CORPORATE BOND MARKET
For too long, most of the corporate entities have been depending on loans from banks and institutions and they have not shown any interest to raise at least a small of the required resources from the market through bonds or commercial paper. The cash credit system also made them complacent about cost effective fund management through treasury operations.
Under their age-old cash credit system, banks grant credit/borrowing limits to the corporates. They can use bank funds within the granted credit limits at their convenience and return the same back to the banks as they receive from their customers. Since the interest is charged by banks only on the average outstanding drawals, the cash management responsibility of the corporates got transferred from the borrowers to the banks.
Corporates have been raising funds from the retail markets by way of term deposits just as the banks do. This is an age-old system quite popular with several corporates. The company statute permits corporate entities to raise public deposits within certain limits. Currently the amount of deposits that a corporate can raise is equal to 50% of its capital and free reserves.
Surprisingly even the corporate units which raise funds through public deposits have also not shown interest in issuing bonds although they could raise more money this way than through public deposits. Corporates can raise bond funds so long as their term debt does not exceed twice the amount of paid up capital plus free reserves.
Several good credit-rated corporates have been showing interest in raising funds by way of private placement from big lenders/investors but they do not like to tap the public issue market. One of the reasons why they do not like to make public issue of debt is that the regulatory requirements including quality and the type of disclosures are more rigorous or onerous in the case of public issues. Although the interest rates they pay on such placements would be equally attractive to retail investors, corporates have not shown much interest in the retail investors.
Recently through an amendment to Companies Act government has tried to plug possible misuse of the system by stipulating that the privately placed debt cannot be distributed to more than 50 investors. Market feed back suggests that the corporates are not happy with this amendment and a number of them are trying to find ways for bypassing the legal requirement of distributing debt among not more than 50 investors.
One of the possible that is being discussed is to issue the privately place to less than 50 investors in the initial stage and these investors to sell it to much larger number of investors at the second stage as if it is a secondary market operation.
The US experience clearly bears out that the Indian private corporate sector is adopting a myopic approach by overlooking the advantages of financial disintermediation. Sooner it gets out of the habit of depend ing excessively on the banks, institutions, and the privateplacement market, the better it would be for it from a long-term point of view.
The problem of asset-liability mismatches is going to catch up with the banks sooner than later and their appetite for term debt will decline. In so far as the DFIs are concerned they are already in a transition phase toying with the idea of commercial/universal banking.
Since their access to long-term funds has dwindled they will not be in a position to meet demand for term funds of industry and infrastructure sectors when investment activity picks up from the present low levels. Continued excessive dependence on banks and DFIs is not in the interest good credit-worthy borrowers, as they would end up paying up more than what they would have to pay if they decide to raise funds from the market directly.
Initially, before an extensive good retail distribution network is built up, the borrowing costs of good-credit rated borrowers from the primary savers including the hous eholds may turn out to be slightly higher than those charged to them by banks and institutions. There are also those hassles of servicing large number of investors, which the corporates have been avoiding all these years by either taking loans or tapping the private placement market.
A number of significant reforms have taken place in the Indian financial and capital market areas, which make it possible to tap the retail bond market with minimum hassles.
During the last five years movement to depository form for ownership and secondary market transactions has made tremendous progress. Currently, 99.7% of the secondary market transactions in equities are settled through book entry transfers in the depository.
The National Securities Depository Ltd (NSDL) promoted by the National Stock Exchange (NSE) along with IDBI and UTI has helped in almost getting rid of paperbased settlements in equities. About a year ago through suitable legislative changes the debt instruments have been brought under the ambit of depository. As a result all ownership transfers through the depository have been completely exempted from the payment of stamp duty, which is quite prohibitively costly.
NSE now provides direct online connectivity to 430 cities and towns across the whole country through a satellite communication link-up for secondary market trades. The response time for trades from any part of the country is less than 1.5 seconds.
NSE has extended its secondary market infrastructure for making primary issues of debt and equity through either direct fixed price mechanism or through the book-building route. The costs of primary issues as also of secondary market trades of debt and equity can be kept at very modest levels by relying on the infrastructure of NSE and NSDL.
