Indian Corporate Debt Markets – Risk and Hedging Related Issues (Part II)

By Rajeswari Sengupta, IFMR B-school

In our previous post we discussed the development and current status of the Credit Default Swap (CDS) market in India. Any corporate debt market also suffers from an inherent interest rate risk-one of the most pervasive risks in an economy. The increasing importance of interest rate risk for the corporate sector in a deregulated interest rate environment is now widely appreciated. A way to hedge against such a risk is to use an interest rate future.

Like the CDS, an interest rate future (IRF) is a financial derivative based on an underlying security, a debt obligation that moves in value as interest rates change. Buying an interest rate futures contract will allow the buyer to lock in a future investment rate. When the interest rates scale up, the buyer will pay the seller of the futures contract an amount equal to the profit expected when investing at a higher rate against the rate mentioned in the futures contract. On the flip side when the interest rates go down, the seller will pay off the buyer for the poorer interest rate when the futures contract expires.

In other words, IRFs are an agreement to buy or sell an underlying debt security at a fixed price on a fixed day in the future, and the prices of these derivatives mirror the rise and fall in the yield of the underlying government bonds. Unlike overnight interest rate swaps, IRFs have to be traded on exchanges rather than over the counter.

IRFs account for the largest volume among financial derivatives traded on exchanges worldwide. For financial markets in India, IRFs present a much needed opportunity for hedging and risk management by a wide range of institutions and intermediaries, including banks, primary dealers, corporates, foreign institutional investors, retail investors etc.

2003 Initiative in India

As a part of the process to make Indian financial market more robust, the finance ministry and regulators like Reserve Bank of India introduced some new financial products between 2000 and 2005. Introduction of Interest Rate Futures in 2003, which allowed participants to take a call on the future movement of interest rates as a hedging tool, was once such move.

The Securities and Exchange Board of India (SEBI) group on Secondary Market Risk Management first discussed the introduction of interest rate derivatives in India at its meeting on March 12, 2003 and then the NSE first launched 10-year bond futures in June 2003. According to the RBI, it was necessary to supplement the OTC market for interest rate products by an active exchange-traded derivative market. However the initiative turned out to be a failure-in less than three months after the launch, trading in bond futures literally stopped. Among other factors, restrictions on short selling and requiring financial institutions to use derivatives only for hedging purposes could account for the inactivity of the product. In other words, the absence of speculators may have robbed the market off badly needed liquidity.

2009 Initiative

As the market for interest rate futures failed to pick up and almost vanished, it was reintroduced in August 2009 to allow participants to buy protection against and bet on interest rates changes. Trading in interest rate futures on 91 day Treasury Bills began on August 31, 2009, clocking trading volumes of Rs 276 crore on the first day of trade. The SEBI and the Reserve Bank of India have limited the maturity of IRF contracts between a minimum of three months and a maximum of 12 months. While the maximum tenor of the futures contract is 1 year or 12 months, usually it would have to be rolled over in three months making the contract cycle span over four fixed quarterly contracts.

This time around banks have been allowed to hedge interest rate risks as well as take bets on the rate trajectory. Also, foreign institutional investors have been given access to the market. This apart, a company, or a non-resident Indian or a retail investor is also eligible to trade in the IRFs market. Under normal circumstances, the weighted average price of the futures contract for the final 30 minutes would be taken as the daily settlement or closing price. Usually, the daily settlement is done on a daily marked-to-market procedural basis while the final settlement would be through physical delivery of securities. In the absence of last half an hour trading the price as determined by the exchange would be considered as daily settlement price.

The following are the advantages of this initiative:

  • Interest rate futures on 91-day treasury bill can be used for hedging against volatile interest rates.
  • They are cash-settled, as a result, investors can trade without the worry of being saddled with illiquid contacts, which could have been the case if the contracts were physically settled.
  • No securities transaction tax (STT) is levied.
  • Low margins required as compared to trading in equities and equity derivatives.
  • The new product would be traded in the currency segment of the exchange so there is no requirement of any new formalities of a new account.

Some of the salient features of exchange traded IRFs are:

  • Increased market reach enables higher liquidity.
  • Exchange platform ensures protection against counterparty default risk.
  • Greater transparency due to automated anonymous order matching system and settlement.
  • Delivery of underlying asset is possible on exchange platform.
  • Large number of informed participants can trade using online electronic trading systems leading to efficient price discovery.

However the 2009 initiative failed to click as well. The average daily trading turnover on NSE fell from Rs 77.5 crore in September 2009 to Rs 6 crore in January 2010. By February 2010, the average trading value dropped to a piffling Rs 3.02 crore. Since then NSE has been registering almost nil volumes for many months now. Trading in IRFs has thus slowed to a trickle as initial enthusiasm has been replaced by worries about the limited variety of players in the market and fears that the dice are loaded in favor of sellers. Bankers have said that one problem is that the underlying bonds are illiquid. In a bid to ease concerns over delivery obligations, in December 2009, SEBI allowed exchanges to set any period of time during the delivery month as the delivery period for the securities.

