Lack of investor appetite fails to lift market for junk bonds

Despite the capital market regulator’s nod early this month, the market for junk bonds here is yet to take off because investors do not seem to have an appetite for such papers in the wake of the credit crisis in the US which was largely brought about by too much emphasis on similar high-risk and high-yield instruments.

Analysts say that as long as Indian stock markets offer high returns, investors will not turn to such bonds. The Sensex, the benchmark index of the Bombay Stock Exchange, has risen 36.94% since the beginning of the year; it gained 46.82% last year. Junk bonds are of speculative grade (BB) and generally issued by corporations of questionable financial strength or without a proven track record. They tend to be more volatile and return higher yields than bonds with better ratings. In some cases, they are used to fund leveraged buyouts where an acquirer issues such bonds to pay for the acquisition and then uses the acquired company’s revenues to service the debt.

Issuers of bonds with lower credit ratings pay a higher rate of interest than those whose bonds are given an investment-grade rating. This, in turn, generates a higher yield for investors. For example, if a company that qualifies for the highest rating (AAA or AA+) issues a 10-year bond with a yield of 6%, a company with a speculative grade may need to offer a yield of 9% or even more to compete for capital. From the investors’ perspective, it is a high-risk-high-return game.

Small firms in the infrastructure space that are finding it difficult to raise funds for various projects are likely issuers of junk bonds as they do not get access to bank credit easily, according to Raman Uberoi, director, financial sector ratings at Crisil India Ltd, a subsidiary of global rating agency Standard and Poor’s. He added that the instances of a company getting a grading below BB have come down drastically over the past years and said he did not anticipate a junk bond market evolving in India.

Vibha Batra, co-head financial sector ratings, Icra Ltd, an associate of Moody’s Investors Services, also ruled out the possibility of the junk bond market taking off here and said that there is no interest in these—from issuers and borrowers alike.

Globally, foreign institutional investors (FIIs) are big buyers of lower grade papers but after the credit crisis in the US, they have kept away from such bonds. Junk bond issuance around the world stands at $133 billion (Rs5.26 trillion) for the year to date, a drop of 11.3% from a record $150 billion in 2006, according to Thomson Financial, a financial information services provider.

Estimates by financial services institutions in the US predict that junk bond sales in the country could fall a further 10% in 2008. In fact, junk bonds are on track for their worst investment performance since 2002 when the bankruptcy of several issuers wreaked havoc on the market.

FIIs have a small role to play in the Indian debt market as their exposure to corporate as well as government bonds is capped at $3.2 billion. Commercial banks, mutual funds and insurance companies are the other buyers of debt papers. At a time when the fear of subprime looms large worldwide and relatively stronger quality papers themselves do not have too many takers in a thin corporate bond market in India, paper below investment grade may not attract any investors, say analysts. In November, the trading volume of corporate bonds in the secondary market was Rs5,893 crore. A robust corporate bond market is a prerequisite for a junk bond market to take off.

Sundeep Bhandari, regional head, global markets—South Asia at Standard Chartered Bank, said that all the players in the debt market in India have become “credit-sensitive and risk averse.” According to him, the chances of junk bond market taking off in India are bleak. Unlike the developed markets, asset reconstruction companies in India also cannot invest in junk bonds, as they are only allowed to invest in distressed assets of banks and financial institutions and cannot directly buy inferior quality paper issued by corporations.

That leaves only mutual funds as a possible class of investors in junk bonds. In fact, some financial market analysts expect Indian mutual funds to create a special category of funds called junk bond funds to cater to investors with appetite for high risk. Mutual fund managers, however, rule out this option, and say no fund would buy papers that are below investment grade as there is no clarity as to what happens in the event of a default by the issuers.

K. Ramanathan, head, fixed income securities, ING Investment Management India Pvt. Ltd, said that he would not take the risk of investing in junk bonds. He added that investors with a high risk appetite have been “spoilt by the equity market” and would not go for junk bonds.

Nilesh Shah, deputy managing director at ICICI Prudential Asset Management Co. Ltd said that there is also a “reputation risk” involved in case of junk bonds. “There is no clarity on what happens in case of a default. Who takes responsibility?” Shah asked.

“In a disclosure-based regime, it should be left to the investor to decide whether or not to invest in a non-investment grade debt instrument,” Sebi said early this month. Previously, the regulator’s guidelines required any debt instrument issued publicly to be at least investment grade.