Corporate Debt Market

Corporate Debt Market

September 2010

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Corporate Debt Market

Contents
1. Introduction.................................................................................................................................3
1.1 Significance of a well developed corporate debt market ...............................................................4
1.2 Prerequisites of a well developed corporate debt market ...............................................................5
1.3 Reasons for slow development of Indian corporate debt market ................................................5
2. Development of corporate debt markets in other countries and its implications .....................8
2.1 United States .................................................................................................................................8
2.1.1 Structure .................................................................................................................................8
2.1.2 Learning ..................................................................................................................................8
2.2 China .............................................................................................................................................. 8
2.2.1 Structure .................................................................................................................................8
2.2.2 Instruments in China’s Bond Market ..........................................................................................9
2.2.3 Learning ....................................................................................................................................12
2.3 Lessons from Other Asian Bond Markets ....................................................................................12
2.3.1 Features ....................................................................................................................................12
2.3.2 Steps taken to develop the bond markets ................................................................................12
2.4 Singapore.....................................................................................................................................13
2.5 Malaysia.......................................................................................................................................13
2.6 Korea ...........................................................................................................................................13
3. Indian Scenario ..............................................................................................................................14
3.1 Demand Scenario ........................................................................................................................14
3.2 Supply Scenario ...........................................................................................................................15
3.3 Tata Capital Bond Issue ...............................................................................................................15
3.4 Recommendations ......................................................................................................................16
References: ........................................................................................................................................17

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Executive Summary

The growth of any economy is dependent, among other factors, on the development of its
financial markets and institutions. A well developed corporate debt market can play crucial
role in supporting economic development in of a country.

This research seeks to study the following:

• To understand the significance of a well developed corporate debt market

• To identify the pre-requisites for its proper development
• To understand the reasons underlying the under development of the corporate debt
market in India
• To study the growth of corporate debt markets in other economies
• To suggest how India could provide a conducive environment for the development of
its corporate debt market

The study shows that India satisfies most of the pre-requisite conditions needed for the
growth of a corporate debt market. However, the high dependence of the private corporate
sector on bank finance acts as a disincentive for any player opting for debt financing.

The paper explains the regulatory hurdles India faces in this sector. Also, there is a dearth of
an informed and diversified investor base. Till now, the Indian private sector has mainly
focussed on private placement rather than public issues.

The paper further provides recommendations to will help stimulating growth in this dormant
market. India has a tremendous opportunity to leverage on its vibrant government securities
bond market. Reducing the time and cost of public issuances, introduction of repos in the
corporate debt market, encouragement of innovation in securitized instruments among the
other initiatives will provide a more conducive environment to the development of the
corporate debt market in India.

1. Introduction

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Corporate Debt Market

The Planning era began since 1951 and DFIs were increasingly encouraged to finance the
project funding needs of the Indian corporate sector. The Government of India and RBI
facilitated the concessional rates for corporate sector by giving the following to the DFIs:
- Access to low cost funds
- Permission to issue bonds with government guarantee
- Allocations from budget

With the onset of economic reforms, the budgetary support and government guarantee to
DFIs was withdrawn. The DFIs converted themselves into commercial banks to have access
to the public deposit mechanism and served as source of long term finance to the Indian
corporate sector.

Primary issuance market, in the corporate debt market, is dominated by non-banking finance
companies and relatively small amount of funds are raised through issuance of debt papers by
manufacturing and other service industries.

The following are some of the different types of corporate debt securities issued:

• Non-Convertible Debentures
• Partly-Convertible Debentures/Fully-Convertible Debentures (convertible in to Equity
Shares)
• Secured Premium Notes
• Debentures with Warrants
• Deep Discount Bonds
• PSU Bonds/Tax-Free Bonds

The sections herein explain the following:

• Significance of a vibrant corporate bond market
• Prerequisites for the development of corporate debt market
• Reasons for under-development of the corporate bond market in India

1.1 Significance of a well developed corporate debt market

1. Reduced dependence on banks for long term finance
Due to regulatory constraints and lack of sufficient incentives to opt for corporate
debt, the corporate sector in India prefers the banks as a source of long term finance.
The East Asian crisis showed the pitfall of excessive reliance on bank financing.