According to SBI officials, the product itself is defective because only the seller gains as he has the discretion of delivering either liquid or illiquid securities. Moreover, developed markets where IRFs have already taken off allow short selling and provide a good repo market. In India, short selling is not allowed beyond five days, and the repo market is not adequately developed. As a result there are mostly people who want to the sell the futures and buy bonds on spot thereby creating a situation wherein everyone sits on one side of the market.

To alleviate some of these concerns, Life Insurance Corp. of India, India’s largest insurer, and Central Bank of India in December decided to purchase government bonds from members who desire to liquidate the securities received against their interest rate derivative obligations.

Analysts have also pointed out that the three months’ tenor for the underlying asset (91- day Tbills in this case) is too short to base an interest rate futures product on. Interest rate futures seem to be on a deathbed due to complete lack of interest among the participants. In fact, in some of the trading days the volume has been as low as Rs 9 lakh. Lack of awareness among the Indian financial institutions is another major reason while the foreign financial institutions find the Indian market too small and the size of the deals tiny.

The second reason is the lack of depth because only two government securities have been introduced for future options while large number of other government bonds and corporate bonds are still out of the purview of interest rate futures. Moreover, according to market players, the prime reason for the failure of this segment is that banks are staying away from it. While the over-the-counter (OTC) market sees huge participation from foreign and private sector banks, the exchange platform has not been able to attract the same players. In order to revive this promising financial product and to make it robust, a long term planning is required. We need to create much more awareness on the efficacy of interest rate future as a hedging tool against interest rate volatility, and there should be many more securities.

2011 Initiative

In 2011, SEBI decided to introduce new products in the sagging interest rate futures segment such as derivatives based on shorter-tenure bonds that can be cash-settled.

On Dec 30, 2011, RBI and SEBI decided to introduce IRFs on notional 2-year and 5-year coupon bearing Government of India securities. The 2-year and 5-year IRF contracts shall be cash-settled and the final settlement price shall be based on the yields of the basket of securities underlying each Interest Rate Futures contract specified by the respective stock exchange. Shorter duration products that can be settled in cash are expected to attract market players.

The industry has been asking for such products and the policymakers are hoping that it will provide new life to the IRF segment. However according to skeptics, the market has totally shunned these instruments and the current environment does not guarantee any success for the new products either. No one is willing to bet on rates on account of high inflation and high borrowing.

This post concludes our Long Term Debt Markets Blog series. If you have any feedback for the authors or on the topic please do share in the comments section below or drop us a line at blog [at] ifmr.co.in


Indian Corporate Debt Markets – Risk and Hedging Related Issues (Part I)

By Rajeswari Sengupta, IFMR B-school

This post is part of our series of posts on Long Term Debt Markets in the Indian context.

One of the standard instruments used to hedge against risk in a corporate debt market is the credit default swap or CDS instrument. A CDS is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event. Development of a CDS market may lead to a gradual deepening of the corporate bond market as CDSs can enhance the bond market investors’ appetite for lower rated issuers, beyond their traditional favorites in the high-safety category. Before going into the details of the CDS market in India it maybe useful to understand the different elements of risks associated with CDS.

Default Risk: When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk i.e. the buyer takes the risk that the seller may default (in which case the buyer loses its protection against default by the reference entity) while the seller takes the risk that the buyer may default on the contract, depriving the seller of the expected revenue stream. More important, a seller normally limits its risk by buying off-setting protection from another party — that is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, which may be at a lower price than the original CDS and may therefore involve a loss to the seller.

Jump Risk: Another kind of risk for the seller of credit default swaps is jump risk or jump-to- default risk. A seller of a CDS could be collecting monthly premiums with little expectation that the reference entity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers. This risk is not present in other over-the-counter derivatives.

Systemic Risk: This risk arises from the interconnectedness of the different parties involved in a CDS transaction. One of the factors contributing to systemic risk in a CDS market is a ‘naked’ CDS contract–a CDS in which the buyer does not own the underlying debt. These “naked credit default swaps” allow traders to speculate on the creditworthiness of reference entities and were widely prevalent in the US financial markets before the Global Recession of 2008. If participants are permitted to purchase CDS without having the underlying risk exposure, there could be huge build-up of positions resulting in a scenario where the amount of protection purchased is higher than the total bonds outstanding. Such a position, if concentrated among a handful of participants and unregulated, can have systemic implications and lead to a dangerous build up of risks.

