A Financially Mature Debt Market Well Recognised Need

Published Date: 02 Nov 2017

TABLE OF CONTENTS 3

CHAPTER I 1

INTRODUCTION 1

1.1 RESEARCH METHODOLOGY 3

CHAPTER II 4

Debt Market in India: Evolution and Functioning 4

CHAPTER III 6

CORPORATE DEBT MARKET: US, JAPANESE AND OTHER JURISDICTIONS 6

CHAPTER IV 8

PATIL COMMITTEE RECOMMENDATIONS AND THE CHALLENGES AHEAD 8

CHAPTER V 14

CONCLUSION 14

BIBLIOGRAPHY 17

CHAPTER I

INTRODUCTION

A capital market generally has several segments namely financing from commercial banks, equity capital financing, non-banking financial institutions and financing through issuance of bonds. The choice of adoption or rather encouragement to a particular mode of financing is though largely a policy matter of a government, there are several other factors that have an influence. In most countries the debt segment of the market develops with the maturity of the financial sector in general. Taking India’s specific case, in the pre-globalised era impetus was given to financing by commercial banks, which were largely nationalised banks, in order to further the state’s commitment towards sustaining a mixed economy. The impacts of this deliberate channelizing of industrial financing activity could be easily observed in the period that followed. An over-sized, mostly publicly owned and controlled banking system did nothing but to amass huge deposits and channel these to preferred investment plans charging administered interest rates. [1] 

If we are to map the emergence of bond market in India, it started developing only after 1990s when the interest rates were deregulated finally resulting into an active growth of the government securities’ bond market. [2] However, the market in corporate securities other than the government securities has remained lukewarm and has witnessed less action. Though in the recent past there have been initiatives to bolster the existing situation in the corporate bond market, for instance the constitution of the High Level Expert Committee on Corporate Bonds and Securitisation a.k.a. Patil Committee [3] whose recommendations have been put to effect, although with a slow pace. A conclusion as to its success/failure however still seems premature. [4] 

A Financially Mature Debt Market: well recognised need

It is well accepted that over reliance on financing by the banks is not a practice worth support and encouragement. If the banking system is largely publicly owned, overreaching, highly regulated and dominates the other segments, bank lending to business firms may frequently go bad and become unrecoverable. The same consequence may follow even in an instance where due to immense pressure of attainment of targets banks compel themselves to go for unproductive advances only to add to their non-performing assets. In contrast, when these banks face competition from the debt market, lending becomes more regulated and funds flow to the most productive of the investment demands. This follows not only because a mature debt market enables a more realistic assessment of the investment demands in light of the disciplinary role of market forces but also because of the efficiency concerns of these banks which run the risk of buckling down under burden of inefficient lending and non-performing assets. [5] 

In fact, scholars opine that a primary reason for the Asian Financial Crisis of 1997 was this failing of banks which were operating under the burden of huge short term working capital finance and long term fixed capital loans. [6] It is speculated that had there been a well functioning debt market, the impact would have been much less. Neither had the borrowing firms amassed debts disproportionate to the securitized assets nor had these banks been subjected to the shocks that their borrowers faced. [7] To be precise the basic philosophy of developing a diversified financial system with banks and non-banks operating in equity market and debt market is that it enhances risk pooling and risk sharing opportunities for investors and borrowers. [8] 

1.1 RESEARCH METHODOLOGY

The mode of research undertaken for the purpose of completion of this project has been the doctrinal. The project as is evident from the very subject of it does not entail the requirement of empirical research and so the ambit has been limited to doctrinal method only. However, for the purpose of showing the trends and reflecting upon the walk of the corporate debt market in India and abroad reliance has been placed upon the figures/data collected by other researchers and sources. For the research purposes extensive utilisation of the GNLU Library has been made.

CHAPTER II

Debt Market in India: Evolution and Functioning

In countries across the world, the debt market is generally assumed to be a more widely used source of financing in comparison to the equity market. However, Indian capital market marks an exception with the latter being more acceptable source of financial leverage than the former. The debt market, as was confined only to the issuance of government securities, was used primarily to monetise the fiscal benefit where the borrowings were made by the government on already announced coupon rates from a captive group of investors. [9] 

The debt market in India comprises broadly two segments, viz., Government Securities Market and Corporate Debt Market. The latter is further classified as Market for PSU Bonds and Private Sector Bonds. [10] The trading platforms for government securities are the "Negotiated Dealing System" and the Wholesale Debt Market segment of National Stock Exchange and Bombay Stock Exchange.