2. Creation of a source of long term finance

Developing countries like India will have opportunities for long term investments,
especially in infrastructure projects. Banks, having short term liabilities, may not be
able to continue and meet the growing needs of a developing country with long term
financing requirements. A vibrant bond market gives access to such long term debt.
The ability of raise funds has a long lasting effect of the growth of the economy of a
country. Hence creating a more stable source of long term finance is crucial.

3. Creation of a cheaper avenue for fund generation

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Corporates with good credit rating lose out on the opportunity to raise funds directly
from the market. As the corporate debt market develops and becomes liquid, the cost
of raising funds will also reduce and also bring stability.

1.2 Prerequisites of a well developed corporate debt market

1. Simplified regulatory framework for public issues

The main deterrence to corporate in issuing debt securities to the public is the lengthy
and rigorous procedure that entails it. Thus the regulatory framework needs to be
simplified and made more conducive and issuer friendly to good credit rated
companies.

2. Reduced time and cost of issuances

The time required and the costs incurred in making public issues must be reduced to
incentivise the corporate sector.

3. Reduced dependence of corporate sector on banks

The mindset of the Indian Corporate sector to depend on banks to finance their long
term investment needs must change.

4. Presence of a robust legal structure

There must a robust legal structure in place to encourage innovative financial products
that would cater to various risk-return appetite of a diverse set of investors.

5. Presence of rating agencies

Credible rating agencies must be present in the market to give information about the
credit worthiness of the issuer and the debt securities

6. Conducive market infrastructure

The market must be made more conducive to the trading, reporting and settlement of
trades in the corporate bond market. Transparency must brought in through efficient
price discovery process.

7. Developed Government securities market

The G-Sec market needs to be well-developed as the price and yield of corporate
bonds are marked on the basis of the benchmark G-Sec prices and yields.

1.3 Reasons for slow development of Indian corporate debt

market

1. Lengthy regulatory requirements and disclosures

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The regulatory requirements for public issues were rigorous in terms of quality and
type of disclosures

• Utilization of funds
The utilization of funds raised through public debt securities was required
approval and was mandatorily needed to be disclosed to the retail investors.
• Minimum Investment Grade
Bonds had to have a certain minimum investment grade for it to be issued in
the primary market. Those below this minimum investment grade were not
allowed to be issued to the public. This clause was removed as per circular to
amend the DIP (Disclosure and Investor Protection) Guidelines, 2000.
• Risks Involved
The offer document must contain the issuer’s perception of risk on matters
such as assets and debtors, dilution risk (changes in credit quality of pool of
assets), currency, interest and other risks.
• Disclosures
Disclosures regarding the public offer, the debt instruments, the issuer, the
originator, the servicer, the Trustees, the transaction structure and cash flows.

The rigorous norms that have to be followed for issuing bonds make this process
lengthy and burdensome process as compared to raising funds from the banks or other
institutions or through private placement option

2. Listing of debt securities

• Filing on stock exchanges:

The firm needs to make an application to one or more recognized stock
exchanges for listing of their debt securities.

• Draft offer documents:

The firm needs to file draft offer documents with the designated stock
exchange and have it posted on the websites (if any) of the company, lead
merchant banker and the designated stock exchanges.

3. Excessive dependence on bank loans and private placement

The Corporate prefers bank loans to finance its long term investment needs to issuing
debt securities in the primary market. Also, they can raise funds in the primary market
through public issue of bonds or through the private placement route. The Indian
corporate sector still prefers private placement as the firms find issuance of public
debt securities is a lengthy and rigorous task. Also, the cost of issuance exceeds the
cost of private placement. Another factor is that more funds can be raised through the
private placement route.

4. Non-transparency

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Corporate Debt Market

The corporate bond market was non-transparent as there was no system to enable
efficient price discovery and allow comparison of prices quoted by seller and strike
the best deals.

5. Non-availability of information
Till 2007, there was no information available on the trading activities in the corporate
debt market. To improve this, SEBI, in 2007, permitted BSE and NSE to set up
reporting as well as trading platforms to get real time information of trade volume,
trading prices and other trading activity related data. Trading on OTC market could be
reported through the reporting tool of NSE or BSE.