Counterparty default as mentioned earlier is also another factor that can contribute to systemic risk. The risk of counterparties defaulting has been amplified during the 2008 financial crisis, particularly because Lehman Brothers and AIG were counterparties in a very large number of CDS transactions. This is a classic example of systemic risk that threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk.

CDS market in India

India’s fledgling credit default swap (CDS) market kicked-off on Dec 6, 2011 with two deals covering 100 million rupees ($1.9 million) worth of bonds. The deals, both 1-year trades were between ICICI Bank and IDBI Bank (underwriter), at 90 basis points and covered 50 million rupees each of 10-year bonds issued by Rural Electrification Corp (REC) and India Railway Finance Corp, according to details on the Clearing Corp of India Ltd’s website. The RBI has since then allowed banks to begin hedging their banking and trading books using CDS, signaling that the infrastructure is finally in place for the launch of the instruments in Asia’s fourth biggest bond market.

According to paragraph 113 of the Second Quarter Review of Monetary Policy for year 2009-10, an Internal Group was constituted by the RBI to finalize the operational framework for the introduction of plain vanilla OTC single-name CDS for corporate bonds in India. Draft guidelines on CDS based on the recommendations of the Group were placed on the RBI website on February 23, 2011 and were open for comments from all concerned. Comments were received from a wide spectrum of banks, primary dealers and other market participants and accordingly the guidelines were suitably revised in the light of the feedback received. The guidelines became effective from October 24, 2011.

The RBI guidelines which incorporate learning from the CDS markets worldwide ensure that CDS is neither used for speculative purposes nor to build up excessive leveraged exposures. Following stipulations are directed particularly at avoiding any serious systemic threat that maybe caused by such an innovative and complex financial product:

  1. Only investors who own the underlying securities are allowed to purchase CDS insurance thereby ruling out the entire gamut of ‘naked’ CDS contracts and ensuring that the CDS market cannot get bigger than the underlying debt market. The investors are required to submit an auditor’s certificate or custodian’s certificate to the protection sellers, of having the underlying bond while entering into/unwinding the CDS contract. This is good for ensuring liquidity in the bond market without inviting systemic risk related troubles by curbing speculation but bad for the CDS market development per se.
  2. Trading in the derivative contracts will remain confined to lenders based in India thereby limiting the number of participants and making it easier to regulate and monitor. At the moment only banks can sell protection whereas in markets like the US, the sellers would include hedge funds, insurance companies, and asset managers. In India, only Banks, primary dealers, financially strong non-bank finance companies and any institution approved by the RBI will be eligible as market makers and will be allowed to sell protection. Foreign participants and hedge funds, which typically have a big appetite for credit risk, are not allowed to sell protection. Foreign institutional investors are allowed as “users”, which means that they can buy credit protection to only hedge their credit risk. Although RBI’s guidelines allow insurance companies and mutual funds to be sellers, this is subject to their respective regulators (IRDA and SEBI) permitting them to do so. This is not likely to happen until the market has become a bit more developed.
  3. Entities permitted to quote both buy and/or sell CDS spreads — market makers — need a minimum capital to risk (weighted) assets ratio (CRAR) of 11 percent and Net NPAs of less than 3 per cent.
  4. Users or buyer of CDS contracts are not allowed to sell protection and are not permitted to hold net short positions in the CDS contracts.
  5. Investors can exit their bought CDS positions by unwinding them with the original counterparty or by assigning them in favor of buyer of the underlying bond. The RBI has also included restructuring under credit events for CDS. Buyers will have a grace period of 10 business days from the sale of the underlying bond to unwind the CDS position.
  6. CDS will be allowed only on listed corporate bonds as reference obligations. However, CDS can also be written on unlisted but rated bonds of infrastructure companies.
  7. The CDS contract shall be denominated and settled in Indian Rupees.
  8. The RBI does not permit dealing in any structured financial product with CDS as one of the components neither will it allow dealing in any derivative product where the CDS itself is an underlying.
  9. Fixed Income Money Market and Derivatives Association of India (FIMMDA) shall devise a Master Agreement for Indian CDS. There would be two sets of documentation: one set covering transactions between user and market-maker and the other set covering transactions between two market-makers.
  10. The CDS contracts shall be standardized. The standardisation of CDS contracts shall be achieved in terms of coupon, coupon payment dates, etc. as put in place by FIMMDA in consultation with the market participants. This guards against customized contracts wherein the market-makers and users are free to determine the terms.
  11. Protection seller in the CDS market shall have in place internal limits on the gross amount of protection sold by them on a single entity as well as the aggregate of such individual gross positions. These limits shall be set in relation to their capital funds. Protection sellers shall also periodically assess the likely stress that these gross positions of protection sold, may pose on their liquidity position and their ability to raise funds, at short notice.
  12. Market-makers shall report their CDS trades with both users/investors and other market-makers on the reporting platform of CDS trade repository within 30 minutes from the deal time. The users would be required to affirm or reject their trade already reported by the market- maker by the end of the day.
  13. For CDS transactions, the margins would be maintained by the individual market participants. Participants may maintain margins in cash or Government securities.