The market for trading of securities from private corporate and PSUs as different from the market for governmental securities is termed as the corporate debt market. Now, in the corporate debt market the securities can be traded (a) in the primary market (b) in the secondary market. Recent statistics reveal that the trade in non-governmental securities whereas occupy a substantial portion of the total turnover on the primary market, the same falls steeply to negligible proportions when it comes down to trade on the secondary market. [11] This in fact has been one of the causes of unpopularity of the corporate debt market – absence of an active secondary market which makes the investors feel that their debt is highly illiquid. [12] 

Again in the primary market the securities can be traded either by way of (a) public issues (b) private placement. Over the years, there has been a constant increase in the share of private placement trading in the overall turnover of primary debt market. [13] Such a dominance of private placement is attributed to several factors [14] â€”viz. involved issuance procedure and higher costs attached to public issues [15] , much higher subscription in case of private placements etc. Also the whole public issue procedure often results into delays. [16] This tilt towards private placement alongwith lack of dedicated intermediaries is, on the other hand, considered to be one of the structural weaknesses of the Indian primary market. [17] 

The trade in corporate securities, in the secondary market can be by three modes i.e. (a) over the counter exchange of cheques and securities directly through the depositories (b) through the brokers registered with the stock exchanges (c) at the Wholesale Debt Market (WDM) segment of the NSE like government securities’ trading. In common practice the WDM segment involves maximum trading of corporate bonds. It involves an automated trading system known as National Exchange for Automated Trading (NEAT) which is an order based system operative across the country which matches best buy and sell orders and fixes the deals. The WDM provides trading facilities for a variety of debt instruments including government securities, Treasury Bills and bonds issued by PSUs, corporate, banks like Floating Rate Bonds, Zero Coupon Bonds, Commercial Paper, Certificate of Deposit, corporate debentures, State Government loans etc.

In the next part of the project we shall visit the US and Japanese corporate debt market and identify the distinguishing features which can be assumed to be borrowed to Indian market.

CHAPTER III

CORPORATE DEBT MARKET: US, JAPANESE AND OTHER JURISDICTIONS

The corporate bond market in US is the biggest global bond market with Japan being a distant second. Bond investors in the US market involve both retail investors and institutional investors. The debt trading in the secondary market is characterized by high quantum of transactions in the OTC market while the stock exchanges have not been able to attract the same amount of trading. [18] Interestingly, the US corporate debt market stands higher in terms of worth than the US treasury securities. However, it is lower than the mortgaged backed securities that account for 23percent of the outstanding debt. The market analysts observe that the participation of retail investors is rising steadily however despite this increasing share of the retail investors it is doubtful that as much as 65% of these investors are even aware of the risks attached with the bond market. It is in fact understood that an investor in the corporate debt market does not have the same levels of access to information as he does in other commodity market. In fact had there been higher access to information, a significant component of which would be risk awareness, the retail investor participation would automatically shoot up. [19] 

To address the lack of price transparency and risk awareness in corporate debt, the US market adopted rules requiring dealers to report all transactions in U.S. corporate bonds to the NYSE automated Bond System and to develop systems to receive and redistribute transaction prices on an immediate basis. Also a database of transactions was created which would help in supervising the debt market and a surveillance program was developed to better detect fraud to foster investor confidence and fairness. Thus all over the counter deals are now reported by the brokers. [20] 

The corporate bond market in Japan was heavily regulated until 1985. The relaxation of market eligibility standards, the establishment of rating agencies, and the start of bond futures trading followed by the liberalization of financial transactions in general contributed to the development of the bond market. The measures included abolition of securities transaction tax, deregulating brokerage commission, preparing legal framework for securitization, allowing banks to issue straight (unsecured) bonds, and introduction of registration system for securities companies.

As far as the participation of retail investors is concerned there are no specific restrictions on their participation. The market comprises of the individual investors, the Postal Savings System, Postal Life Insurance Service (Kanpo), public and corporate pension fund systems, investment trusts, licensed banks, and insurance companies.

Initially, the bond market in Japan was regulated by a Bond Committee controlled by major commercial banks and the conditions which were imposed were unfavourable such as use of collateral, quantitative limits upon the company’s equity etc which were relaxed. Also measures for maintaining price transparency were undertaken which included the expansion of the number of bond issues for which the quotations were announced by the Dealer’s association, removal of any transaction price range etc. Again the corporate bond issuance is less in comparison to the issuance of government securities. The trade in the secondary market is again primarily through the OTC market. The efficiency and fairness of the trading atmosphere is enhanced by publication of reference information for the market participants by the Japanese Securities Dealer’s Association. [21] The world debt market has seen recent technological developments primarily in the arena of electronic trading platforms. However, as different from the fully electronic trading platforms, many markets even make use of Alternative Trading Systems which are either dealer based systems or user based systems. Whereas in the former the dealer displays quotes or enables users to request quotes from multiple dealers, and negotiate electronically with the dealer that provides the best price, the latter enables the users/investors to deal with each other directly through a cross matching system.

