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Abhiskek Surana Project Report
1. Retail participation in
debt market
Welingkar Institute of
Abhishek Surana
Management
Development &Research
Final Year Project Report
Bangalore
PGPe-BIZ 2005-2007
3. `
S.P.MANDALI'S
PRIN.L.N.WELINGKAR INSTITUTE OF
MANAGEMENT DEVELOPMENT & RESEARCH
SYNOPSIS
(PROFORMA)
: Abhishek Surana
NAME OF THE STUDENT
PROGRAM & YEAR : PGPe-BIZ
AREA OF PROJECT RESEARCH : Retail Bond Market
NAME OF THE GUIDE : Prof Hemchand
TITLE OF THE PROJECT : Retail participation in debt market
PROJECT DETAILS
(A) Objective of study : _______________________________________
:_______________________________________
: _______________________________________
(B) Research Methodology
Step I : Collection of primary data (using questionnaire, personal visits & surveys) and
secondary data (through library study publications, Journals etc.)
Step II : Tabulation and presentation of data collected.
Step III: Analysis of above tabulated data, using statistical & financial tools.
Step IV: Drawing conclusions and giving suggestions
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(C) Expected Results of the study :
The secondary debt market in India is practically non-existent. This study argues that with the
recent economic reforms, an efficient and active debt market, particularly in long-term private
debt instruments, is essential for the country to realize the full benefits of the reform process
and to achieve its potential. It is further argued that the presence of small investors is critical to
this process, given the limitations of the institutional investors. The essential conditions for a
well-functioning debt market are identified from a study of the U.S. and European markets, and
an assessment made of their presence in India. Specific concerns of small investors in the Indian
context are described, and suggestions made as to how these can be addressed.
GUIDE'S SIGNATURE STUDENT'S SIGNATURE
Guide’s Details Student’s Details.
Name: Name:
Contact No.: Course:
Email Id: Specialisation:
Contact No.:
Email Id:
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Foreword
Financial Markets have several facets and are segregated into Capital and Money markets. Product
based classification gives rise to segmentation of market into equity, debt, foreign exchange and futures.
In many countries, debt market (both sovereign and corporate) is larger than equity markets. In fact, in
matured economies debt market is three times the size of the equity market. Investment in equity
being riskier, certain classes of investors choose to invest in debt, based on their risk appetite and
liquidity requirements. In fact, most investors like to spread their investments into equity, debt and
other classes of assets for reasons of optimal combination of return, liquidity and safety.
A vibrant debt market enables investors to shuffle, reshuffle their portfolio depending upon the
expected changes. Debt market, in particular, provides financial resources for the development of
infrastructure. Hence, a well-functioning debt market becomes significant for all the market
participants. The robustness of Indian debt market, notwithstanding some of major initiatives taken
recently, leaves much to be desired. It was, therefore, felt in line with regulatory responsibility of
developing the market that greater focus should be provided by SEBI on development of debt market.
With this thought, I started working on the project and have tried a fairly comprehensive study, with
some findings from an online survey conducted to find out general awareness of bond market and in
particular to bond market .The working paper outlines the significance of debt market in general and its
role in accelerating the development of economic growth in particular. It reviews various regulatory and
non-regulatory developments, instruments available, investors, issuers and intermediaries in the Indian
context. The study also identifies several weaknesses in the present system along with areas hindering
the growth of debt market.
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6. `
Acknowledgement
I’m immensely grateful to Prof Hemchand for his unstinting guidance and support
throughout the project. He has been a tremendous source of inspiration and
motivation to me throughout my project, to Prof Anuradha Mahesh, Prof
Madhavi Lokhande & Prof G.P Sudhakar for their support and suggestions.
I’m also indebt to all the participation of the online survey who took time out of
their busy schedule and shares their views.
I would also like to thanks our Director Prof Dr Uday Salunkhe and Dean
Marketing Prof Rajagopalan for providing me with this great learning opportunity
and to share my opinions.
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7. `
Abstract
The secondary debt market in India is practically non-existent. This study argues that with the
recent economic reforms, an efficient and active debt market, particularly in long-term private
debt instruments, is essential for the country to realize the full benefits of the reform process
and to achieve its potential. It is further argued that the presence of small investors is critical to
this process, given the limitations of the institutional investors. The essential conditions for a
well-functioning debt market are identified from a study of the U.S. and European markets, and
an assessment made of their presence in India. Specific concerns of small investors in the Indian
context are described, and suggestions made as to how these can be addressed.
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TABLE OF CONTENTS
Why the small investor? ..................................................................................................................................................... 10
Financial Structure ............................................................................................................................................................... 11
FINANCIAL MARKETS ....................................................................................................................................................... 13
FINANCIAL INTERMEDIATION ....................................................................................................................................... 14
FINANCIAL INSTRUMENTS .............................................................................................................................................. 15
Money Market Instruments ..................................................................................................................................... 15
1. Call /Notice-Money Market ................................................................................................................................ 15
2. Inter-Bank Term Money ...................................................................................................................................... 15
3. Treasury Bills. .......................................................................................................................................................... 15
4. Certificate of Deposits........................................................................................................................................... 16
5. Commercial Paper .................................................................................................................................................. 16
Indian Debt Market .............................................................................................................................................................. 17
The microstructure of the Indian Debt Market can be explained under two broad sub
sections: ................................................................................................................................................................................... 20
a) Primary Corporate Debt Market.......................................................................................................................... 20
b) Secondary Corporate Debt Market..................................................................................................................... 22
Issues.......................................................................................................................................................................................... 26
a) Poor Quality Paper .................................................................................................................................................... 26
b) Inadequate liquidity ................................................................................................................................................. 26
c) Investor base................................................................................................................................................................ 27
d) Regulatory arbitrage (additional costs on listed companies) ................................................................. 27
e) Debt Versus equity: Cost and risks ..................................................................................................................... 27
f) Incomplete access to information........................................................................................................................ 27
g) Interest rate structure ............................................................................................................................................. 28
Next Steps: Where do we go from here? ..................................................................................................................... 29
1. Transparency – ........................................................................................................................................................ 29
2. Market unification and communication – .................................................................................................... 29
3. Regulatory Autonomy and Effectiveness – .................................................................................................. 29
4. Trustworthy and transparent benchmarks ................................................................................................. 30
5. Competing and autonomous credit rating agencies ................................................................................ 30
6. Liquidity – .................................................................................................................................................................. 31
7 Natural investor base – .............................................................................................................................................. 32
8. Macroeconomic stability – ....................................................................................................................................... 32
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9. Legal system –............................................................................................................................................................... 33
10. Efficient equity markets to compete with the debt markets – ............................................................... 33
11. Developing a high yield market –....................................................................................................................... 33
The Role of Securitization ........................................................................................................................................ 34
Small Investor Perspectives ...................................................................................................................................... 35
“Why bonds? Well, they supplement income….” ................................................................................................. 35
. “But, mutual funds are stock portfolios…”........................................................................................................... 36
“I don’t trust corporations – can I buy insurance?” ........................................................................................... 37
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WHY THE SMALL INVESTOR?