The vast majority of the Indian corporate debt market consists of bonds from state banks and quasi government entities. The rest comprises mostly of debt from high investment-grade corporate borrowers where the motivation of the bondholder to buy CDS protection is low. The volume of medium to low investment-grade corporate bonds in India is insignificant but the availability of CDS protection may help it grow substantially.

Increased use of CDS, over the medium term, has the potential to impart additional liquidity to the bond markets, which have so far been predominantly illiquid. It will help lower rated borrowers diversify their funding sources by accessing the bond markets. CDS also holds promise of providing a thrust to the much-needed infrastructure financing. RBI has allowed dealing in CDS for infrastructure companies even on unlisted bonds, rather than only on the listed ones. A coordinated action by the other regulators can allow insurance companies, pension funds, and provident funds to also participate in this space through the CDS route.


Indian Corporate Debt Markets – Secondary market issues

By Vaibhav Anand, Satya Srinivasan, Mohammed Irfan, IFMR Capital & Rajeswari Sengupta, IFMR B-School

This post is part of our series of posts on Long Term Debt Markets in the Indian context.

The absence of secondary markets for corporate bonds in India is arguably the single most important reason for this market not seeing the kind of growth one would expect. The public (government securities or GSecs) debt market with an outstanding issue size close to Rs. 19,74,467 crores (USD 421.35 billion), had a secondary market turnover of around Rs. 30 lakh crores (USD 640.20 billion) for the year 2009. Besides the G-Secs market, there is a market for corporate debt papers in India which trades in short term instruments such as commercial papers and certificate of deposits issued by banks and also in long term instruments such as debentures, bonds, zero coupon bonds, step up bonds etc. The outstanding issue size of listed corporate debt was Rs. 2.2 lakh crores (USD 46.95 billion) in 2009. The corporate debt turnover in the secondary market was roughly 1.5 lakh crores (USD 31.6 billion) during the year 2009. To put things in context, by the end of 2008, the Indian equity market turnover was roughly $ 1.05 trillion.


Investors have stayed away from the fixed income secondary market as the market lacks liquidity, transparency and depth. Some of the key issues that have traditionally plagued the secondary markets in long term debt in India are: 1) Absence of market makers and liquidity; 2) Preference to bank deposits, postal savings schemes, NSCs etc over bonds because of liquidity risk; 3) Lack of pricing and benchmarking-there is no yield curve at longer horizons due to thin trading volumes and poor price discovery. Although in principle, it is possible to determine a 30-year yield curve but insufficient liquidity makes it less credible; 4) Small institutional investor base; 5) Lack of adequate risk management products; 6) Higher interest rates-falling interest rates during 2000s made G-Secs attractive and trading peacked during these periods. However, the reversal of the interest rate trend since 2004 has robbed the trading in G-Secs off its sheen.


This reluctance in investor participation warrants some amount of surprise as the necessary infrastructure for an active secondary market, i.e. trading, clearing and settlement seems to be in place. It is commonly accepted that even with sufficient market infrastructure, the corporate bond market continues to operate over-the-counter (OTC). This is the case even in bigger and more developed markets like the corporate debt markets of the USA, where most trading occurs in an OTC dealer market. In the US, broker-dealers execute majority of the transactions in a principal capacity and act on behalf of their clients. In India however, the Securities and Exchange Board of India (SEBI) has mandated that all OTC trades are to be reported, settled and cleared through the authorised clearing houses. This paves the way for greater price discovery and an actual measure of the activity in the OTC bond market. To explore the steps taken by the SEBI to deepen secondary market activity, we feature here a timeline that lists the developments in trading, reporting, clearing and settlement over the years:

  1. In 2005, the High Powered Expert Committee (HPEC) on Corporate Bonds & Securitisation, led by Dr. R.H. Patil, mandated the creation of a corporate bonds database by the major stock exchanges that would cover credit events in addition to other information about the bonds. Also, in order to address outstanding issues on the trading, reporting, clearing and settlement of corporate bonds, HPEC also mandated that all trades be reported.
  2. In order to develop an exchange traded market for corporate bonds SEBI vide circulars dated December 12, 2006 and March 01, 2007 authorized the two stock exchanges- BSE and NSE, to set up and maintain corporate bond reporting platforms to capture all information related to trading in corporate bonds as accurately and as close to execution as possible. Subsequently, Fixed Income Money Market and Derivatives Association (FIMMDA) has also been permitted to operate a reporting platform. As per the circulars, all issuers, intermediaries and contracting parties are granted access to the reporting platform for the purpose and transactions shall be reported within 30 minutes of closing the deal. The data reported on the platform is disseminated on the websites of BSE, NSE and FIMMDA.
  3. Further, In March 2007, NSE and BSE were advised by the SEBI to provide data pertaining to corporate bonds comprising issuer name, maturity date, current coupon, last price traded, last amount traded, last yield (annualized) traded, weighted average yield price, total amount traded, rating of the bond and any other additional information as the stock exchanges think fit. In August 2007, SEBI started placing information on secondary market trades (both exchange and OTC trades) on its website on the basis of data provided by the two exchanges. Key Features:
    • a. Trades executed by members of BSE/NSE shall be reported on the respective platforms of their stock exchanges. In the case of OTC trades parties can choose between any one of the 3 platforms.
    • b. BSE and NSE shall coordinate amongst themselves to ensure that the information reported with BSE and NSE is aggregated, checked for redundancy and disseminated on their websites in a homogenous manner.
    • c. The mandate applies to all trades in listed debt securities issued by banks, public sector undertakings, municipal corporations, bodies corporate and companies.
    • d. Subsequent to the launch of the corporate bond reporting platform at NSE, reporting may be made to either platforms of BSE or NSE but not to both for the same transaction.
  4. As a second phase of development, SEBI vide Circular dated April 13, 2007 permitted BSE and NSE to have in place corporate bond trading platforms to enable efficient price discovery and reliable clearing and settlement in a gradual manner. To begin with, BSE and NSE have launched an order driven trade matching platform which retains essential features of OTC market where trades are executed through brokers. OTC trades however continue to be reported on the exchange reporting platforms. In order to encourage wider participation, the lot size for trading in bonds has been reduced to Rs.1 lakh. Subsequently BSE and NSE may move towards anonymous order matching with clearing and settlement.
  5. On October 16, 2009, SEBI mandated the clearing and settlement of corporate bond trades through clearing corporations. Key features:
    • a. It was decided that all trades in corporate bonds between specified entities namely, MFs, FIIs, VCs, Foreign Venture Capital Investors, Portfolio Managers and RBI regulated entities shall necessarily be cleared and settled through the National Securities Clearing Corporation Limited (NSCCL) or the Indian Clearing Corporation Limited (ICCL). NSCCL issued a circular on November 23, 2009 facilitating a centralized clearing and settlement mechanism for enabling smooth transaction closures.
    • b. The provisions of the circular apply to all corporate bonds traded OTC or on the debt segment of stock exchanges on or after Dec 01, 2009. However, the provisions are not applicable to trades in corporate bonds that are traded on the capital market or equity segment of the stock exchanges and are required to be settled through clearing houses of stock exchanges.
  6. On November 29, 2010 SEBI requested the Ministry of Labour to issue directions to authorities responsible for Provident Funds/Pension Funds/Pension Schemes to ensure mandatory reporting of corporate bond trades and to ensure clearing and settlement of such trades through NSCCL or ICCL. Subsequently the Pension Fund Regulatory and Development Authority (PFRDA) in a circular dated December 30, 2010 asked all Provident Funds to mandatorily report and settle the trades in corporate bonds with the Clearing Corporation.

Through these measures, the SEBI has tried to promote secondary market activity in the bond market. With the infrastructure that these measures have spawned, the Indian bond market potentially enjoys improved transparency and pre-requisites for greater activity such as an established clearing and settlement mechanism, a market-driven trading platform and smaller lot sizes for trading. For a variety of other reasons however, secondary market activity continues to be subdued.

Retail Debt Market (RDM)

The retail trading in G-Secs started on January 16, 2003 in accordance with the SEBI Circular dated January 10, 2003. Both NSE and BSE introduced trading facility through which retail investors could buy and sell G-Secs. Table 2 below shows the dismal picture of volume and number of trades in the retail debt market (RDM) at NSE.


Wholesale Debt Market (WDM)

This segment provides trading facilities for a variety of debt instruments including Government Securities, Treasury Bills and Bonds issued by Public Sector Undertakings/ Corporates/ Banks like Floating Rate Bonds, Zero Coupon Bonds, Commercial Papers, Certificate of Deposits, Corporate Debentures, State Government loans, SLR and Non-SLR Bonds issued by Financial Institutions, Units of Mutual Funds and Securitized debt by banks, financial institutions, corporate bodies, trusts and others. During 2009-10, turnover in the WDM segment at NSE increased to Rs.5,63,816 crore from Rs.3,35,950 crore in 2008-09. However, during 2010-11, the turnover decreased marginally to 5,59,447 crore from 5,63,816 crore in 2009-10.



The WDM segment though, shows increasing volumes year on year but lacks the depth. Figure 4 above shows that a significant proportion of trading volumes are accounted for by the top few most active securities.


