India’s corporate bond market puzzle

Banks and equity markets are the dominant sources of capital for business in India even as the corporate bond market has languished for decades now. This is a puzzle. Several committees have opined on how to fix this, yet little has changed. Today, corporate bonds are a $287 billion (about ₹ 19 trillion) market—around 14% of gross domestic product (GDP). This is large on an absolute basis but small compared to bank assets (89% of GDP) and equity markets (80% of GDP). In its current state, it is a market for highly rated, plain vanilla instruments, issued by financial firms and public sector enterprises. Also, issuance is fragmented and trading dries up within a few days of issuance.

Going forward, the stress in the banking sector along with increased capital requirements under Basel III will force banks to tighten lending. Bond markets could then become pivotal in supporting the diverse financing requirements of the growing Indian economy. Especially so for small and medium enterprises and infrastructure projects, which carry higher risks or require longer-term financing that banks with their asset-liability constraints cannot provide.

This year’s budget proposes six measures for corporate bond market development: an electronic platform for private issuance, a platform for corporate bond repurchase agreement (repo) and a consolidated reporting platform. It also seeks to extend foreign investment to unlisted debt securities and pass-through securities, asks the Reserve Bank of India (RBI) to encourage bond financing by large borrowers and requires the Life Insurance Corporation of India to set up a credit enhancement fund for infrastructure projects.

These measures are neither new nor likely to have any significant impact. Most of them could have been implemented by RBI and Securities and Exchange Board of India (Sebi) all along. Electronic platforms for issuance, trading, settlement and reporting were first recommended by the R.H. Patil committee in 2005. Sebi mandated the listing of bond private placements in 2008, so there are no new unlisted bonds to allow foreign investment into. The securitization market is languishing due to regulatory and taxation challenges and just permitting foreign investment will not help revive it.

How RBI will “encourage” bond financing by large borrowers will be interesting to see. Large companies are already heavily leveraged. Loans to them form a large part of banks’ stressed advances. If such companies seek additional financing, it will not be through bonds. Traded bonds reflect the credit quality of the borrower. Both companies and banks may not want this to become transparent. Also, domestic capital available for this market is limited. The Life Insurance Corp. of India is being called into action to support everything from disinvestment to railways’ capital expenditure. Pension fund investment mandates are biased towards government bonds. Banks can invest, but would prefer to hold these bonds to maturity to avoid the mark to market costs. This reduces secondary trading, investor participation and, in turn, new issuance.

The development of this market requires fundamental reforms in financial markets, public finance and regulatory governance, something not easy to achieve.

First, the basic market infrastructure needs to be put in place. Until now, lack of regulatory action and inter-regulator coordination has hampered this. For example, a platform for corporate bond repo, on the lines of collateralized borrowing and lending obligation, has been proposed by Sebi, but not approved by RBI.

Second, the government uses financial institutions as a captive investor pool for government bonds to finance its deficit. This combined with the governance problems of public sector banks and financial institutions constrains domestic financial development and crowds out private sector financing needs.

Third, foreign investment in local currency bonds is still considered the “original sin” by regulators and policymakers. Capital controls, such as the $50 billion investment limit, and participation frictions, such as the ban on investment in less than three-year residual maturity instruments, are part of this mindset.

Fourth, the thinking on integrated financial markets is still at a nascent stage in India. Various elements of what would form the “bond-currency-derivatives” nexus are either missing or are underdeveloped. There is no reliable and accurate benchmark yield curve, which makes pricing of corporate debt securities difficult. The repo market which enables secondary liquidity and the credit default swaps market which allows credit risk to be traded do not exist, despite regulatory guidelines for them being in place. The interest rate derivatives market is in its early stages and the currency derivatives market is fraught with frictions in the form of documentation requirements.

Finally, creditor rights and insolvency law are big missing pieces. Contract enforcement and judicial efficiency are areas that need significant improvement. The bill related to insolvency and bankruptcy is in Parliament, but when it will be passed and implemented remains to be seen.

All these are structural reforms which require a long-term commitment, not easy to achieve from a political economy perspective. Even as work on the Indian Financial Code, proposed by the Financial Sector Legislative Reforms Commission, and the Insolvency and Bankruptcy Code is underway, many more reforms such as dismantling capital controls and comprehensive thinking on financial market architecture needs to be undertaken.

Only then will the aspiration of developing the corporate bond market become a reality.

Anjali Sharma is a research consultant at Indira Gandhi Institute of Development Research.

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