6. Issuance costs

• Advertisements
The public issue needs to be accompanied by advertisements in a national
daily with wide circulation informing the public about the issue and giving
truthful information.
• Credit Rating
Earlier, bond issuers had to obtain rating from two separate credit rating
agencies increasing the cost of issuances. This clause has been amended since
2007 to obtain rating from just one rating agency.
• Minimum Subscription
The issuer may decide on a minimum amount of debt it seeks to raise from the
public and it must be mentioned in the offer document. In the event of non-
receipt of the minimum subscription, the money needs to be refunded to the
applicants. Thus all costs involved for issuance like merchant banker charges,
advertisement costs will have to be incurred with no result.
• Dematerialization of instruments
Also, the issuer has to enter into an arrangement with a registered depository
for dematerialization of the securitized debt instruments that are proposed to
be issued to the public.
• Auditing expenses
An auditor and a valuer may be appointed to look into the books of accounts
of the entity and for proper valuation of asset pools. The expenses of such an
audit may be borne by the originator.
• Fees
Application fees, registration fees, annual fees, filing fees for offer documents.

7. Settlement and Clearing System

There was no settlement and clearing system in place for the corporate bonds. The
settlement on BSE is done on a rolling basis using BOLT (BSE Online Trading)
whereas NSE uses its NSCCL (National Securities Clearing Corp. Ltd) platform to
settle corporate bonds trades. However, majority of the transaction is in the OTC
market with bilateral settlement.

8. Investor diversity
Most of the investors do not have a long term view in mind. The household which
could form a major part of the investor base is practically absent in the corporate debt
market in India.

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2. Development of corporate debt markets in other

countries and its implications

This section tries to present the development of corporate debt market across the world and
the implications of various policies and regulations

2.1 United States

2.1.1 Structure

• The corporate debt market in Unites States is mainly over-the-counter (OTC)

• It does not have a centralised inter-dealer quotation system, and, therefore, cannot be
described as either a quote-driven dealer market or an order-driven auction market
• Now, both segments have moved to electronic negotiation and execution.
• Prior to 1940’s bonds were mostly traded on the New York Stock Exchange (NYSE)
but later migrated to the OTC market not due to regulatory changes but due to growth
of institutional trading
• The dealer structure competed mostly on dealer relationships. So to regulatory
intervention was required to bring in transparency
• In July 2002, Trade Reporting and Compliance Engine (TRACE) became operational
to report OTC trades and bring in more transparency

2.1.2 Learning

• No structural change due to transparency: Theoretically, expectations would be

that having quicker and wider access to information would increase competition,
change the existing market structure and improve market efficiency. However, it was
observed that introduction of TRACE did not bring about any fundamental change in
the market structure.
• No increase in aggregate profits: Also, the introduction of transparency in the
corporate bond market would be believed to increase trade volumes and hence higher
aggregate profits. However, this was there was another contradiction as traders
reported a drop in profit levels after TRACE became operational. Hence the
incentives to trades to trade more became lesser.

2.2 China
2.2.1 Structure

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Corporate Debt Market

China’s bond market is segmented into three markets:

• Interbank Market
• Exchange Market
• Bank Counters

But it is mainly an interbank bond market.

Table 1: Trading Activities in Chinese Bond Market (billion RMB)

Source: National Association of Financial Market Institutional Investors (NAFMII)

Interbank bond market

This market was formed in 1997 after the passing of a notice ‘The Notice on Cessation of
Repo and Bond Trading by Commercial Banks in the Stock Exchanges’ by the State Council
mandating all commercial banks to move their repo and bond trading operations out of
Shenzhen and Shanghai Stock Exchanges to form the inter-bank bond market

This market is mainly quote driven OTC market whereby deals are struck based on bid and
ask prices negotiated between two trading counterparties. Institutional investors like
commercial banks are the main players in this market. The inter-bank bond market accounts
for more than 95% of the trading volume in China’s bond market.

Exchange bond market

After inter-bank bond market, the exchange market where most of the trading occurs. This
segments accounts for a little over 4% of the trading activities in the bond market.

This is an order-driven market.

Bank Counters

This segment accounts for a mere 0.003% of the trading activities in the bond market. This is
an OTC market.