With the disappearance of paper securities and abolition of stamp duty in depository mode transfers, the costs of secondary market transactions as also the costs and hassles of servicing of large number of investors can be significantly minimised. Banks and the DFIs can earn good returns if they undertake market making in bonds of their choice. Market making will provide liquidity to the bonds and help in popularising them among millions of investors who have natural preference for fixed income securities.
Banks can perform this role with minimum level of risk if they hold investors’ security accounts as depository participants besides holding their cash accounts.
Like in most of the well-developed markets all over the world the Indian stock exchanges had also adopted trading systems that relied overwhelmingly on the jobbing or market making mechanism.
The Bombay Stock Exchange (BSE), which until November 1994 used to account for about 70% of the trading turnover of all the stock exchanges in India, had adopted jobbing or market makers system of trade. It was in November 1994 that NSE introduced fully screen-based order driven trading system in India.
Many market observers had opined that NSE, as an Exchange would not take off since it did not adopt the time-tested market making trading system. For about a year since November 1994 there was a fierce competition between the order driven system adopted by a totally new exchange like NSE and the market making system of a well-entrenched stock exchange like the BSE. Interestingly the market preferred the order driven system as could be noted from the fact that after about a year’s time, that is by November 1995,
NSE emerged as the largest stock exchange of the country in terms of daily trading turnover. Since the Indian equity market has a history of more than a 120 years investors could quickly discover that the advantages of the order driven trading system in terms of much lower transaction costs and freedom from the stranglehold of the market makers.
However, Indian investor is still new to the debt market. As of now, most of the investors in favour of fixed income assets prefer bank deposits, postal savings schemes, etc. To entice these investors to the debt market they will have to be assured of adequate liquidity in the secondary market for debt instruments.
In the case of the fixed income assets such as bank deposits or postal savings schemes the investors are protected in regard to both the principle value of investment and the rate of return. However, principal value of the debt instruments traded in the secondary market may not always be equal to their original investment value.
Most of the investors are aware that the market value of the bond is likely to fluctuate in response to movements in interest rates.
For instance, the market value of the bond may be below its issued price in response to upward movement in interest rates. The opposite would happen if interest rates decline. Most of the investors would be prepared to absorb this price risk. But what they may not be willing to live with is the decline in the bond value merely because there is hardly any liquidity in the secondary market.
Until the market provides a mechanism for pricing bonds based on their intrinsic worth and that bonds do not get quoted at a discount merely because there is no liquidity investors may be unwilling to go in for traded debt instruments.
Conscious efforts therefore need to be made to create liquidity in the debt instruments by encouraging market makers to give two-way bid and offer quotes with reasonably narrow spreads. Once the investors are convinced that they are assured of liquidity in the market their willingness to shift from the currently popular fixed income assets like bank deposits to tradable debt instruments like corporate debentures would be greater.
As of now the average investors are not yet aware of the advantages of investing in debt instruments that are traded in the market. Tradable debt instruments are yet to catch fancy of most of the average investors although they prefer to invest major part of their savings in the fixed income securities.
Therefore, it is more a matter of developing investors’ tastes for such instruments before the fixed income oriented investors naturally start investing in them. In the early stages of development of the debt market it would be both desirable and necessary to introduce active market making so that investors are assured of liquidity for the debt instruments.
The banks and DFIs are best suited to take upon themselves the role of market makers for their clients who enjoy good credit rating.
The existence of information asymmetry is actually in favour of the banks and DFIs. They have good access to far more dependable information about their corporate clients than average investors do. Since they can assess credit risk of the debentures of their clients they are in a better position to make bid and offer quotes for such debentures. Instead of extending loans/credits to their corporate clients, banks and institutions should persuade some of their clients to tap the debt market for long-term bonds or commercial paper.
The attractions of such instruments to the investors would be considerable if the banks actively make market in these instruments by making two-way quotes.
Banks can offer r both cash account and depository account facilities to investors at most of their branches. They are, therefore, in a better position to tempt their depositors to invest in the bonds floated by their good clients. Investors would be better inclined to invest in a debt instrument if they know that their bank would be willing to buy/sell the instrument from them at a pre-announced price.
This being a fee-based income activity banks will be passing on the credit risk directly to the investors. Banks do not have to raise additional capital to meet the stringent capital adequacy norms if they choose to play the intermediary role in the sale of debenture rather accept deposits to extend credit to their corporate clients.
