Going Global

Global rupee bonds, offshore settlements and rising international interest have all added some welcome energy to India’s domestic debt markets. However, there is far more to be done.

From the launch of electronic trading platforms to the first global rupee bonds, India’s local currency debt market has taken on new breadth this year. Yet, it still appears to be caught in a trap. While foreign interest in the Indian debt markets has surged, corporate bond volumes remain stunted.

From January to September, net foreign investment in local debt amounted to a record Rs118.3bn (US$19.3bn), a marked turnaround from 2013, when foreign investors sold a net Rs50.8bn of Indian debt. Total corporate bond volumes between January 1 and October 9 this year, however, stood at a flat US$26bn-equivalent versus US$35bn for full-year 2013, according to Thomson Reuters data.

Industry experts say proactive measures need to be taken to retain the interest of both foreign and domestic investors if the rupee bond market is to reach its true potential.

The Indian corporate bond market is only three decades old and stands at around US$900bn, fourth largest in Asia behind Japan, China and Korea. Its growth has long been a priority for the government, but supply-demand issues have put a cap of the potential.

“Channeling of the savings to the right assets, a proper electronic-trading platform, change in trading culture from hold-to-maturity to active trading are some serious gaps that need to be fixed for the rupee bond market to grow.”

On the supply side, private placements from a handful of issuers, mostly state-owned companies, continue to dominate the market, indirectly impacting the growth of the secondary market. As bond sales remain restricted to private placements – limited to 49 investors – new issuers also typically either toe the line or just turn to the more familiar, albeit costlier, bank market.

Instruments with AA+ or higher ratings continue to dominate rupee bond issuance, and innovation is sporadic.

“Lack of supply of innovative debt instruments, such as step-up bonds, index bonds and dual-currency bonds, and missing markets, such as bond derivatives, are other supply side factors that have prevented the development of a robust corporate bond market in India,” said a study paper published on the Reserve Bank of India’s website in March 2014.

On the demand side, the participation of key investors, such as pension funds, provident funds and insurance companies, remains restricted due to their investment guidelines, which limit many from buying bonds rated below AA+. Participation of retail investors also remains abysmal.

“India has one of the largest bond markets in Asia with a savings rate of around 30%, which is reasonably high, but not as much as in China, where it exceeds 50%,” said Vijay Chander, executive director, Asia Securities Industry & Financial Markets Association, or Asifma.

“However, the unfortunate part is the savings in India get invested in unproductive investments, such as gold and real estate partly because the country is under-banked or there is a cultural affinity towards certain asset classes

“Channeling of the savings to the right assets, a proper electronic-trading platform, change in trading culture from hold-to-maturity to active trading are some serious gaps that need to be fixed for the rupee bond market to grow,” Chander said. “As India’s is structurally a high interest-rate economy, the hold-to-maturity trend suits investors because, if you sell a bond, it will result in mark-to-market losses. However, such an approach is not good for the market.”

Electronic trading platforms for corporate bonds at the Bombay Stock Exchange and the National Stock Exchange were introduced earlier this year, but these have been barely active since becoming operational.

Highlighting another structural flaw, Chander said the clearing and settlement mechanism too had gaps as the counterparty risk was not covered in every trade. He pointed out that the entity clearing and settling these trades (the Clearing Corp of India) assumes counterparty risk on government bond trades.

“This facilitates greater liquidity in the government bond markets. On the other hand, the National Stock Exchange, which has the facility to clear and settle corporate bond trades, merely settles and matches trades without assuming any counterparty risk. This aspect results in much lower liquidity/trading volumes in corporate bonds,” Chander said.

However, some steps the RBI has taken recently give some hope. The central bank allowed short sales of government securities, or G-secs, in the over-the-counter market. To date, such short-selling was allowed only on the order-matching electronic screens platform. With effect from January 2015, The RBI also lowered to 22% from 24% the ceiling on the category for G-secs that banks hold to maturity.

Some feel the high composition of the G-secs at over 60% of the total bond market also acts as a deterrent to the growth of the corporate bonds, which make-up for about 18% of the total market.

“Right now, Indian lenders are holding G-secs in excess of regulatory requirements, but this trend may change gradually in future as government borrowing will come down at some stage. The new government is moving strongly on fiscal consolidation, which will improve the economy and a contraction in the fiscal deficit will follow”, said Naresh Takkar, managing director and CEO of Icra, an associate of Moody’s.

On the supply side, Takkar sees a pick-up in the refinancing market, especially for annuity projects involving certainty of cash flows.