2.2.2 Instruments in China’s Bond Market

China’s bond investors enjoy a broad array of fixed income securities with different risk and
return profiles. Quite different from the situations in overseas countries, China’s corporate
bond market includes not only the enterprise bonds or listed company bonds but also
nonfinancial corporate debt financing instruments.

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These comprise of six types of nonfinancial corporation bonds. The interbank corporate bond
market has four instruments: CPs, MTNs, enterprise bonds and SME collective notes as given
in the table below

Table 2: Instruments in Chinese Bond Market

Source: NAFMII

There has been a remarkable expansion in the amount of corporate bonds outstanding. It has
in the past 2 years, up from 937 billion RMB in first quarter of 2008 to 2916 billion RMB in
first quarter of 2010 as shown in the graph below. Corporate bonds’ percentage of quarterly
trading volume has increased from less than 10 percent in first quarter of 2008 to nearly 35
percent in first quarter of 2010.

Fig. 1: Amount of corporate bonds outstanding (billion RMB)

Source: NAFMII
The dramatic growth in China’s corporate bond market is attributed to the following three
aspects: issuance, supply and demand.

From the perspective of issuance, it is seen that product innovation (that is introduction of
MTNs) led to more corporate bond issuance. In 2009, almost 40% of the total volume of
corporate bond was due to MTNs.

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Fig. 2: Corporate Bond Issuance Volume (billion RMB)

Source: www.chinabond.com.cn

The attractiveness of MTNs was mainly due to the following factors:

• Lesser regulatory requirements: Less rigid issuance requirements than enterprise

bonds with more flexibility in bond issuance. After completion of the registration, the
enterprises may issue MTNs in small amounts, consecutive or cyclical mode and have
great flexibilities in offering amount, maturity and issuance time.

• No bank guarantees: No bank guarantee was required for the issuance of MTNs.

• Banks as rating agencies: As China’s credit rating agencies are not mature,
commercial banks are the ones with the best knowledge of the corporations. Thus,
commercial banks’ act as underwriters, buy the MTNs and thus negate problem of
underdeveloped credit rating system.

• Reduced interest rates: Interest rates were reduced in view of sub-prime crisis, thus
increasing the holding and trading of MTNs by commercial banks which increased
liquidity in the inter-bank corporate bond market

• Restriction of investment portfolio to:

o Fixed income instruments Unlike insurance companies and mutual funds
which can invest both bonds and stocks, Chinese commercial banks’
investment portfolio are restricted to fixed income instruments only, including
government bonds, policy bank bonds, high grade enterprise bonds,
commercial bank subordinate bonds, CPs and MTNs.
o High grade corporate bonds: Restrictions are imposed on the investment of
low grade corporate bonds and other credit products. Thus the credit spread
and good credit rating attract commercial banks to hold and trade MTN
actively.

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2.2.3 Learning

Product innovation (MTNs) along with other supporting factors led to a dramatic increase in
issuance of MTNs. Simplification of regulatory procedures like removal of the bank
guarantee for bonds also helped in increased issuance and trading of bonds
However, the bond market is dominated by the banking sector with very little issuances from
the non-financial corporate sector.

2.3 Lessons from Other Asian Bond Markets

2.3.1 Features

• Small bond markets

• Heavily depended on bank finance
• Post the East-Asian crisis in 1997, the main aim has been to develop a deep and liquid
bond market

2.3.2 Steps taken to develop the bond markets

• Government Issuances: Government issuances were scheduled to help achieve a

liquid benchmark yield curve to price other bonds
• Domestic participants: Participation was encouraged from private pension funds,
insurance companies, investment trusts by lower regulatory hurdles with registration
and participation.
• Foreign participants: Domestic financial markets have been liberalized allowing
foreigners to invest and also issue bonds.
• Infrastructure: Improvement in infrastructure by improving the settlement process to
enhance the immediacy and transparency of the trading process. Reduction in
information asymmetry in the market by engagement between international and local
rating agencies

Previously, the main institutional investors had been local banks and government pension
funds, which were buy-to-hold investors that did not enhance turnover in these markets. The
lack of diversity among these investors tended to mean markets were dominated by
participants on one side of the market i.e. buyers or sellers.

