In last month’s budget speech, the finance minister announced plans to issue tax-free bonds for infrastructure to the extent of Rs30,000 crore, and to create a debt fund with suitable tax breaks. These are commendable plans to raise funds. But they can realize their ultimate potential only if there is an active market for such debt, which could allow people to enter and exit at will.
The development of a sophisticated debt market in India has unfortunately proved to be elusive. Almost every financial luminary in the country has at one point or the other been associated with a committee to identify measures needed to correct the current shallowness of the debt market. The quirks of withholding tax, the asymmetrical effects of taxes on different participants, the fear of having to hold debt instruments to maturity—all these have been cited as reasons for the narrowness of these markets. As recently as last month, the Prime Minister remarked on the importance of market-making in this area.
With the passage of time, some of these structural weaknesses appear to have been corrected. The government has provided preferential treatment for bonds, particularly those pertaining to infrastructure, and the Reserve Bank of India has permitted certain forms of repurchase to encourage trading.
At first glance, when such markets fail to develop, one can come to the conclusion that there is not enough skin in the game for market participants. This, however, is not true in India’s case.
Over the last two years, a number of non-banking financial companies (NBFCs), including Tata Capital (where this writer works), have actually issued listed bonds. The coupon on these bonds varies between 10% and 12%. However, as interest rates fell last year, the capital value of these bonds improved, giving some investors pre-tax returns of as high as 20%. It is difficult to comprehend, when this kind of return can be made from the bonds of highly rated borrowers, why the market is not deep enough.
Most countries, including the US, have historically tended to trade bonds over the counter. The bulk of these bonds are not listed. But being unlisted need not automatically imply the total lack of liquidity one sees in India. In the absence of an adequate social security net, Indian investors have an inordinate amount of their savings in fixed income instruments, which yield low real rates of return. Retail investment in equities is still relatively small, and has perhaps been hurt by the volatility in recent years. The bond market can provide a meaningful alternative to this, combining a fair degree of capital protection with higher returns.
In today’s context, with high inflation and low real rates of return on bank deposits, the extra spread one can earn on a bond could also make a real difference in wealth creation over the years.
There is an opportunity for some financial institutions to play the role of a market maker—one who is available on call to buy and sell at some price. Merely the possibility of easy entry and exit—facilitated by the market maker—would enable some to make investments that they might not have made otherwise.
The dearth of transactions in the corporate bond market now suggests that in order to obtain liquidity, a fair amount of value is left on the table for the market maker to enjoy. Even if the size of the market is not yet attractive enough for large institutional players, it can surely be worthwhile for some small bank or NBFC to take the lead in this socially useful and profitable initiative of market making.
Govind Sankaranarayanan is chief financial officer and chief operating officer, corporate affairs, Tata Capital. He writes on issues of governance.
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