For too long, most of the corporate entities have been depending on loans from banks and institutions and they have not shown any interest to raise at least a small of the required resources from the market through bonds or commercial paper. The cash credit system also made them complacent about cost effective fund management through treasury operations.
Under their age-old cash credit system, banks grant credit/borrowing limits to the corporates. They can use bank funds within the granted credit limits at their convenience and return the same back to the banks as they receive from their customers. Since the interest is charged by banks only on the average outstanding drawals, the cash management responsibility of the corporates got transferred from the borrowers to the banks.
Corporates have been raising funds from the retail markets by way of term deposits just as the banks do. This is an age-old system quite popular with several corporates. The company statute permits corporate entities to raise public deposits within certain limits. Currently the amount of deposits that a corporate can raise is equal to 50% of its capital and free reserves.
Surprisingly even the corporate units which raise funds through public deposits have also not shown interest in issuing bonds although they could raise more money this way than through public deposits. Corporates can raise bond funds so long as their term debt does not exceed twice the amount of paid up capital plus free reserves.
Several good credit-rated corporates have been showing interest in raising funds by way of private placement from big lenders/investors but they do not like to tap the public issue market. One of the reasons why they do not like to make public issue of debt is that the regulatory requirements including quality and the type of disclosures are more rigorous or onerous in the case of public issues. Although the interest rates they pay on such placements would be equally attractive to retail investors, corporates have not shown much interest in the retail investors.
Recently through an amendment to Companies Act government has tried to plug possible misuse of the system by stipulating that the privately placed debt cannot be distributed to more than 50 investors. Market feed back suggests that the corporates are not happy with this amendment and a number of them are trying to find ways for bypassing the legal requirement of distributing debt among not more than 50 investors.
One of the possible that is being discussed is to issue the privately place to less than 50 investors in the initial stage and these investors to sell it to much larger number of investors at the second stage as if it is a secondary market operation.
The US experience clearly bears out that the Indian private corporate sector is adopting a myopic approach by overlooking the advantages of financial disintermediation. Sooner it gets out of the habit of depend ing excessively on the banks, institutions, and the privateplacement market, the better it would be for it from a long-term point of view.
The problem of asset-liability mismatches is going to catch up with the banks sooner than later and their appetite for term debt will decline. In so far as the DFIs are concerned they are already in a transition phase toying with the idea of commercial/universal banking.
Since their access to long-term funds has dwindled they will not be in a position to meet demand for term funds of industry and infrastructure sectors when investment activity picks up from the present low levels. Continued excessive dependence on banks and DFIs is not in the interest good credit-worthy borrowers, as they would end up paying up more than what they would have to pay if they decide to raise funds from the market directly.
Initially, before an extensive good retail distribution network is built up, the borrowing costs of good-credit rated borrowers from the primary savers including the hous eholds may turn out to be slightly higher than those charged to them by banks and institutions. There are also those hassles of servicing large number of investors, which the corporates have been avoiding all these years by either taking loans or tapping the private placement market.
A number of significant reforms have taken place in the Indian financial and capital market areas, which make it possible to tap the retail bond market with minimum hassles.
During the last five years movement to depository form for ownership and secondary market transactions has made tremendous progress. Currently, 99.7% of the secondary market transactions in equities are settled through book entry transfers in the depository.
The National Securities Depository Ltd (NSDL) promoted by the National Stock Exchange (NSE) along with IDBI and UTI has helped in almost getting rid of paperbased settlements in equities. About a year ago through suitable legislative changes the debt instruments have been brought under the ambit of depository. As a result all ownership transfers through the depository have been completely exempted from the payment of stamp duty, which is quite prohibitively costly.
NSE now provides direct online connectivity to 430 cities and towns across the whole country through a satellite communication link-up for secondary market trades. The response time for trades from any part of the country is less than 1.5 seconds.
NSE has extended its secondary market infrastructure for making primary issues of debt and equity through either direct fixed price mechanism or through the book-building route. The costs of primary issues as also of secondary market trades of debt and equity can be kept at very modest levels by relying on the infrastructure of NSE and NSDL.