It could be pointed out, however, that the presence of small investors may not be essential for
generating the necessary volumes of long-term debt. The traditional institutional sources of such debt,
namely the insurance companies and pension/provident funds, could possibly meet the demand, at
least in the immediate future. In the Indian context, there are at least two important reasons why every
effort needs to be made to woo the small investor into the debt market. First, while there is no doubt
that the institutional sources of long-term debt do account for a substantial quantum of funds in India;
practically all of it is monopolized by the government. There is logic to this. It needs to be remembered
that such institutions carry a fiduciary responsibility, and it is therefore essential that limitations be
placed on their deployment of funds for prudential reasons. The problem is compounded by the fact
that the responsibility for management of most of these funds is either that of the government or of the
employer. As a result, there is an excessive focus on issues of safety and security, with inadequate
emphasis on returns. This coupled with the regulatory framework, has led to a situation where such
funds have been deployed only in government securities or in “trustee bonds”, which are generally also
public debt instruments. Correcting this situation will not be easy. In the first place, the public sector will
continue to play the major role in infrastructure development in the foreseeable future, and it can be
nobody’s case that it should be denied access to long-term debt funds. More importantly, until the
regulatory limitations on and management preferences of institutional funds change, most of these
resources will continue to be directed towards investment in public debt instruments. Given the hyper-
sensitivity of the social and political system in India to safety issues, it does not appear very likely that
these limitations will change very soon. Thus, expanding the availability of long-term debt to the private
sector will be contingent upon attracting investments through alternative routes. Certainly corporate
savings can contribute to some extent through an inter-corporate debt market, but this will only lead to
a pari passu reduction in equity funds, which are just as critical as debt. Participation by small investors,
whether directly or through mutual funds, in the debt market, therefore, appears to be the only way
out.
Second, in the past, a fair proportion of long-term debt funds for the private sector, especially for small
and medium cap companies, came from the development finance institutions (DFIs). These agencies,
whose principal function was maturity transformation, borrowed medium term funds to lend long.
The intermediation margin was derived principally from tax and other concessions that were granted to
these institutions. With fiscal and financial sector reforms, however, all the DFIs are under serious stress,
and their lending activities have been curtailed drastically. As a result, the flow of long-term debt to
small and medium companies has reduced sharply. In the absence of an active debt market, these
companies cannot raise such funds, since the large institutional investors have simply no appetite for
debt instruments issued by them, preferring to invest in bulk in the bonds of large corporates. Meeting
this demand will require investors whose approach is more retail and who are less constrained by the
prudential regulations governing the larger funds.
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All definitions listed above refer to finance as a source of funding an activity. In this respect providing or
securing finance by itself is a distinct activity or function, which results in Financial Management,
Financial Services and Financial Institutions. Finance therefore represents the resources by way funds
needed for a particular activity. We thus speak of 'finance' only in relation to a proposed activity.
Finance goes with commerce, business, banking etc. Finance is also referred to as quot;Fundsquot; or quot;Capitalquot;
when referring to the financial needs of a corporate body. When we study finance as a subject for
generalizing its profile and attributes, we distinguish between 'personal financequot; and quot;corporate
financequot; i.e. resources needed personally by an individual for his family and individual needs and
resources needed by a business organization to carry on its functions intended for the achievement of
its corporate goals.
The economic development of a nation is reflected by the progress of the various economic units,
broadly classified into corporate sector, government and household sector. While performing their
activities these units will be placed in a surplus/deficit/balanced budgetary situations.
There are areas or people with surplus funds and there are those with a deficit. A financial system or
financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus
to the areas of deficit. A Financial System is a composition of various institutions, markets, regulations
and laws, practices, money manager, analysts, transactions and claims and liabilities.
Financial System;
The word quot;systemquot;, in the term quot;financial systemquot;, implies a set of complex and closely connected or
interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy.
The financial system is concerned about money, credit and finance-the three terms are intimately
related yet are somewhat different from each other. Indian financial system consists of financial market,
financial instruments and financial intermediation. These are briefly discussed below;
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FINANCIAL MARKETS
A Financial Market can be defined as the market in which financial assets are created or transferred. As
against a real transaction that involves exchange of money for real goods or services, a financial
transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments
represents a claim to the payment of a sum of money sometime in the future and /or periodic payment
in the form of interest or dividend.
Money Market- The money market ifs a wholesale debt market for low-risk, highly-liquid, short-term
instrument. Funds are available in this market for periods ranging from a single day up to a year. This
market is dominated mostly by government, banks and financial institutions.
Capital Market - The capital market is designed to finance the long-term investments. The transactions
taking place in this market will be for periods over a year.
Forex Market - The Forex market deals with the multicurrency requirements, which are met by the
exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes
place in this market. This is one of the most developed and integrated market across the globe.
Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-
term loans to corporate and individuals.
Constituents of a Financial System
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FINANCIAL INTERMEDIATION
Having designed the instrument, the issuer should then ensure that these financial assets reach the
ultimate investor in order to garner the requisite amount. When the borrower of funds approaches the
financial market to raise funds, mere issue of securities will not suffice. Adequate information of the
issue, issuer and the security should be passed on to take place. There should be a proper channel
within the financial system to ensure such transfer. To serve this purpose, financial intermediaries came
into existence. Financial intermediation in the organized sector is conducted by a wide range of
institutions functioning under the overall surveillance of the Reserve Bank of India. In the initial stages,
the role of the intermediary was mostly related to ensure transfer of funds from the lender to the
borrower. This service was offered by banks, FIs, brokers, and dealers. However, as the financial system
widened along with the developments taking place in the financial markets, the scope of its operations
also widened. Some of the important intermediaries operating ink the financial markets include;
investment bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio
managers, mutual funds, financial advertisers financial consultants, primary dealers, satellite dealers,
self regulatory organizations, etc. Though the markets are different, there may be a few intermediaries
offering their services in move than one market e.g. underwriter. However, the services offered by
them vary from one market to another.
Intermediary Market Role
Stock Exchange Capital Market Secondary Market to securities
Corporate advisory services,
Investment Bankers Capital Market, Credit Market
Issue of securities
Subscribe to unsubscribed
Underwriters Capital Market, Money Market
portion of securities
Issue securities to the investors
Registrars, Depositories,
Capital Market on behalf of the company and
Custodians
handle share transfer activity
Market making in government
Primary Dealers Satellite Dealers Money Market
securities
Forex Dealers Forex Market Ensure exchange ink currencies
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FINANCIAL INSTRUMENTS
MONEY MARKET INSTRUMENTS
The money market can be defined as a market for short-term money and financial assets that are near
substitutes for money. The term short-term means generally a period upto one year and near
substitutes to money is used to denote any financial asset which can be quickly converted into money
with minimum transaction cost.
Some of the important money market instruments are briefly discussed below;
1. Call/Notice Money
2. Treasury Bills
3. Term Money
4. Certificate of Deposit
5. Commercial Papers
1. CALL /NOTICE-MONEY MARKET
Call/Notice money is the money borrowed or lent on demand for a very short period. When money is
borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday
are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day,
(irrespective of the number of intervening holidays) is quot;Call Moneyquot;. When money is borrowed or lent
for more than a day and up to 14 days, it is quot;Notice Moneyquot;. No collateral security is required to cover
these transactions.
2. INTER-BANK TERM MONEY
Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The
entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations,
the specified entities are not allowed to lend beyond 14 days.
3. TREASURY BILLS.
Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an
IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated
period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount
to the face value, and on maturity the face value is paid to the holder. The rate of discount and the
corresponding issue price are determined at each auction.
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4. CERTIFICATE OF DEPOSITS
Certificates of Deposit (CDs) is a negotiable money market instrument and issued in dematerialized form
or as a issuance Promissory Note, for funds deposited at a bank or other eligible financial institution for
a specified time period. Guidelines for issue of CDs are presently governed by various directives issued
by the Reserve Bank of India, as amended from time to time. CDs can be issued by (i) scheduled
commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-
India Financial Institutions that have been permitted by RBI to raise short-term resources within the
umbrella limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. An FI
may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other
instruments viz., term money, term deposits, commercial papers and intercorporate deposits should not
exceed 100 per cent of its net owned funds, as per the latest audited balance sheet.