The move to paperless trading in Korea, Malaysia, Singapore, Philippines and Thailand for
both government and corporate bonds is almost complete, while the reporting of the price and
volume of trades in Hong Kong, Korea, Malaysia, Singapore and Thailand ensures that the
secondary market for bonds can utilize recent information.

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2.4 Singapore
• Four fold expansion: Between 1997 and 2004, the size of the Singapore corporate
debt market expanded four-fold, with the result that the value of corporate securities
outstanding is now about twice that of bank loans.
• Non-resident issuers: The Singapore case is interesting in that despite the small size
of its economy, the authorities have made an effort to attract non-resident issuers in
both local and foreign currencies as a way to enhance the size and depth of the
corporate bond market.

2.5 Malaysia

• Larger than local government bond market: Malaysia’s corporate bond market
called as the “private debt securities” (PDS) market is larger than the local
government bond market. The PDS market currently accounts for over 80% of funds
raised domestically, compared with less than half in 1997.
• Participants: This market has been dominated by issuers from the infrastructure,
construction and utility sectors. The maturities of Malaysian PDS issues range from
one to 28 years, matching the needs of different issuers, but their relatively small
issuance sizes may have contributed in some degree to market illiquidity.
• Lower regulatory hurdles: The approval process for corporate issuance has been
reduced from 9-12 months to no more than 14 days. The size of Malaysia’s corporate
bond market surged 124 times from 1989 to 2004, and is now approaching 40% of
GDP.
• Infrastructure: The corporate bond market and the government bond market have
the same market infrastructure: same dealers, same reporting system and same real-
time gross settlement system. Though the US Treasuries and US corporate bond
market have a separate system for each, it may not be advisable for smaller economies
to import the US model. Shared systems help in achieving economies of scale due to
merger across government and corporates.
• Transparency: Malaysia has a reporting system in place which has made the bond
market very transparent thereby removing asymmetry of information.

2.6 Korea

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• Lower controls: Earlier, the market was characterised by strict government controls
on the amounts of bonds that could be issued and by mandatory bond guarantees. Post
the 1997 crisis, governments restricted their role to supervision.

• Non-mandatory bank guarantees: Earlier, the pricing and risk assessment of bonds
was based on the bank guarantee provided. About 85% of bonds in the market in
1997, were had bank guarantees. East Asian crisis forced the regulators to question
bank guarantees and there after this percentage reduced to less than 1% by 2004.

• Participant’s attitude: It is a market in which investors seem to be learning very

quickly how to monitor issuers’ credit quality and to trade and price default risk.

3. Indian Scenario

Like every market, the corporate bond market is also a play of demand and supply. The
development of this market will depend on the demand and supply conditions that will
prevail in the market.

The below section examines the demand and supply conditions in the Indian scenario

3.1 Demand Scenario

1. Foreign Funds
Foreign players had exhausted their investment limits and are demanding a raise in
the cap on investment in the Indian bond market. The current investment cap in
corporate debt market is $15 billion.

2. Insurance Companies and Pension Funds

Institutional investors with long term liabilities like pension funds and insurance
companies need avenues to invest in. These bonds, with good credit ratings, low
default risks and a higher rate of return, serve as a good investment opportunity for
them.

3. Mutual Funds
Mutual funds seeking a higher rate of return at a risk lower than the equity market can
look at corporate bonds as one of the options. Also, as these bonds become more
liquid, it would be easier to enter and exit them thereby increasing their attractiveness.

4. Household
This sector is completely absent from the corporate bond market. The minimum lot
size is one of the deterrence. However, the development of a proper legal system and
improvement in the quality of issuances are needed to reassure the investors and gain
their confidence.

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3.2 Supply Scenario

1. Public sector units

PSUs have been an important component of the corporate bond market. They had a
very good credit rating, almost a quasi-sovereign rating, due to government ownership
of the units.

2. Financial Institutions
Financial institutions have dominated the corporate bond market, both as an issuer as
well as an investor.

3. Private corporate sector

Manufacturing units and other non-financial sectors have played a very small role in
the corporate debt market. The main reasons are excessive dependence on bank
finance and the high cost and time of bond issuance. However, with the initiatives to
develop the bond market and make it more attractive for the private sector, it is hoped
that they see it as a source of financing their long term investment needs.