With the disappearance of paper securities and abolition of stamp duty in depository mode transfers, the costs of secondary market transactions as also the costs and hassles of servicing of large number of investors can be significantly minimised. Banks and the DFIs can earn good returns if they undertake market making in bonds of their choice. Market making will provide liquidity to the bonds and help in popularising them among millions of investors who have natural preference for fixed income securities.
Banks can perform this role with minimum level of risk if they hold investors’ security accounts as depository participants besides holding their cash accounts.
Like in most of the well-developed markets all over the world the Indian stock exchanges had also adopted trading systems that relied overwhelmingly on the jobbing or market making mechanism.
The Bombay Stock Exchange (BSE), which until November 1994 used to account for about 70% of the trading turnover of all the stock exchanges in India, had adopted jobbing or market makers system of trade. It was in November 1994 that NSE introduced fully screen-based order driven trading system in India.
Many market observers had opined that NSE, as an Exchange would not take off since it did not adopt the time-tested market making trading system. For about a year since November 1994 there was a fierce competition between the order driven system adopted by a totally new exchange like NSE and the market making system of a well-entrenched stock exchange like the BSE. Interestingly the market preferred the order driven system as could be noted from the fact that after about a year’s time, that is by November 1995,
NSE emerged as the largest stock exchange of the country in terms of daily trading turnover. Since the Indian equity market has a history of more than a 120 years investors could quickly discover that the advantages of the order driven trading system in terms of much lower transaction costs and freedom from the stranglehold of the market makers.
However, Indian investor is still new to the debt market. As of now, most of the investors in favour of fixed income assets prefer bank deposits, postal savings schemes, etc. To entice these investors to the debt market they will have to be assured of adequate liquidity in the secondary market for debt instruments.
In the case of the fixed income assets such as bank deposits or postal savings schemes the investors are protected in regard to both the principle value of investment and the rate of return. However, principal value of the debt instruments traded in the secondary market may not always be equal to their original investment value.
Most of the investors are aware that the market value of the bond is likely to fluctuate in response to movements in interest rates.
For instance, the market value of the bond may be below its issued price in response to upward movement in interest rates. The opposite would happen if interest rates decline. Most of the investors would be prepared to absorb this price risk. But what they may not be willing to live with is the decline in the bond value merely because there is hardly any liquidity in the secondary market.
Until the market provides a mechanism for pricing bonds based on their intrinsic worth and that bonds do not get quoted at a discount merely because there is no liquidity investors may be unwilling to go in for traded debt instruments.
Conscious efforts therefore need to be made to create liquidity in the debt instruments by encouraging market makers to give two-way bid and offer quotes with reasonably narrow spreads. Once the investors are convinced that they are assured of liquidity in the market their willingness to shift from the currently popular fixed income assets like bank deposits to tradable debt instruments like corporate debentures would be greater.
As of now the average investors are not yet aware of the advantages of investing in debt instruments that are traded in the market. Tradable debt instruments are yet to catch fancy of most of the average investors although they prefer to invest major part of their savings in the fixed income securities.
Therefore, it is more a matter of developing investors’ tastes for such instruments before the fixed income oriented investors naturally start investing in them. In the early stages of development of the debt market it would be both desirable and necessary to introduce active market making so that investors are assured of liquidity for the debt instruments.
The banks and DFIs are best suited to take upon themselves the role of market makers for their clients who enjoy good credit rating.
The existence of information asymmetry is actually in favour of the banks and DFIs. They have good access to far more dependable information about their corporate clients than average investors do. Since they can assess credit risk of the debentures of their clients they are in a better position to make bid and offer quotes for such debentures. Instead of extending loans/credits to their corporate clients, banks and institutions should persuade some of their clients to tap the debt market for long-term bonds or commercial paper.
The attractions of such instruments to the investors would be considerable if the banks actively make market in these instruments by making two-way quotes.
Banks can offer r both cash account and depository account facilities to investors at most of their branches. They are, therefore, in a better position to tempt their depositors to invest in the bonds floated by their good clients. Investors would be better inclined to invest in a debt instrument if they know that their bank would be willing to buy/sell the instrument from them at a pre-announced price.
This being a fee-based income activity banks will be passing on the credit risk directly to the investors. Banks do not have to raise additional capital to meet the stringent capital adequacy norms if they choose to play the intermediary role in the sale of debenture rather accept deposits to extend credit to their corporate clients.