Corporate bond creases need to be ironed out

Recommendations of the Sebi panel can improve the trading system, but they cannot revitalise the market.

The Securities and Exchange Board of India (Sebi) has recently come out with a set of recommendations made by an internal committee for development of the corporate bond market in India.

The recommendations include a) developing a repo market for corporate bonds, b) gaining tax exemptions for debt funds, c) setting up a unified exchange traded corporate bond market under the Bombay Stock Exchange, d) reduction of minimum size of corporate debt paper, e) activating the interest rate derivative market, f) trading corporate bonds in an order matching system and g) developing professional trustee companies for ratings.

If implemented, these recommendations will definitely improve the system for trading in corporate bonds. However, if the intention is to revitalise the corporate bond market, it will turn out to be a complete failure. This is because the corporate bond market in India is highly complex and the only way the market can improve is by smoothening out the complexities.

The complexities:
The corporate bond market plays second fiddle to the government bond market, since the Government of India is the largest issuer of debt in the country. Bond market players tend to shun corporate bonds, terming them illiquid, and preferring to trade in the much more liquid government bond market.

Typically, corporate bonds factor in two kinds of risks — credit and liquidity. Credit risk is usually measured by the ratings assigned to the credit by the rating agencies, while liquidity risk is measured by the acceptability of a credit in the market.

In India, trading is concentrated in AAA-rated bonds, as they carry the highest safety and are the most liquid. Among AAA bonds, bonds of public sector units are much more liquid than private sector bonds. This is because a large part of the market, including insurance companies, provident funds and banks, has restrictions on private sector paper. This really means that trading activity in Indian debt market is concentrated in government debt, directly in government securities and indirectly through bonds of government-owned entities.

The lack of market for private sector companies has resulted in absolutely no price discovery for issuers of debt, especially for issuers rated below AAA. This has resulted in private sector issuers going for bank loans or accessing the foreign currency bond or loan market. The lack of issuers across the rating scale has led to a non-existent credit spread curve in the corporate bond market.

Banks in India have a peculiar problem. The Reserve Bank of India has instructed them to mark corporate bonds taken in their trading books as credit exposures to the underlying credit.

This has resulted in many of the banks being unable to trade certain credits as they have hit the exposure limit in their loan books. This has also restricted the freedom of a corporate bond trader in a bank, as he has to take credit clearance from the credit risk officer belonging to the corporate bank. This, in effect, violates the principle of the Chinese Wall between the trader and the corporate bank (who has confidential information of the issuer).

The fixed income markets in India cannot trade credit spreads and interest rates separately. By de-linking credit spreads from interest rates, the market can trade only the underlying credit of the issuer and does not take on interest rate risk. Pure credit spread trading also enables holders of credit spreads to lower their credit risk by selling the spread. This creates a vibrant credit spread market where traders take positions on the perception of credit rather than interest rates. Trading pure credit spreads also enables lower rated issuers to issue bonds locally at market determined rates.

A large part of the market does not mark-to-market the corporate bond portfolio. Insurance companies and provident funds, the largest buyers of corporate bonds in India, do not mark-to-market their portfolios. As a result, once any bond goes into their books, it does not come out. This takes away liquidity from the market.

The settlement of corporate bonds carries counterparty risk. The settlement takes place between counterparties as there is no centralised clearing system as existing in government securities market. This makes many counterparties not 'dealable' with each other, due to lack of counterparty risk limits.

What needs to be done:
The committee for reviving the corporate bond market in India should focus on the following:
Remove limit restrictions on private sector issuers for insurance companies, provident funds and banks
Separate corporate bond trading and loan books for earmarking credit exposures
Allow corporate bond traders to short interest rates and take on the risk of the underlying credit
Increase depth in the market by allowing FII's to trade in the corporate bond market
Make it compulsory for insurance companies and provident funds mark to market a part of their corporate bond portfolios
Introduce centralised settlement system for corporate bonds
Allow repos in corporate bonds
Encourage lower rated issuers to access domestic bond markets
Ensure all issuers stick to standard issue norms akin to government securities
A unified exchange trading system and reporting platform is good for the market, but BSE is the wrong exchange to pick. The exchange has been a miserable failure in new products and corporate bonds whose complexities are way beyond its scope. NSE has a standardised reporting platform and it can adapt to the corporate bond market easily
Introduce credit derivative market, as characterised by credit default swaps, for trading pure credit risk.