5. COMMERCIAL PAPER
CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt
obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed
with investors at a discount rate to face value determined by market forces. CP is freely negotiable by
endorsement and delivery. A company shall be eligible to issue CP provided - (a) the tangible net worth
of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the working
capital (fund-based) limit of the company from the banking system is not less than Rs.4 crore and (c) the
borrowal account of the company is classified as a Standard Asset by the financing bank/s. The minimum
maturity period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such equivalent
rating by other agencies. (for more details visit www.indianmba.com faculty column)
CAPITAL MARKET INSTRUMENTS
The capital market generally consists of the following long term period i.e., more than one year period,
financial instruments; in the equity segment Equity shares, preference shares, convertible preference
shares, non-convertible preference shares etc and in the debt segment debentures, zero coupon bonds,
deep discount bonds etc.
HYBRID INSTRUMENTS
Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as
hybrid instruments. Examples are convertible debentures, warrants etc.
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INDIAN DEBT MARKET
The debt market is much more popular than the equity markets in most parts of the world. In India the
reverse has been true. This has been due to the dominance of the government securities in the debt
market and that too, a market where government was borrowing at pre-announced coupon rates from
basically a captive group of investors, such as banks. Thus there existed a passive internal debt
management policy. This, coupled with automatic monetisation of fiscal deficit prevented a deep and
vibrant government securities market.
The debt market in India comprises broadly two segments, viz., Government Securities Market and
Corporate Debt Market. The latter is further classified as Market for PSU Bonds and Private Sector
Bonds. The market for government securities is the oldest and has the most outstanding securities,
trading volume and number of participants. Over the years, there have been new products introduced
by the RBI like zero coupon bonds, floating rate bonds, inflation indexed bonds, etc. The trading
platforms for government securities are the “Negotiated Dealing System” and the Wholesale Debt
Market (WDM) segment of National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).
The PSU bonds were generally treated as surrogates of sovereign paper, sometimes due to explicit
guarantee of government, and often due to the comfort of government ownership. The perception and
reality are two different aspects. The listed PSU bonds are traded on the Wholesale Debt
Market of NSE.
The corporate bond market, in the sense of private corporate sector raising debt through public
issuance in capital market, is only an insignificant part of the Indian Debt Market. A large part of the
issuance in the non-Government debt market is currently on private placement basis. Tables 1, 2 and 3
provide details of amount raised by financial institutions and non-financial institutions by way of public
issue and private placement. From the tables, it is clear that, on an average private placement accounts
for little over one-third of the debt issuance. Unofficial estimates indicate that about 90 per cent of the
private corporate sector debt has been raised through private placement in the recent past. The amount
raised through private placement has been continuously rising for the past five years which increased by
more than 300 per cent over the five year period. The growth rate in the public issue processes is only
about 80 per cent over the period, increasing from Rs. 20896 crore to Rs. 36466 crore. The listed
corporate bonds also trade on the Wholesale Debt Segment of NSE. But the percentage of the bonds
trading on the exchange is small. The secondary market for corporate bonds till now has been over the
counter market. With the recent guidelines issued by SEBI the scenario is expected to change.
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Table 1: Participants and Products in Debt market
Issuer Instrument Maturity
MAJOR INVESTORS
Central Government Dated Securities 2-30 years RBI, Banks, Insurance
Companies, Provident
Treasury Bills 91/364 days Funds, Mutual Funds, PDs,
Individuals
State Government Dated Securities 5-10 years Banks, Insurance
Companies, Provident
Funds
PSUs (Centre and Bonds 5-10 years Banks, Insurance
States) Companies, Corporate,
Provident Funds, Mutual
Funds, Individuals
Corporates Bonds and 1-12 years Banks, Mutual Funds,
Debentures Corporates, Individuals
Commercial Paper
15 days to1 year
PDs Commercial Paper 15 days to1 year Banks, Corporate,
Financial Institutions,
Mutual Funds, Individuals
Banks for minimum 5 years Banks, Corporates
Bonds issued
Tier II capital
Certificates of
Deposit, 3 months to 1 year
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THE MICROSTRUCTURE OF THE INDIAN DEBT MARKET CAN BE
EXPLAINED UNDER TWO BROAD SUB SECTIONS:
A) PRIMARY CORPORATE DEBT MARKET
Market structure consists of issuers, instruments, processes, investors, rating agencies and regulatory
environment.
I) ISSUERS
Indian Debt Market has almost all possible variety of issuers as is the case in many developed markets. It
has large private sector corporate, public sector undertakings (union as well as state), financial
institutions, banks and medium and small companies: Thus the spectrum appears to be complete.
Figure 1, delineates details on various classes of issuers. Two main classes include private sector
corporate and banks.
II) INSTRUMENTS
Figure 1 provides names of some of the more popular instruments that have been issued. Till recently
Indian debt market was predominantly dominated by plain vanilla bonds. Over a period of time, many
other instruments have been issued. They include partly convertible debentures (PCDs), fully convertible
debentures (FCDs), deep discount bonds (DDBs), zero coupon bonds (ZCBs), bonds with warrants,
floating rate notes (FRNs) / bonds and secured premium notes (SPNs). The coupon rates mostly depend
on tenure and credit rating. However, these may not be strictly correlated in all cases. The maturities of
bonds generally vary between one to ten years. However, the median could be around four to five
years. The maturity period by and large depends on outlook on interest rates. In expectation of falling
interest rates environment, corporate, it is observed, mostly go to shorter term instruments while the
opposite is true in case of possible hike in interest rates. For the past few years interest rates have been
falling and short end issues are on the rise. This is one of the reasons that many corporate are reluctant
to go for public issue route and listing of their securities.
III) PROCESSES
There are several processes that are in vogue in India as well as in other markets. The more popular
ones are public issue and private placement routes. Both these have their own pros and cons. In a
mature and developed market where large number of institutional investor /sophisticated investors are
available and a highly developed mutual fund industry is in operation, the private placement route may
be acceptable to issuers, investors and regulators. In a less developed market / small market it is a catch
22 position. Private placement is not suitable because this market do not have adequate number of
informed investors and the public issue route may create regulatory arbitrage, higher compliance costs
resulting sometimes in migration of markets. In India private placement route is highly popular owing to
various reasons (These are given in the following Box 1).
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IV) INTERMEDIARIES
Two classes of intermediaries required for the proper development of debt market are broker and
investment banker/ merchant banker. Most of the brokers as well as merchant bankers in India are
inadequately capitalized and their professional knowledge also needs further improvement. In some
markets, it is observed that there are dedicated “Debt Managers” who facilitate subscription or
sometimes subscribe to the issue and later on even facilitate trading in bonds. India needs a dedicated
“Bond Manager” concept.
V) INVESTORS
For the development of Corporate Debt Market / Fixed Income Securities Market, it is necessary and
sufficient to have a large as well as diverse number of sophisticated / institutional investors. Figure 1
lists some of the classes of investors that have been investing in the debt market. Institutional Investors
in India are few in number and the variety also is limited. We have only 37 mutual funds, hardly five
insurance companies till recently and there are no pension funds. Banks and financial institutions, by
and large, do not take active interest in Corporate Debt Market. Investors with diverse expectations are
a precondition for the development of corporate debt market. Diversity could be in terms of maturity
needs as well as expectations on interest rates. The most important structural weakness in India is lack
of large and diverse institutional investors. India has large number of retail investors; however, their
expectations are quite contrary to market principles - risk and return. Most investors think and perceive
that investments in bonds should provide them guarantee, repayment of principal and regular payment
of coupons. Any delay/default causes worries in their minds. And sometimes these investors complain
to regulators or to the government for non receipt of coupons or non-repayment of principal. This type
of behavior implies lack of understanding of the principles of the capital market on the part of the
investors.