Thus it seems that the market regulator (in this case, SEBI) has systematically attempted to weed-out secondary market issues and tried to promote more activity, in the process of attempting to enable the corporate bond secondary market and making them more efficient. However, data suggests that secondary market activity remains subdued. Though the necessary infrastructure is in place for a conducive and active secondary market, there is one more portion of the larger issue that regulators have tried to address time and again but without much suceess– the presence of an active hedging market or the availability of adequate risk-management tools. The hedging market is fairly new and has witnessed very low levels of activity owing to it being highly complex and regulated. Our next post in this series will explore the evolution of this market and the issues it faces in greater detail.


Indian Corporate Debt Markets – The Demand-Side issues

By Satya Srinivasan, Mohammed Irfan, IFMR Capital & Rajeswari Sengupta, IFMR B-School

In this post we analyze the demand-side issues that the Indian corporate debt market wrestles with. Our previous post highlighted the supply-side roadblocks in the development of long term debt markets in India and the regulatory measures adopted so far to address these issues. In addition to the supply side constraints on bond issuances, the development of a corporate debt market also needs to be driven by demand-side reforms in institutional investors.

A study of the investment norms for banks, insurance companies, pension funds, and provident funds helps to understand specifics of the investment bottlenecks that may have prevented the development of a well-functioning corporate debt market in India. According to the eligible Statutory Liquidity Ratio (SLR) investments (as per Master Circular – Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) issued on July 01, 2011), banks are required to hold 24% of their liabilities in cash, gold, central and state government investments, thereby leaving non-government bond market instruments completely out of the picture.

For a life insurer it is very important to generate high returns while maintaining asset quality to avoid credit risk. In India, the norms for insurance company investments are made in the Insurance Regulatory and Development Authority (IRDA) Investment Amendment Regulations, 2001, and cover the following businesses: life insurance, pension and general annuities, unit linked life insurance, general insurance and re-insurance. The only section of the Act that allows for long-term, non-government investments are the infrastructure and social sector investments of 15+% and unapproved investments of 15%. Further, according to this Act, the pensions and annuities businesses cannot have any portion of their funds invested in non-government linked investments. Investment regulations governing life businesses require that at least 65% of assets be held in various types of public sector bonds. Funds are permitted to invest in corporate bonds, but the category of “approved investments” only includes bonds rated AA or above. Bonds below AA (which are rare in India), can be held in unapproved assets. Then again, total unapproved assets cannot exceed 15% of the portfolio and are subject to exposure norms limiting exposure to any company or sector. In practice, insurance companies hold less than 7% in unapproved assets. For instance, according to the ICRA, SBI Life’s exposure to equity and unapproved investments has been around 6% only.

A major part of investments (approx. 47%) for life and pension businesses is thus being held in G-Secs and other government approved securities which are relatively safe instruments. Poor appetite for corporate bonds is also on account of the lack of a secondary market – thereby making such an investment a buy and hold play which, considering the long tenor, is decidedly a sub-optimal investment. In other words, the investment norms of insurance companies, banks, pension funds in India are heavily skewed towards investment in government and public sector bonds which acts as a detriment to the corporate bond market development. Without long-term investors like pension funds and insurance companies investing in corporate debt, it is difficult to see how the corporate debt market will take off.

The adverse effect of this legal/regulatory lacuna on corporate debt market is further aggravated by the fact that the high fiscal deficit of the Government of India (GoI) is financed by the issue of GoI bonds or government securities (G-Secs). The fact that the Fiscal Responsibility and Budget Management (FRBM) Act – that required the GoI to reduce its deficit to sub-3% levels by 2009 – has been put in abeyance in the wake of the financial crisis of 2008, implies that the fiscal deficit has been going up and government bond issuances continue to finance this deficit. This has effectively served to further crowd out private corporate debt issuance.

The discussion above highlights a few major issues:

  1. The high level of G-Sec issuances in the Indian debt market,
  2. The low level of corporate bond issues; both these issues are inter-related since large government debt issuance on account of high fiscal deficit has a crowding out effect on corporate debt,
  3. Market preference for very safe AA+ assets with no market for issuances below AA thus creating a very thin debt market; As shown in the following graph, the volume of bonds rated below A is around 5% of the total issue.

The High Powered Expert Committee (HPEC) on corporate bonds and securitisation also popularly known as the Patil Committee, made a few recommendations on enhancing the investor base-an important demand-side issue that was subsequently addressed in part by the SEBI. We detail here the recommendations of the Committee and actions taken thereafter by the SEBI.