CHAPTER IV

PATIL COMMITTEE RECOMMENDATIONS AND THE CHALLENGES AHEAD

The recommendations of the Patil Committee in the year 2005 and its subsequent implementation by the SEBI, has definitely improved the transparency in the Indian debt market. However, the market still lacks diversity with primary emphasis and investment being only by means of private placement. There have been considerable improvements which include dematerialisation of holdings, increased transparency in trading due to the requirement of reporting of all transactions taking place, elaboration and enhancement of the doumentation requirements in case of private placements, linking of rating agencies etc. [22] Further, the SEBI has in December 2007 relaxed the requirement of bond issues being rated by two agencies and that of the public issues being of investment grade. However, despite these measures there are still certain factors which have limited further development of corporate bond markets.

(1). Rare Public Issues and small size of private placement [23] : A public issue of bonds is similar to an issue of bonds in the equity capital market. The bonds are issued to a wide range of investors including retail investors and are subject to the regulatory standards such as issuance of a prospectus, as applicable in the equity market. A private placement, on the other hand, involves an issuance of the whole lot to a set of 50 qualified institutional buyers which require much less documentation. An objective opinion suggests that the maturity of financial markets is measured by how widespread the public issues are and how frequently are the instruments traded on the secondary market. Indian debt market both primary and secondary falls on these counts. Stringent disclosure requirements, the time consumed to make a public issue and other procedural formalities say issuance prospectus etc anyway make public issues as unattractive means of raising debt. Private Placement, which is relied upon, in turn narrows the market mainly because there is a maximum prescribed limit on the number of investors to whom the bonds can be offered. Also, since the size of private placement issues is small, within a day when there might be limited number of investors available, the issues will all go to the same lender, under similar terms. Further, in the debt market, the private non financial issuers which in other markets are major issuers, occupy only a small segment. Public financial and non-financial entities and private financial entities like banks form a major portion. These do not represent borrowing for structural investment but only for re-lending purpose. [24] 

(2). Demand for corporate bond finance is limited: The demand for genuine bond finance is limited. The corporate have traditionally relied upon banks as their major source of finance. As the development banks are barred from lending out of the deposits, they undertake debt issues for the same. Thus these development banks are active in the bond market which is also evident from the figures which show that the borrowing by private non financial entities was the least. The choice of what means of generating finance needs to be adopted depends upon several factors.

At various times the RBI has prohibited banks from lending at rates below their published lending rate (PLR)—but the prohibition did not apply to investments in private placements. Therefore, a bank that wanted to offer a very tight rate to a highly rated corporate borrower would present the loan as a bond.

Interest rate expectations may influence the choice—when interest rates are falling, as they have been for several years, the borrowers will prefer a floating rate loan rather than a fixed-rate bond.

Loans are not subject to stamp duties, whereas bonds are, making loans desirable for tax sensitive borrowers.

Loans may be preferable for banks because they are not marked-to-market. Bonds not held-to-maturity are marked-to-market. But, in the absence of reliable secondary market prices; there is scope for manipulation and window dressing. [25] 

(3). Market for companies with high credit rating: The credit rating agencies in India rate bonds on several scales. The bonds with highest degree of credit worthiness get rated as AAA grade followed by AA, A, BBB and then non-investment grade. An indicator of the degree of market efficiency would be whether or not bonds of various ratings get transacted regularly in the market. [26] Indian bond market has shows an interesting attribute. Firstly, the market is predominantly a high credit grade market so as to say that the volume of bonds with highest credit rating say AAA or AA occupy both in terms of number and value a substantial portion of the market. Figures show that AAA and AA grade bonds occupy as much as 92% of the market i.e. out of the total capital generated from the bond market or total investment in the bond market, 92% goes to the account of high grade securities. [27] 

Further, if the distribution of total trading has to be done across the type of bonds, it is observed that the majority of transactions have taken place within the low grade securities. During a span of four years from April 1997 to March 2001 there was a qualitative change in the composition of the market wherein there was increased trading in lower end bonds. [28] Now, because the number of high rate bonds is much higher in the Indian market than the lower rate bonds, an increasing level of trading in this segment would suggest sluggish market activity. Also, it indicates the tendency of an investor to hold onto the high rated bonds perhaps to ensure a consistent interest earning. Also we need to note that the period under consideration was one of dwindling interest rates wherein an investor would want to have an assured piece of market earning as opposed to increasing interest rates in which case the market is speculated to see more activity.