VI) RATING AGENCIES
India has a well developed Credit Rating Agency system and rating agencies are well experienced and
regarded. By and large, their ratings do carry confidence in the market.
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B) SECONDARY CORPORATE DEBT MARKET
Appropriate ‘micro-structure’ of secondary market is vital for trading, clearing and settlement. The
present infrastructure has its own merits and demerits. Some of the micro structure features are
discussed below:
I) TRADING PLATFORM
Corporate debt instruments are traded either as bilateral agreements between two counterparties or
on a stock exchange through brokers. Worldwide, the majority of transactions in corporate bonds is
conducted in the over-the-counter (OTC) market by bilateral agreements. In India corporate bonds are
traded, mostly, on WDM segment of NSE. The National Stock Exchange (NSE) introduced a transparent
screen- based trading system in the whole sale debt market, including government securities in June
1994. The wholesale debt market (WDM) segment of NSE has been providing a platform for trading /
reporting of a wide range of debt securities.
The WDM trading system, known as NEAT (National Exchange for Automated Trading), is a fully
automated screen based trading system, which enables members across the country to trade
simultaneously with enormous ease and efficiency. The trading system is an order driven system, which
matches best buy and sell orders on a price/time priority.
TRADING SYSTEM PROVIDES TWO MARKET SUB-TYPES:
CONTINUOUS AUTOMATED MARKET: In continuous market, the buyer and seller do not know each
other and they put their best buy/ sell orders, which are stored in order book with price/time priority. If
orders match, it results into a trade. The trades in WDM segment are settled directly between the
participants, who take an exposure to the settlement risk attached to any unknown counter-party. In
the NEAT-WDM system, all participants can set up their counter-party exposure limits against all
probable counter-parties. This enables the trading member/participant to reduce/minimize the counter-
party risk associated with the counter-party to trade. A trade does not take place if both the buy/sell
participants do not invoke the counter-party exposure limit in the trading system.
NEGOTIATED MARKET: In the negotiated market, the trades are normally decided by the seller and
the buyer, and reported to the exchange through the broker. Thus, deals negotiated or structured
outside the exchange are disclosed to the market through NEAT-WDM system. In negotiated market, as
buyers and sellers know each other and have agreed to trade, no counter-party exposure limit needs to
be invoked.
II) CLEARING AND SETTLEMENT MECHANISM
Primary responsibility of settling trades concluded in the WDM segment rests directly with the
participants and the exchange monitors the settlement. Mostly these trades are settled in Mumbai.
Trades are settled gross, i.e. on trade for trade basis directly between the constituents / participants to
the trade and not through any clearing house mechanism. Thus, each transaction is settled individually
and netting of transactions is not allowed. Settlement is on a rolling basis, i.e. there is no account period
settlement. Each order has a unique settlement date specified upfront at the time of order entry and
used as a matching parameter. It is mandatory for trades to be settled on the predefined settlement
date. The Exchange currently allows settlement periods ranging from same day (T+0) settlement to a
maximum of two business days from the date of trade (T+2).
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23. `
III) INSTRUMENTS TRADED ON WDM:
The WDM provides trading facilities for a variety of debt instruments including government securities,
Treasury Bills and bonds issued by Public Sector Undertakings(PSU)/ corporate/ banks like Floating Rate
Bonds, Zero Coupon Bonds, Commercial Paper, Certificate of Deposit, corporate debentures, State
Government loans, SLR and Non-SLR bonds issued by financial institutions, units of mutual Funds and
securitized debt by banks, financial institutions, corporate bodies, trusts and others.
IV) INVESTORS IN WDM
Large investors and a high average trade value characterize this segment. Till recently, the market was
purely an informal market with most of the trades directly negotiated and struck between various
participants. The commencement of this segment by NSE has brought about transparency and efficiency
to the debt market, along with effective monitoring and surveillance to the market.
V) REGULATORY ENVIRONMENT:
The listed corporate debt is under the regulations of SEBI. SEBI is involved whenever there is any entity
raising money from Indian individual investors through public issues/ private placement. It regulates the
manner in which such moneys are raised and tries to ensure a fair play for the retail investor. It forces
the issuer to make the retail investor aware of the risks inherent in the investment. SEBI has in fact laid
down guidelines known as Disclosure and Investor Protection (DIP) Guidelines, 2000 guidelines to
maintain transparency in the market and make it efficient.
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ISSUES
After reviewing functioning of debt market in some other markets and in India, the following issues have
been identified as some of the major aspects affecting the market.
A) POOR QUALITY PAPER
Quality of paper refers to regular payment of coupon and repayment of principal at the right time.
Companies that do not default on these two counts are said to be issuing high quality paper. High
quality paper issued in the market does not create problems / issues for investors, regulators and
issuers. The question of private placement vs. public issue and institutional investors vs. retail investor
are of less significance and almost no consequence in the market, if the quality of the paper is good. It is
the poor quality paper with a possibility of non-payment of coupon and principal that poses threat to
the development of the market and hence stringent regulatory norms are warranted. Imposition of
additional regulatory provisions, though has its opportunity cost, therefore, it is essential to strike a
balance between regulatory protection and disclosure based regulation.
Further, in an emerging market / developing market the incidence of industrial sickness is relatively
high. This high industrial sickness generally translates into default of companies and their obligations.
The bond paper issued by companies turns worthless and creates problems in the minds of investors.
Since most retail investors, who invest in bonds, hold for maturity and also hold their investment in a
fewer number of companies, any default will wipe out their savings and security for the post retirement
/ old age requirements.
Therefore, defaults in fixed income securities market attract more attention of the public and the
regulators.
B) INADEQUATE LIQUIDITY
Secondary Market for Corporate Debt lacks liquidity in India. Hardly few trades take place, that too, in a
limited number of issues. There is a chicken and egg problem. Poor liquidity is attributable to
inadequate number of good papers and lack of sufficient investor base in terms of quantity as well as
diversity. We can address the liquidity issue in the following ways:
1) By developing ‘bond manager’;
2) By enlarging number of investors;
3) By introducing good quality paper.
The third factor is exogenous and the second will take long time. Therefore, what is feasible and
achievable in the near term is the development of ‘bond manager’ so that liquidity issue can be
addressed and to some extent the quality of paper also.
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C) INVESTOR BASE
In many markets the number of investors in fixed income securities market runs into thousands and
their variety include mutual funds, insurance companies, pension funds, endowments, private banking
institutions, banks and retail investors. In India, we have primarily mutual funds investing in bond funds
and their investment requirements are one sided, if money starts coming in all mutual funds will get in
large quantities and if it starts going out it will go in huge quantities thus creating storms in the market.
Insurance funds and pension funds are the long term investors. Any short term shocks can be absorbed
by these long term players. Insurance companies in India till recently were limited in number and they
were investing to hold till maturity. Individual investors generally hold for maturity. Now that we have
more private sector and joint sector players, their presence in the primary as well as in the secondary
market can be felt in the time to come. Pension funds are not there today. Banks do invest in the
primary market and their activity in the secondary market is almost nil.
