up as dedicated 25% funds for investment in Government securities and which have been approved by SEBI ii) a) Govt. Securities; created and issued by any State Government; and/or units of such Mutual 15% Funds which have been set up as dedicated funds for investment in Govt. Securities and which have been approved by Securities and Exchange Board of India (SEBI) b) Any other negotiable securities the principal whereof and interest thereon is fully and 15% unconditionally guaranteed by the Central Govt. or any State Government iii) a) Bonds/Securities of `PFIs', Public sector companies' including public sector banks 30% b) Short duration Term Deposit Receipt (TDR) issued by public sector banks iv) To be invested in any of the above three categories decided by their trustees 30% v) The trust, subject to their assessment of risk-return prospects, may invest up to 1/3rd of (iv) above, in private sector bonds/securities, which have an investment grade rating from at least two credit rating agencies. Source: EPFO guidelines Table A4.4 Maximum exposure to an asset for pension funds in Latin American countries Argentina Chile Colombia Peru Uruguay Government Debt 50% 50% 50% 40% 60% Time Deposit 28% 50% 50% 30% 30% Bonds 28% 45% 20% 49% 15% Stocks 35% 37% 30% 35% 25%' Mortgage Bonds 28% 50% 30% 40% 20% Foreign Investment 10% 12% -- 10% -- Close-End Investment Funds 14% 5% 10% 15% -- Futures and Exchange Risk Coverage 2% 9% -- 10% -- Source: Organization for Economic Cooperation and Development (OECD) Annexure Annex 5.Use of financial instruments to increase liquidity Country Repos and Securities Borrowing Bond Futures and Interest Rate Reverse Repos Short selling and lending Options Swaps India Yes No Yes No Yes Brazil Yes No No No No Chinese Taipei Yes No No No Yes Singapore Yes Yes No Yes Yes South Africa Yes Yes Yes Yes Yes Argentina Yes Yes No Yes Yes Hungary Yes Yes Yes Yes Yes Korea Yes Yes Yes Yes Yes Thailand Yes Yes Yes No Source: The development of corporate bond markets in emerging market countries, IOSCO publication, May 2002. Annex 6.Report of the High Level Expert Committee on Corporate Bonds and Securitization Pursuant to the announcement made in the Union and the disclosure and listing requirements for Budget 2005­06, the Ministry of Finance appointed private placements. a High Level Expert Committee to examine issues Setting up a system of market makers, developing impeding the growth of a market for corporate bonds the secondary market through a trade reporting and securitization. In its recently submitted report, system, and improving the clearing and settlement the committee's recommendations have addressed system to address market microstructure issues.. the problems identified in the bond market through two sets of reforms: first through addressing removal While the committee has recommended several measures of hurdles in the legal framework that determines that help address the market infrastructure issues and regulation of the securities market and second through a few legal and regulatory issues, the key issue relating addressing issues of market microstructure. Some of to the development of a sophisticated debt market-- the positive reform measures recommended by the product diversification--has not been adequately committee relate to: addressed. One of the key lacunae in the bond markets today is the lack of product innovation, which Recognizing pass-through-certificates issued by addresses the risk management concerns of the various securitizationSpecialPurposeVehiclesassecurities institutional investors and creates the right incentives to under the Securities Contract Regulation Act, participate in the bond markets. In this context, one of which enables these instruments to be listed and the most interesting issues in the lack of development traded thereby improving liquidity. of the corporate bond market in India is the inability Abolishing differential treatment of tax deduction to separate interest rate risk from credit risk, thereby at source on bonds for different investors; limiting the pool of investors. Expanding the scope for investment by provident, pension,andgratuityfundsandinsurancecompanies Until a year ago, this inability to distinguish types of risk in corporate bonds on the basis of a rating system, did not affect market participants, as interest rates fell rather than the category of issuers similar. from over 12 percent to less than 5 percent. Commercial Allowing a separate higher limit for foreign banks, which are the main players in the debt market, institutional investors for investment in corporate have virtually stopped trading in debt, because with the bonds. The earlier limit was a ceiling of $ 0.5 rise in interest rates they need to mark-to-market their billion, which has been proposed to be increased bond portfolio and provide for notional losses. Mutual to $ 1.5 billion. funds, another set of active participants, have been Removing the differential stamp duty across staying away since a fall in bond prices erodes their various state governments on debt instruments, underlying portfolios. At the root of both these trends although the stamp duty is a matter of is the absence of any derivative to hedge the interest jurisdiction of individual state governments risk and credit risk in a rising interest rate scenario. and the issue will need to be taken up with each Specifically, the needed products are credit derivatives, state government. interest rate derivatives, and interest rate futures. While Enhancing the issuer base through reducing and credit derivatives do not exist in the Indian debt market, simplifying the time and cost of public issuance interest rate derivatives and futures had a very short 56 Corporate Bond Market Report existence. Part of the reluctance of the regulators to clearing and settlement system that would facilitate push for derivative products could be the lack of clear over-the-counter deals, since "the efforts of SEBI and regulatory structure in a multivenue trading market the stock exchanges to bring the trading to the stock (exchange-traded versus over-the-counter markets). exchange platforms have not yielded desired results." A key issue that needs to be addressed in this context This recommendation of setting up `inter-dealer is how to ensure that responsibilities for regulation electronic broking platforms' could help better address and enforcement in the secondary markets result in the particularities of corporate bonds, as debt markets consistent treatment of all trades, irrespective of their are very different in nature from equity markets. origin, and that trading should be under a single, clear However, the legal framework for securities market does regulatory remit. not recognize any organized platform for trading and settlement, unless it is registered as an exchange. There A related area of concern is the introduction of order- is a need to address this issue in greater detail to develop matching trading platforms. 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