3.3 Tata Capital Bond Issue

Tata Capital was the first company to make a public issue of non-convertible debt (NCD)
securities under the Debt Regulations in February 2009. The issue opened on February 02,
2009 and closed on February 24, 2009. The size of the issue was set at Rs.500crore with a
green shoe option up to Rs.1000crore. Since the issue was oversubscribed, Tata Capital
exercised the green shoe option. The final issue size, thus, stood at Rs.1500crore.

This oversubscription indicates that there is an adequate demand for such bonds.

Tata Capital’s NCD had the following characteristics:

1. Good quality paper

NCD securities issued by Tata Capital were rated highly. CARE rated it as AA+
which indicates high safety and ICRA rated it as LAA+ indicating high credit quality
and low credit risk.
2. Liquidity
This security was tradable as it was listed on the exchange. This gave the investor an
option to exit the bond or buy more even beyond the window period.
3. Features
Tata Capital NCD had both put and call options which could be exercised after 3
years. Thus, the bond provided extra features to incentivise investors.
4. High return

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It gave a return of 12% with an option to redeem interest on a monthly, quarterly or

annual basis.

Based on the demand-supply evaluation and a study of the success of Tata Capital issue of
NCD, the following recommendations can be implemented to develop India’s corporate debt
market:

3.4 Recommendations

1. Rationalize primary issuance procedures

This is an important step to move away from the private placement dominated
situation. Though it is important to have stringent regulations on disclosures, it is also
crucial to not make it very complex and burdensome so as to discourage corporates
from issuing bonds to the public in the primary market. The long time taken for this
issuance deters corporates from opting for this route.

2. Allow pension funds to invest

Pension funds should be allowed into the corporate bond market. This would increase
the diversity of investors, as pension funds are long term investors.

3. Increase the cap on foreign fund investment in the corporate bond market:
India has recently announced an increase in the investment limit for foreign funds.
The cap has been raised $5 billion from $15 billion to $20 billion. India has huge
infrastructure needs currently. This raise in cap is limited to bonds from the
infrastructure sector only having a minimum maturity period of 5 years. Also, foreign
investors are more active and take advantage of interest rate differentials. These steps
would discourage short-term investment and stall the volatility created by the sudden
outflow by foreign funds.

4. Have a uniform TDS structure

All market participants, except insurance companies and mutual funds, are subject to
the provisions of TDS with respect to the interest payments. Having a uniform TDS
regulation will help in improving efficiency of price discovery mechanism.

5. Introduce repos in corporate bonds

RBI has recently announced that repos would be allowed in corporate bonds. This
move would bring in some liquidity in the system. Most institutional investors follow
the buy-and-hold strategy with respect to bonds. Thus the bond is locked in their
portfolio remaining out of the liquidity cycle. Introduction of repos would allow
pledging of corporate bonds, like government securities bonds, to borrow would help
in making this market more liquid and would attract investors to invest in them.

6. Encourage securitization
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Securitization gives small and medium sized firms to pool in assets and raise funds.
Also, the individually

7. Provide credit enhancements

Securitization is one way of providing credit enhancements. Other ways are
enhancements through third party guarantee (e.g. parent company bound to meet
obligations) or through credit insurance. These credit enhancements would improve
the credibility of bonds. Different tranches (securitized products) can be given
different guarantees thus leading to the development of products with varying
maturities and varying risks to cater to a multitude of risk appetites.

References:

1. Report of High Level Expert Committee on Corporate Bonds and Securitization

2. ADB Report TA 3473-IND - Development of a Secondary Debt Market
3. BIS - The corporate debt market in India by V K Sinha and Chandan Sharma
4. BIS - Developing corporate bond markets in Asia
5. SEBI Working Paper No. 9 – Corporate Debt Market in India: Key Issues and Some
Policy Recommendations, July 2004
6. Research Paper - Growth of China’s Interbank corporate debt market
7. Hong Kong Institute for Monetary Research (HKIMR) Working Paper No. 18/2010 -
What effect has bond market development in emerging Asia had on the issuance of
corporate bonds
8. http://www.sebi.gov.in/
9. http://www.nseindia.com/
10. http://www.bseindia.com/
11. http://www.bis.org/speeches/sp051117.htm

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