D) REGULATORY ARBITRAGE (ADDITIONAL COSTS ON LISTED COMPANIES)
Companies operating in India can be broadly divided into two categories on the basis of regulatory
jurisdiction: Listed and Unlisted. All companies are, by and large, administered by the Companies Act,
1956 and the regulatory administration is carried out by DCA, Ministry of Finance. Listed companies are
overseen by SEBI through Listing Agreement of exchanges. Listed companies are required to follow
elaborate corporate governance principles, accounting and disclosure standards, continuous disclosure
standards and hence incur additional costs. Unlisted companies, thus, enjoy regulatory arbitrage over
listed companies. There is a perception that listed companies seek delisting owing to perceived
regulatory arbitrage.
E) DEBT VERSUS EQUITY: COST AND RISKS
By design and necessity debt has finite life sometimes, very short whereas equity is said to have
perpetual life. Therefore, debt paper is offered and reoffered quite frequently by companies. In falling
interest rate scenario, as has been the case in India for the past few years, corporates tend to borrow for
shortest possible period thus restoring to repeated issue costs and interest rate risks. High regulatory
and compliance costs add to cost of resources. Therefore, corporates might led innovate new methods
of raising capital. Either way, the corporate debt market will be affected adversely.
F) INCOMPLETE ACCESS TO INFORMATION
One of the most important issues is lack of sufficient, timely and reliable information on bonds and on
bond markets to the investors. Information on bond issue, size, coupon, latest credit rating, trade
statistics are sparsely available. If the investors have access to the relevant information more frequently
then it may be possible for them to assess the quality of the paper and take decisions. In addition, there
is no one place in India where one can have all the data pertaining to corporate debt issues. No one
knows exactly how much debt is outstanding on any given date and different agencies have incoherent
estimates for the same. Tables 1 and 2 amply demonstrate this point. Annual public issue amount
averages around Rs. 40,000 crore for the past 3 years. If the entire 5 year period is considered roughly
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Rs. 170,000 crore was raised through public issue. However, the amount of debt outstanding for trading
at NSE excluding government securities and treasury bills comes to roughly Rs. 100,000 crore. There is a
wide gap between publicly issued amount and that which is admitted for trading even if one considers
average maturity period of five years. Generally bonds have longer maturity. Hence, any regulatory
action either becomes ineffective or misdirected leading to unintended results target. Therefore, there
is an urgent need to launch a survey and prepare a comprehensive database and bring in transparency.
Transparency ensures confidence which in turn ensures liquidity. Sudden shocks can be mitigated.
G) INTEREST RATE STRUCTURE
Very skewed interest rate structure exists in India. Corporates with “AAA” rating offer lower coupon
than soverign rate offered on certain instruments such as public provident fund, National Saving
Certificates. Individual investors, therefore, have almost nil or no interest in coupon debt market, both
primary as well as in secondary, unless they are accompanied by some fiscal concessions resulting in net
higher return compared to above cited instruments.
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NEXT STEPS: WHERE DO WE GO FROM HERE?
Before turning to small investor perspectives, it would be desirable to outline the conditions which
contribute to a well-functioning debt market, and the extent to which these are met in India. It should
be quite obvious that the most vulnerable segment of investors would be least likely to participate in a
market which does not inspire the confidence of even more robust entities. Thus, the minimum
conditions will have to exist before the specific measures to attract the small investor can be discussed
meaningfully.
Upon studying developed debt capital markets in the United States and Europe,
I feel that there are some common features that contribute significantly to their highly evolved and
efficient characteristics.
1. TRANSPARENCY –
The market’s functionality needs to be transparent both to the entity issuing the debt security,
as also to the intermediary investing his money into it. Transparency also needs to exist for the
regulatory bodies that oversee the capital markets. Only transactions made under a system of
“full-disclosure” will increase the overall liquidity of the markets and provide all concerned
parties with the level of confidence required for them to actively participate. Transparency also
needs to exist at the corporations and other entities issuing the debt instruments. This involves
a further level of legal, institutional and infrastructural change in the Indian system. The
minimum requirement of course is that companies’ financial statements should be required by
law to be audited and filed for public perusal regularly, and it must be enforced rigorously. This
is, however, not enough. Access to such information must be made easy and user-friendly. At
present, the balance sheet libraries in India are still governed by laws and procedures which lay
more emphasis on preserving the confidentiality of companies than on meeting the information
needs of the investors. Regular publication of company data by independent third-party
agencies is not allowed. The net result is a degree of opacity which is not conducive for investor
confidence.
2. MARKET UNIFICATION AND COMMUNICATION –
The current market fragmentation has to be reduced. Setting up more nodes for securities
exchange seems like a well meaning but misplaced idea. This has led to the steady demise of
regional bourses, which on the face of it may appear to be a process of consolidation. This,
however, would be a misplaced view, since the listing requirements of the two major exchanges
– Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) – are such that they
would exclude a large number of smaller companies. Consequently, extent of coverage is likely
to reduce significantly as the process moves forward. Rather we should focus on setting up a
communication network that can replicate the NASD type negotiated market in the US, so that
everyone interested in buying a security gets a “firm” quote of the “inner market” regardless of
location and information channel. The National Stock Exchange (NSE) has the potential for
moving in this direction, but its present approach would have to change.
3. REGULATORY AUTONOMY AND EFFECTIVENESS –
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The regulatory mechanism is key to fair pricing of securities, as it prevents colluding and
intermediary pricing bias and inefficiencies. Without effective regulation, transparency will
remain a pipe dream. In the Indian context, the regulatory functions are divided between two
entities – the Securities and Exchanges Board of India (SEBI) and the Department of Company
Affairs of the Government of India.12 The primary functions of the SEBI are to over-see the
public issue of new securities, including specifying the listing conditions and disclosure norms,
and to supervise the operation of the stock markets in order to prevent anti-market behaviour.
Thus, as far as the secondary market is concerned, the SEBI’s role is limited to market-related
developments, and not to the companies themselves. This function comes in the domain of the
Department of Company Affairs, and especially the Registrar of Companies. Unfortunately, the
operation of these entities leaves much to be desired. Mention has already been made of the
excessive confidentiality regarding company information, but the situation is even worse than
that. Indian companies routinely get away with non-compliance with the reporting
requirements, and quite often companies close without the regulator even being aware of the
fact. As a consequence, secondary market participation is fraught with enormous informational
risk arising out of poor regulatory practices.
4. TRUSTWORTHY AND TRANSPARENT BENCHMARKS –
For a debt capital market to function efficiently, the existence of a credible benchmark is critical.
In most markets, Government Treasury Notes play this role. It is common practice in most
developing markets to use the US Treasuries as a global benchmark. Another criterion for a good
benchmark is that it should be liquid and the market for it should be transparent. In the United
States monthly auctions are held to appropriately price new Government securities. Another
important aspect of the US Treasuries Market is its low margin/high volume nature. The bid/ask
spread is never greater than 0.25 basis points. 13 This provides the market the ability to predict
trading levels with a high degree of confidence. Historically, The US Treasury rate was fixed by
the Federal Reserve till the early 1970’s. This resulted in low liquidity. Ever since it moved to a
floating rate regime, liquidity has been very high. Currently, only the Federal Interest Rate (“Fed
Rate”) is fixed. While US Treasuries trade freely on a floating basis, they tend to trade within a
very tight range to this Fed Rate. The question that arises in the Indian context is whether Indian
Government Bonds can perform the function of such a benchmark. Although, in India,
Government Bonds have been auctioned for many years, the price discovery mechanism is
inefficient and heavily influenced by Government monetary policy. The minimum transactions
size, even in secondary trade, is too large to permit widely dispersed participation, and
therefore the prices may not reflect ‘true’ valuations. The main feature required of a market
benchmark is that it should be a close proxy for the unrestricted “Risk Free Rate”. Bonds issued
by the GOI are backed by a Government guarantee, and since India’s default rating is very
favorable, this should not pose a problem, except that holdings are concentrated in a few hands
and therefore reflect only a part of the larger market.