“As bank capital will become more expensive due to Basel III norms, more funding is likely to flow to the bond markets. New instruments, such as the REITS and Infrastructure Investment Trusts, should help drive demand for corporate bonds”, he said.

Big leap forward

Some recent developments are adding to investors’ interest in the market. Global entities, such as the International Finance Corp, the private sector lending arm of the World Bank, and the Asian Development Bank, have made significant progress in invoking the interest of investors in the local bond markets.

In September 2014, IFC sold a Rs6bn debut tranche of rupee bonds in the onshore market, a month after launching a financing programme that will allow it to issue up to US$2.5bn over the next five years.

The so-called Maharaja bonds, along the lines of China’s Panda bonds, Japan’s Samurais and Australia’s Kangaroos for issuance in local markets from foreign entities, scored a few firsts. For the first time, Indian rupee bond markets saw a multilateral bond offering piercing the sovereign yield curve.

The Maharaja bonds were sold in four tranches, matching the needs of different investor bases and IFC’s requirements to fund Indian projects. The first two tranches of around Rs1.5bn each were bullet bonds at tenors of five and 10 years, paying semi-annual coupons of 8.00% and 7.97%, respectively. Both priced approximately 50bp below Indian Government bonds yields of comparable maturities.

Two other tranches were issued under the separately tradable redeemable principal parts (STRPPs) format. The STRPPs include callable bonds and were priced at a range of 20bp–30bp above the relevant maturity IGB benchmark yields.

Besides the IFC, the Asian Development Bank is the only other foreign entity to issue bonds in the local market, with a Rs5bn 10-year bond in February 2004, 17bp above G-secs at the time.

In April this year, IFC also completed the last offering off its US$1bn offshore rupee-linked programme set up October 2013.

Challenges and remedies

FIIs interest in corporate bonds has increased in the last few months, but bank lending remains the preferred source of financing for Indian companies. This is because enforcement of creditors’ rights has always worried investors for their investments in the bond markets. The absence of a bankruptcy regime and an overburdened legal system make enforcement punitive, keeping investors away from long-tenor or lower-rated instruments.

“In case of default, bond trustees do not have the same rights to recover expeditiously as either a bank or a financial institution in India and have to get into the long-drawn legal process of liquidation for recovery,” said Icra’s Takkar.

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act and the Recovery of Debts due to Banks and Financial Institutions Act protect banks and FIs in insolvency, but, for others, ordinary civil court litigation is the only recourse.

However, the government has started talking about having a bankruptcy regime, albeit for certain sectors.

Narendra Modi’s pro-reform government has also kept its promise to open the country’s capital markets to foreign investors, having announced international settlement of Indian debt securities in the latest budget in July. In doing so, the Modi administration is promising to restore India’s sub-5% economic growth to 7%–8% in three to four years.

No details on this crucial development are available, but sources aware of the development said India might begin by allowing rupee-denominated corporate bonds to be settled via Euroclear, the world’s biggest provider of cross-border settlement services.

Such a move will open India’s underdeveloped domestic bond market to a worldwide audience, with potentially wide-ranging implications for local liquidity and the currency.

Under current rules, no more than US$30bn of government bonds and US$51bn of corporate bonds may be in foreign hands, but nearly half of the corporate bond quota remains unused.

As such, market participants believe more incentives are needed to boost investor interest. For instance, retail participation can be enhanced through income tax incentives. For long-term bonds, tax-free income can be combined with a lock-in period.

“The withholding tax of 5% on interest payments to FIIs can also be removed to encourage them to buy more rupee bonds,” said a banker.

Bankers also feel the gap between the debt and equity markets also needs to be bridged. For instance, equity investors enjoy exemption from long-term capital gains tax for investments held over a year. This can be extended to bonds, as well.

Key investors, such as the insurance and pension funds, are also greatly inclined to buy government bonds, resulting in nearly half of their annual investments being parked in government debt, with infra bonds next and the rest going to the equity markets.

Regulatory risk remains a hurdle, too. The Ministry of Corporate Affairs badly dented corporate bond sales earlier this year with a rule requiring bond issuers to set aside half of the proceeds of any bond sale in a Debenture Redemption Reserve account.

Even though the ministry relaxed the rules in late May to exempt many frequent borrowers, including non-banking financial companies, from the DRR requirement, other requirements will continue to impact deal flow, as issuers are now required to seek specific permissions from shareholders for bond sales – something not needed earlier.