(4) Wholesale Trading: Whether on the exchange or Over the Counter: Trading on the primary market as is already mentioned can either be by way of public issues or by private placements. In India, it happens primarily through the latter. However, when it comes down to trade in secondary bond market, it can take place in one of the three possible modes – bilateral trade between participants settled by cheques and transfer of securities through depositories (the OTC market); through a broker where the trade is recorded at the exchange where the broker is registered; or at the Wholesale Debt Market (WDM) segment of the NSE like government securities. [29] 

From the beginning of the development of the corporate debt market in India, the trading has been conducted through the OTC market. However, after the recommendations of the Patil Committee and its concerns pertaining to the transparency of pricing of bonds and transactions, the institution of mandatory trade reporting platform has evolved. [30] First the Bombay Stock Exchange and then the NSE since March 2007 and finally the Fixed Income Money Market and Derivatives Association of India (FIMMDA) since September 2007, have set up and maintain corporate bond reporting platforms. SEBI made it compulsory for market participants to report all corporate bond deals. The Patil Committee also recommended that this trade reporting system be further developed and the bond trading should take place within the aegis of the exchange. [31] 

However, the same has been done in debt markets across the world, there are still doubts as to the feasibility of the same in India. It is opined that Indian markets are slightly unsuitable for it because ‘anonymity’ of the seller and buyer which are maintained by Over the Counter (OTC) trading by means of order matching transactions is difficult to achieve at an exchange. [32] 

(5) Non - availability of Delivery versus Payment system: By far the largest financial risks in securities clearance and settlement occur during the settlement process, that is, the process through which the transaction is completed by final transfer of securities from the seller to the buyer (delivery) and final transfer of funds from the buyer to the seller (payment). Now, the principal risk that a seller might encounter is that of delivering the securities while not receiving the payment. So, to avoid this risk such a delivery versus payment mechanism is developed wherein both the delivery and payment happen together. However, some markets like the OTC, which represent the bulk of trading, do not have that mechanism. They are left to be settled bilaterally between the counterparties. However, as different from the trading in paper certificates, the bonds are being issued in the form of scripless securities whereby a computer based depository and settlement system is maintained. When there are title transfers the depository will record such transfers. Also, the delivery and payment shall be through the depository however, still the sellers instruct the depository to transfer the bonds to the buyer before he receives cash. Thus the system still does not work as a delivery versus payment system. This potentially imposes a barrier to trading.

(6). Repurchase Agreements are not permitted for corporate bonds: A repurchase agreement basically refers to a transaction wherein the holder of securities simply sells them off a lender for a period generally a short term ranging from overnight to 30 days, which is why a repo agreement is considered to be a short term money instrument. Also the date of redemption and the price at which a bond shall be redeemed is decided at the date of issuance of bonds. The RBI is the regulatory authority for this part of the market as corporate bond repos would be regarded as money-market instruments.

The RBI has been considering allowing corporate bond repos for some time—and now may be moving toward permitting them. Since late 2007, SEBI has been talking with RBI about corporate bond repos. Inevitably this is linked to the parallel discussions on settlement with the exchanges. [33] There are demands of the shut down period being cut down from fifteen days in the current scenario to three days. This move is justified because dematerialisation is widely prevalent today. Also, the net-off period should be allowed for repos as they can make markets effective [34] 

CHAPTER V

CONCLUSION

Sound development of various segments of the capital market is a pre-requisite for a well functioning financial system. The equity market in India has been modernised over the past 15 years and is now comparable with the international markets. The debt market however remains underdeveloped, possibly due to the absence of a reliable and liquid yield curve, long time taken for floating an issue, high cost of issuance and lack of liquidity in the secondary market. The promotion of a vibrant corporate bond market is essential for meeting the demand for long-term funds, especially for infrastructure requirements.

The development of any market requires removal of bottlenecks on supply as well as demand side, while putting in place alongside sound institutional and legal framework. There is a need to ensure that the corporate are able to raise resources from the capital market in a timely and cost-effective manner. The need is also felt to develop strong domestic institutional investors, which would serve many purposes. Learning from the experience of developing the government securities market, the development of the corporate debt market needs to proceed in a measured manner with well thought out sequencing The initial steps towards developing the corporate bond market based on the recommendations of the High Level Expert Committee on Corporate Bonds and Securitisation have already been initiated. The Union Budget for 2006-07 had proposed to create a single unified exchange-traded market for corporate bonds. As a first step towards creation of a Unified Exchange Traded Bond Market, the SEBI has initiated steps to establish a system to capture all information related to trading in corporate bonds as accurately and as close to execution as possible through an authorised reporting platform.

For step by step development of the corporate bond market, it is necessary to lay down the broad objectives, which may include, (i) building a liquid government securities benchmark yield curve for appropriate pricing of debt instruments; (ii) promoting the growth of an active secondary market for spot and derivative transactions; and (iii) providing encouragement to issuers and investors to participate in the bond market. All these objectives are mutually reinforcing. The reform process will be facilitated by a comprehensive regulatory framework. For the above scheme of things to yield the desired results, the regulators as well as market participants have to play a proactive role. The next phase of development may involve the setting up of a corporate debt trading platform, which enables efficient price discovery and reliable clearing and settlement, in a gradual manner.