5. COMPETING AND AUTONOMOUS CREDIT RATING AGENCIES –
Credible professional credit rating agencies that are autonomous are required to rate
corporations and their securities. The condition of autonomy is important for credibility
purposes. Ideally credit rating agencies should have their interest aligned with that of the
investors and not with the issuing companies, which has implications regarding their revenue
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sources. Further, it is advisable to have competing agencies in order to keep the pressure on any
one to do a thorough and effective risk analysis. In India, there are at present three reasonably
competent credit rating agencies, each of which has a tie-up with a major international agency.
Thus, on the numbers and technical competence fronts, there is sufficiency. The major issues
relate to the accessibility of the credit rating information and to the perceived autonomy of the
agencies. For the most part, credit rating information in India becomes readily available to the
public at large only when a company is about to come out with a fresh issue, and that too mainly
from the company prospectuses. This is driven by the regulatory guidelines, which make credit
rating mandatory for all public issues. While this is fine for fresh issues it is of little help for
secondary market transactions, which require a more or less continuous flow of information on
the financial health of companies with listed securities. Such rating information simply does not
exist, and it absence is perhaps linked to the excessive confidentiality accorded to balance sheet
information. The net result is that rating information becomes available only when the
companies’ desire it, and not when the investors’ need it.
Although all the Indian credit rating agencies have been promoted as independent and
autonomous entities by DFIs in collaboration with international agencies, their revenue streams
are derived primarily from the companies that are being rated. This may raise problems of
perception regarding their autonomy, although as yet no doubts have been raised.
6. LIQUIDITY –
Liquidity is perhaps one of the most important requirements for an efficient, developed capital
market. This in turn requires an efficient settlement system; and the existence of multiple
market makers. To some extent, the issue of an efficient settlement system has been addressed
by the move to rolling settlements in the equity markets, and only needs to be duplicated in the
context of the debt markets. The issue of market makers, however, needs greater attention.
Since the price of debt instruments, unlike that of equity, is linked closely to movements of
interest rates, with a relatively small speculative element, the bid/ask spreads cannot be very
large if any transaction is to result. As a result, the viability of market makers is determined
largely by the volume of trade. This creates a chicken-and-egg problem, whereby market makers
need high volumes to survive and high volumes require the presence of sufficient market
makers. The emergence of market makers in India has historically been constrained by two
factors. First, public debt instruments, which have driven the creation of active debt markets in
developed countries, have been characterized by extremely high denominations in India. As a
result, only large institutions have been able to participate in what has been effectively a
wholesale debt market. Thus no market makers at the retail level have been able to come into
existence on the strength of trading in government securities. Recently, the Indian government
has reduced the denominations significantly, and it now seems possible that smaller institutions
and relatively high net worth individuals can participate in this market. However, further
reduction in the denominations will have to be made before a viable retail debt market can
come into existence.
Second, the bid/ask spread in India has to accommodate not only the intermediary’s margin but
also an element of taxation through what is known as the ‘stamp duty’, which is levied by state
governments on all sale and transfer deeds. The stamp duty rates vary from state to state, but
200 basis points would not be uncommon. With these sorts of spreads, most debt transactions
become unviable for market makers. In recent years, the government has removed the levy of
stamp duty on dematerialized transactions, but this again mainly benefits institutional investors.
Small investors in India still prefer to hold securities in physical form for a variety of reasons, and
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these continue to be subject to this duty. Thus it is unlikely that there will be sufficient market
making in retail debt until the stamp duty is removed completely from all secondary
transactions. We further feel that there exists the need to increase public awareness and user-
friendliness of the offering mechanism by: allowing awareness advertisements to be issued prior
to, and during, the offer period; and opening up new channels of application for securities
including the Internet, ATM and telephone. In our view, these steps will lead to increased
participation by small investors, which in turn will increase the availability to smaller
transactions. These smaller, more affordable transactions do not currently exist, and once they
do, will instantly increase liquidity.
7 NATURAL INVESTOR BASE –
Demand for debt is, needless to say, critical for a debt capital market to exist. For this purpose, it
is necessary to develop a natural investor base that has liquid cash to invest; and, more
importantly, a stated investment objective biasing them towards the debt market. Traditionally,
in the United States and Europe, the largest buyers of fixed rate debt have been insurance
companies and money managers’ i.e. mutual funds and pension funds. It would hence be
prudent to develop the institutional infrastructure in India that would facilitate the creation and
growth of legitimate funds and professional money managers. As has already been mentioned,
insurance companies in India have been entirely public sector entities until recently, and their
investment pattern has been driven by prudential guidelines which effectively limit them to
public debt instruments. The case with provident/pension funds is similar. It is hoped that with
the entry of private sector players in the insurance sector, and possibly in fund management as
well, the natural investor base for private debt instruments will increase. Mutual funds,
unfortunately, have not really been able to make their mark in India primarily due to poor
timing of their launch. Hopefully this problem will get resolved with time. We will have more to
say on this matter.
8. MACROECONOMIC STABILITY –
Investor confidence is guided by many factors, one of the most important of which is
macroeconomic stability. This is for the Government policy makers and implementers to do. In
particular, interest rate management is perhaps the most important macroeconomic factor that the
Government needs to monitor. Historical and empirical evidence shows that debt markets flourish
in low interest rate environments. The interest rate regime in India has been traditionally kept very
high, but recently the Government has taken steps to bring it down. This should encourage
increased debt issuance if coupled with stable interest rate dynamics. It is pertinent to note that
while low interest rates in themselves tend to push investment rupees towards the debt markets, it
is important to stabilize interest rates. Excessive interest rate fluctuations would be counter-
productive as they give rise to arbitrage opportunities, and intermediaries looking for short-term
gains exploit the system, and this deters from the original goal of overall development and market
efficiency.
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9. LEGAL SYSTEM –
A functioning legal system that all parties have faith in is another critical component. Without a
viable legal infrastructure in place, it is very difficult to create investor confidence vis-à-vis the risk
attributes of debt securities. Another necessary component for the debt markets to develop and
flourish is the existence and development of a viable bankruptcy court that specializes in bankruptcy
procedures and claims recovery for creditors. Although India does have an independent and
effective judicial system, the average disposal time for cases is excessively long, which erodes
investment values quite significantly. As far as bankruptcy laws and procedures are concerned,
these are still in their infancy. It is only very recently that the government has passed an act for
attachment of defaulter assets, but even this is really of relevance to primary institutional lenders,
and offers little comfort to the secondary market players. It is, therefore, essential that the ambit of
bankruptcy laws be expanded to cover the interest of relatively small debtors.
10. EFFICIENT EQUITY MARKETS TO COMPETE WITH THE DEBT MARKETS –
In the Indian context, this is something that has already been achieved by the thrust to develop the
equity markets prior to developing the debt markets. The existence of these two markets competing
for investment rupees is critical to the survival and efficient functioning of both. If both markets are
well established, capital resource allocation becomes a natural phenomenon that does not need any
control or active involvement by government or regulatory agencies.