In order to enhance the investor base and diversify its profile, the Committee recommended that the investment guidelines of Provident/Pension Funds be directed by the risk profile of instruments rather than the nature of instruments. The Committee also recommended an increase in investment limits for Foreign Institutional Investors (FIIs). In the “Plan for a unified exchange traded corporate bond market” – a report of the internal committee of SEBI in 2006, it is mentioned that the point it to be taken up with the Government and Reserve Bank of India (RBI) wherever relevant – “So as to encourage the widest possible participation for domestic financial institutions, IRDA, the Central Board of Trustees of the Employee Provident Fund Organisation (EPFO) and the Pension Fund Regulatory and Development Authority (PFRDA) should modify their respective investment guidelines to permit insurance companies, provident and gratuity funds, and pension funds respectively to invest/ commit contributions to SEBI registered Infrastructure Debt Funds.”

In July 2011, the EPFO put out requests for proposal while appointing custodians of Securities of EPFO. The document listed the investment guidelines for EPFO fund managers alongside terms and conditions and duties of custodians. Though the prescribed pattern of investment for EPFO favours investments in central and state government securities, it allows upto 30% to be invested in any central government securities, state government securities or securities of public financial institutions (public sector companies) at the discretion of the Trustees. Of this, 1/3rd is permitted to be invested in private sector bonds/securities which have an investment grade rating from at least two credit rating agencies, subject to the Trustees’ assessment of the risk-return prospects.

Demand-side issues remain trickier to resolve as they are tied to a variety of other regulations on investment and an over-arching prescription for “safe investments” i.e. for instruments rated AA and above. Understandably, demand exists only for such instruments and the market caters to this demand, creating in turn a thin-market. A market for high-yield bonds is practically non-existent, suggesting that risk-return profiles are uniform throughout the market, which need not necessarily be the case. Moreover, much of this lack of appetite is also linked to the lacklustre secondary market in corporate bonds. Investors in any market would require an active platform where they would be able to liquidate their assets or square off positions if need be, especially in a high-yield market. In the case of India’s fledgling secondary market in corporate bonds, market activity is highly bunched up at one end of the market at all times, making holding fixed-income securities riskier unless they are being held till maturity.

In keeping with the Patil Committee’s recommendations, investment guidelines that are directed by risk/return profile of investments and investor appetite rather than the nature of investments will help boost demand for a wider range of debt securities and hopefully help in building a deeper, more active market with varied investor profiles. Our next post in this series will aim to uncover a few pertinent secondary-market issues, and their effects on corporate bond market development or lack thereof.


Indian Corporate Debt Markets – The Supply-Side Issues

By Satya Srinivasan, Mohammed Irfan, IFMR Capital & Rajeswari Sengupta, IFMR B-School

This post is part of our series of posts on Long Term Debt Markets in the Indian context.

This post takes off from where our article on the current status of Indian debt markets ended. The peculiar issue with the Indian corporate debt market is not that it faces challenges due to a lack of adequate infrastructure. In fact, as our previous articles mentioned, India is fairly well-placed insofar as the pre-requisites for the development of a corporate debt market are concerned. Inspite of this, Indian corporate debt markets are yet to witness the level of activity that an organised financial market should. In this post and over the next couple of posts that will follow in this series, we pin down and discuss in detail some of the specific challenges corporate debt markets in India face, which in turn have contributed to the lack of activity in these markets as compared to the equity and Government debt bourses.

Some of the issues are structural and a few are regulatory road-blocks. We have systematically categorised these issues into supply-side, demand-side, secondary-market issues and risk & hedging related issues. This post will focus on supply-side issues in the Indian corporate debt market.

The total corporate bond issuance in India is highly fragmented because bulk of debt raised is through private placements. The private placement route requires that the issuer makes an offer to select a group of investors, no more than 50, to invest in the debt securities for issue1. However, corporates are known to circumvent the 49 investor cap in private issuances by making multiple bond issuances for many groups of 49 investors or satisfying the greater demand through immediate secondary market transfers upon the completion of the primary issue, thus diffusing the issue among a greater number of subscribers. Therefore there is a clear need to remove impediments that hinder the development of the institutional side of the market.

The dominance of private placements has been attributed to several factors, including ease of issuance, cost efficiency and primarily institutional demand. Furthermore, trading is concentrated in few securities, with the top five to ten traded issues accounting for bulk of the total turnover. The SEBI Issue and Listing of Debt Securities Regulations 2008, in Ch III, Sec 20 lays out conditions for private placement2 which include, requiring compliance with The Companies Act of 1956, obtaining credit rating, listing of securities, mandating disclosure standards as per Sec 21 that stipulates the documentation and disclosure requirements (detailed in Schedule I of the Regulations3 ).

The private placement disclosure and documentation requirements are viewed by the market to be comprehensive yet not being too onerous in terms of compliance. On the other hand, the disclosure and documentation requirements for public placement of securities are viewed by the market as being extremely onerous and difficult to comply with. In addition to the Schedule I requirements for private placements, public placements also have to comply with additional disclosure requirements , as specified in Schedule II of The Companies Act of 1956. These are an exhaustive set of disclosures in three parts. The first part contains general information, capital structure information, terms and issue particulars, information on company, management and project as well as information on all companies under the same management, and finally management perception of risk factors. The second part contains additional general, financial, statutory and other informational disclosures.