11. DEVELOPING A HIGH YIELD MARKET –
The development of a high yield market should be a secondary goal for Indian policy makers. It is
commonplace to find debt markets in developing countries to tilt towards high yield securities
owing to the existence of greater default risk. This tends to attract more capital, both domestic and
foreign, on account of the incentive of higher return. During the late 1980s, High Yield debt
securities, known at the time as “Junk Bonds”, became the major financing vehicle for corporate
America. The lack of regulation and the reckless use of these instruments, given their highly risky
nature, eventually led to a crisis in the U.S. markets in the early 1990s. However with the benefit of
hindsight, Indian policy makers can institute strict measures and tap the high yield market that
continues to play an important role in providing financing alternatives to sub-investment grade
companies throughout the world.
While these characteristics help provide a broad outline and goal-set to achieve we believe that, in the
short to medium term, the salvation of the secondary debt markets, especially for private long-term
debt, lies in removing the informational asymmetries, reducing transaction and intermediary costs, and
liberalization of the insurance sector and pension funds. Making these concerns a priority and
subsequently tackling them would yield the most efficient results. It is accepted that these are daunting
challenges, but none of the measures discussed should give rise to any substantive political resistance.
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THE ROLE OF SECURITIZATION
The Concept: Securitization refers to the issuance of new bonds collateralized by a pool of assets which
can be other bonds, loans, or any receivables with a regular cash flow. This is usually done via a Special
Purpose Vehicle (SPV) specifically set up to own and receive the income from the pool of assets, with
which to service the bonds it issues in its name. Proceeds from the bond issue are used to pay the
original owner or owners to acquire the pool of assets. The original owner or owners of the assets, or by
a third party can set up the SPV.
The pooling of assets can provide diversification benefits to potential investors. The asset-backed
securities can be issued in several tranches of different maturities and offering different risk-return
configurations, and can be rated at different credit levels. Specifically, credit guarantees can be used to
enhance the credit worthiness of some of the tranches, making them eligible to a wider range of
investors. Credit enhancement can also be achieved through the over-collateralization of the asset-
backed securities. The asset-backed securities can be issued in bigger sizes than usually the case in
emerging corporate bond markets, and therefore likely to have better liquidity in secondary markets—
again desirable characteristics for investors.
Consequently, securitization can contribute to the development of corporate bond markets by
overcoming the problems of the small size and low credit quality of most emerging market issuers—
problems which have plagued the emerging corporate bond markets. By participating in a securitization
program, or by collateralizing their future-receivable cash flows, small and medium corporates are able
to tap capital markets. In particular, securitization has been an important tool to clean up banks’ balance
sheets and improve their capital ratios in a bank restructuring process.
However as securitization is a derivative product, being packaged from existing securities or other debt
instruments, for its market to function properly, the market and market infrastructure for the
underlying assets have to be already in good working order. On top of that, legal clarity and
predictability on things like the true sale of assets, the taking possession of collateral and realizing its
market value etc. also needs to be sufficiently assured. Consequently, some analysts doubt if
securitization can be used as a means to help develop bond markets, as the cash market has to be
relatively developed before a market for securitized instruments can be introduced. In addition, to be
viable, an asset-backed securities market needs to have in place institutions ready and able to provide
credit guarantees or to buy the higher-risk “mezzanine” tranches of the securitization program. But in
India since bond markets have been in existence for some times, securitization can be useful in
identifying gaps and deficiencies in cash market infrastructures and foundations.
This in turn can help stimulate further reforms and developments in cash markets and beyond, in order
to accommodate the proper functioning of securitization markets. Research work done by the HKMA is
consistent with this line of thinking.
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SMALL INVESTOR PERSPECTIVES
The mere existence of the essential conditions for an active and efficient debt market to exist, as
described in the previous section, may not be sufficient to attract small investors, especially into long-
term private debt instruments. The reason for this is that the average small investor is heavily
conditioned by the past, with investment patterns being determined by known opportunities, and it
takes considerable time for them to alter these patterns. Information flows, especially about structural
changes, are slow in percolating down to them, and their ability to appreciate the implications is limited.
In our opinion, there are three major questions that need to be addressed adequately in order to
persuade the small investor in India to enter and participate in the secondary debt market.
“WHY BONDS? WELL, THEY SUPPLEMENT INCOME….”
There is enough anecdotal evidence to suggest that the graph plotting trading volumes versus time to
maturity is U-shaped for debt securities in India. When a debt security appears in the primary market,
trading is high until the price discovery process is complete and the investors have achieved asset-
liability matching. Once these two effects subside, investors tend to trade debt very close to maturity.
This holding of debt to maturity by the handful of players in the primary markets preempts secondary
trading almost entirely, thereby preempting price formation in the secondary markets. Since this is true
for large institutional investors or primary dealers (PDs), it effectively precludes the participation of
small investors as well. We believe that the reason for this behaviour is twofold:
1.
The major problem in India is that money markets are almost wholly held by public sector banks,
which typically have very high spreads between deposit and lending rates. They are also quick to
reduce interest on deposits when the bank rate is reduced, but sticky in bringing down interest
rates on advances. This inefficiency in the banking sector creates a large window of opportunity
for corporates to issue cheaper bonds that are more attractive to income-seeking investors than
deposits in a bank. Since the alternative use of such funds (i.e. bank deposits) is unattractive,
there is little incentive for bond holders to trade before maturity.
2.
Financial markets in India, especially debt markets are not deep enough to allow “market
pricing”. This leaves the value of debt instruments entirely at the mercy of governmental
monetary policy. While the period of 1995-2000 witnessed enormous stabilization of monetary
policy, the high degree of non-market effects on the valuation of bonds take away from their
trade-worthiness and thus Indian investors, institutional and individual, stick to using them as
income or asset-liability matching instruments. This is not the situation in the US or Europe.
With a very stable government securities market, there exists enough data for the market to
form expectations about forward interest rates in the economy. This allows reliable pricing of
debt instruments. In presence of interest rate volatility, capital gains from price movements
become the predominant reason to engage in debt securities transactions for investors in the
US. It is not the exception, rather the rule, that investors offload debt instruments well before
maturity. In fact it is rather rare investors actually hold debt to maturity. This is not so in India.
Even the large institutional investor in India does not invest in debt instruments like bonds to
capitalize on interest rate or price movements in these instruments.30 The rationale behind
buying bonds is very simple for the most parts – bonds provide a steady inflow of coupon
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payments which is higher than what they could get otherwise. The problem is compounded in
the case of small investors by the fact that the government has a slew of small savings
instruments with maturities ranging from 3 to 15 years, which have much higher risk-adjusted
interest rates than would be affordable on corporate debt instruments. Thus, as far as the small
investor is concerned, secondary debt market neither offers her high enough interest returns,
nor prospects of reasonably predictable capital gains. It is little wonder, therefore, that
practically the entire financial savings of Indian households is either in bank deposits or in small
savings instruments. However, from the point of view of the small savers, especially those who
are not covered by organized social safety nets such as pension/provident funds, considerable
uncertainties have been introduced by the deregulation of interest rates as a part of the reforms
process. Earlier, in a regime of administered interest rates, the almost complete predictability of
future income streams from debt instruments meant that the small saver needed to focus only
on the stock of savings for meeting her future requirements of both income and precautionary
funds. Flexible interest rates, however, demand that portfolios be switched around to ensure
the desired balance between income streams and capital gains. This can only be done if the
small investor becomes an active participant in the debt markets. This message has already
come across to some extent with the recent reduction in interest rates that has taken place in
the Indian economy, including those on small savings instruments. The loss of assurance that
this has entailed, especially as past investments begin to mature, has led to a scramble for
alternative investment avenues. However, in the absence of a functioning debt market, there
are few such options. This is, therefore, an opportune time to create the conditions for an active
debt market since the small investor at large is in a receptive frame of mind to consider
augmenting her income flows even if it involves a relatively higher degree of risk through
market-based instruments.