With such an extensive set of disclosure requirements4 for public issues, it seems to us that the market has been avoiding this route for issuing bonds. For instance, The Patil Committee Report lays out the following statistic that highlights corporates’ preference for the private placement route as against the public:

The figures above are consistent with findings of the Patil Committee.

Analysis of the Private Placement Market

Table 2 above indicates that over the years, number of issuances by the private sector has been much more than that of the public sector. However, the volumes of the private sector have been lower than public sector. This indicates that the average size of issue by private sector corporations has been close to INR 1 billion as against the larger size of public sector issuances amounting to INR 4 to 5.5 billion over the years. As shown in Table 2, resources mobilised through private placements in private sector spiked in 2009-10 but came down in 2010-11. There was close to 120% hike in issues placed during 2009-10 by the private sector. Comparatively, public sector issues increased marginally by around 1% during the same period. What is also evident from Table 2, is the tremendous cost differential, with public issuances on average seven times as expensive as private issuances. This could have further driven market participants to favour the private route.

Analysis of issues and volumes of private placements by financial and non-financial corporates reveals that the financial corporates dominate. However, in terms of growth, volumes placed by financial institutions grew by 71% while the same by non-financial institutions grew by 62% from 2008-09 to 2009-10.

The pie chart below corroborates the finding that financial institutions have dominated the number and volume of issues over the years.

In the winter of 2005, the High Powered Expert Committee (HPEC) on Corporate Bonds & Securitisation led by Dr. R.H. Patil made a variety of recommendations to address the prevailing issues in the corporate bond market. The recommendations were spread across three broad areas – (i) Primary Market, (ii) Secondary Market and (iii) Securitisation. One of the primary recommendations to address supply-side issues, was enhancement of the issuer base.

The Patil Committee recommended that in order to reduce the time and cost of public issuance, the disclosure norms and listing requirements be reduced. The Committee also recommended that in the case of issuers that are already listed, these requirements be reduced even further.

In December 2007, SEBI vide circular dated December 03, 2007 amended the provisions pertaining to issuances of Corporate Bonds under the SEBI (Disclosure and Investor Protection) Guidelines, 2000. The changes to the guidelines were as below:

  • (a) For public issues of debt instruments, issuers now need to obtain rating from only one credit rating agency instead of from two. This was done with a view to reduce the cost of issuances.
  • (b) In order to facilitate issuance of below-investment grade bonds to suit the risk appetite of investors, the stipulation that debt instruments issued publicly shall be of at least investment grade has been removed.
  • (c) Further, in order to provide issuers with desired flexibility in structuring of debt instruments, structural restrictions such as those on maturity, put/call option, conversion, etc have been done away with.

In May 2009, SEBI issued a Listing Agreement for Debt Securities that provided for a simplified regulatory framework for the issuance and listing of Non-Convertible Debentures (NCDs). The circular released by SEBI was split in two parts. The first part prescribed incremental disclosures for issuers that were already listed and the second part pertained to issuers who were unlisted and prescribed detailed disclosures for them.

To conclude, the supply-side issues in the Indian corporate debt market remain primarily cost related and to some extent related to heavy disclosure norms, some of which have recently been simplified through regulatory changes. Hopefully the steps taken by regulators to address these issues will help deepen the bond market development further, by promoting more public issuances in multiple categories. Having discussed supply-side issues that have been constraining the development of Indian corporate bond markets, our next blog post will cover demand-side and secondary market issues that pose additional challenges for this crucial market.

1 – As per definition of private issue in the SEBI Issue and Listing of Debt securities Regulations, 2008. The nature of making an offer to specific investors and therefore constituting a private issue is dealt with in Sec 67 of the Companies Act, 1956.
2 – (1) An issuer may list its debt securities issued on private placement basis on a recognized stock exchange subject to the following conditions:

(a) the issuer has issued such debt securities in compliance with the provisions of the Companies Act,1956, rules prescribed there under and other applicable laws;
(b) credit rating has been obtained in respect of such debt securities from at least one credit rating agency registered with the Board;
(c) the debt securities proposed to be listed are in dematerialized form ;
(d) the disclosures as provided in regulation 21 have been made.

      (2) The issuer shall comply with conditions of listing of such debt securities as specified in the Listing Agreement with the stock exchange where such debt securities are sought to be  listed.
3 – The details of Schedule I of the Annexure 1 of the SEBI Issue and Listing if Debt Securities Regulations, 2008 are reproduced in Annexure 1
4 – These disclosure requirements for public placement are laid out in Ch II, Sec 5 of the SEBI Issue and Listing if Debt Securities Regulations, 2008