. “BUT, MUTUAL FUNDS ARE STOCK PORTFOLIOS…”
Perhaps the biggest vehicles of debt investments by small investors in the United States, mutual funds in
India suffer a fate suitable only for their distant but much more unreliable cousins – stocks. There is an
enormous lack of awareness amongst small investors when it comes to mutual funds and other such
pooled investment vehicles. For example, the common investor in India thinks that mutual funds are
simply stock portfolios and are thus equally risky. This preempts small investor investment in non-
government mutual funds. In the United States, the situation is significantly different. Individuals are
actively advised by their financial advisors to diversify their portfolio evenly between stock and bond
instruments. In order to achieve bond investment allocation, more often than not, they recommend
investing in mutual funds that invest heavily in debt securities. The benefits of this are twofold. Firstly,
mutual funds provide an effective securitization of debt securities that make them accessible to
investors with low capital base. If an individual were to go out and buy bonds, the investment required
would be high owing to the high denominations that these instruments trade in. A pooled investment
vehicle on the other hand can make these investments and indirectly offer small investors stakes
therein. Secondly, due to their massive investment volumes, mutual funds act as catalysts in secondary
market trading for debt. In as far as the risk profile of mutual funds, they cover the entire spectrum from
highly speculative small cap stock funds to capital guaranteed funds that guarantee capital preservation
with possible upside from favorable stock market movements. We believe that mutual funds hold a lot
of promise for the Indian small investor. Policy makers should increase awareness and regulation (if
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needed) about these investment vehicles. The small investor needs to be convinced that mutual funds
do not necessarily mean equity derivatives; rather they can be very stable fixed income investments.34
For example, the abovementioned capital guaranteed funds seem very suitable investments in India.
The idea behind these funds is very simple. For the most parts, these funds invest most of their capital
(say 95%) in fixed income instruments with low or no credit risk and take highly levered equity call
option positions with the remaining money to capitalize on possible favorable equity market swings.
However, for such instruments to be attractive, their expected returns should be at least as high as the
returns on small savings schemes. Since, as has already been mentioned, the latter continue to have tax-
and risk-adjusted returns which are significantly higher than those either on government securities or on
corporate debt instruments, this is a condition which is difficult to meet unless the mutual funds expose
themselves to much higher degrees of risk by placing significant proportions of the funds in the equity
market. Thus, the perception of the small investor becomes a self-fulfilling prophecy. Solutions to this
problem will have to be found in correcting the yield structures both over maturities and between
instruments.
“I DON’T TRUST CORPORATIONS – CAN I BUY INSURANCE?”
Even if the small investor were to decide to invest in bond markets, what would she buy? Despite its
enormous potential, both primary and secondary corporate debt markets are still in stages of infancy in
India. While in the United States, the field is split evenly between corporate debt issuers and
government and government-sponsored agency issuers, Indian debt markets are dominated by
“G-Secs”.36 it is true that a well functioning government debt market is a prerequisite to develop
corporate debt markets. However, we feel that this is already on the government’s radar. As pointed out
earlier, we have progressed somewhat in increasing the depth and width of the primary and secondary
G-Sec markets, although they are still small investor unfriendly. This leaves the corporate bond markets
as a clear area within debt capital markets in India where some policy intervention would go a long way
towards market expansion. There is no doubt that corporations in India are unduly biased towards
raising capital through debt rather than equity issuance. This has been attributed to the fact that a
majority of the large private sector players are family-held businesses where stock issuance threatens
the ownership stake. The low risk and steady return appetite of the average investor also takes a toll on
equity valuation; thus making debt issuance a clear favorite. Most of this demand for debt is presently
met from the banking system, with some, and declining, contribution from the DFIs, with corporate
paper being issued by only a few. This often creates a fairly serious asset-liability mismatch for the
corporate, which can be corrected only through greater infusion of longer term debt funds. Therefore,
conceptually there should be no dearth of supply of corporate bonds, and their absence due largely to
the demand side. I believe that in the current regulatory environment, there would be a lot of resistance
in investing in primary or secondary market for corporate bonds. To some extent this should not come
as a surprise. Indian investors, typically more risk averse than their average counterparts in the United
States, often find themselves victims of corporate fraud or malfeasance.41 In view of the inefficiencies
due to intermediaries and lack of transparency in capital markets, there needs to be a mechanism in
place to protect the investor. This is where we make a bold suggestion of introducing derivatives
contracts that are somewhat similar to “credit derivatives” in the US, that can alleviate counterparty risk
for small investors and channel capital flow into the much starved secondary corporate debt markets.
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38. `
ONLINE SURVEY
I tried to find responses on line; I designed a questionnaire to test awareness on few tropics but was
unable to gather enough responses for survey to be conclusive yet it gives some direction to my study.
Most of the respondents were in the age group of 18 to 35 and graduate or above.
QUESTIONNAIRE
Financial awareness survey
Hello friends, in this survey I'm trying to collect
information on awareness of people on general
financial product and factors influencing their
investment decision and in particular to fixed income securities market.
*1) 1) Name?
2) 2) e-Mail-
*3) Education?
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39. `
*4) Age?
Below 18
18-35
36-55
above 55
*5) Sex?
Male
Female
prefer not to say
*6) Occupation?
*7) Family income? ( per annum)
*8) Who does financial planning for your house?
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40. `
*9) Do you or any one in the family have the following financial product?
Life Insurance.
Mediclaim Policy.
Shares.
Fixed deposits.
Saving Certificates.
Bonds.
*10) Rank the following parameter for your investment decision? (5 being the highest and
1 being lowest)
1 2 3 4 5
Tax Benefit.
Growth.
Security.
Hedging.
Retirement planning.
Credit Ratings.
*11) Do you know about bond market?
Please Select
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41. `
*12) what do you think your level of awareness on following
1 2 3 4 5
Mutual Funds
Insurance
Shares Market
Bonds
Swaps
derivatives
Real Time gross Settlement
RTGS
NEFT
*13) Are all types of bond secured ?
Please Select
*14) Do you think the information available on the fixed income securities is adequate?
Please Select
*15) In my opinion interest rates are
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42. `
Moving upward. Both in short and long term.
Moving Downward both in short and long term.
Moving upward in short term but will comedown in long term.
Moving Downward in short term but will again go up in long term.
*16) If additional tax exemption is proposed on investment in fixed income securities then
would you invest on such schemes?
Please Select
17) Do you plan to invest in bonds or fixed income securities in near future?(National
Saving Certificates Indra vikas pattar) etc
Please Select
*18) Suggestion for increasing retail participation in bond market
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43. `
SURVEY RESULTS
3) Education? Chart Wizard
Perce Respo
ntage nses
High school 0.0 0
Graduation(B.Com, B.sc etc) 23.1 9
professional (CA,CFA,CS other) 7.7 3
PG or Masters 69.2 27
PhD 0.0 0
Total responses: 39
4) Age? Chart Wizard
Res
Perce
pon
ntage
ses
Below 18 0.0 0
18-35 97.4 38
36-55 2.6 1
above 55 0.0 0
Total responses: 39
5) Sex? Chart Wizard
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44. `
Perce Resp
ntage onses
Male 74.4 29
Female 25.6 10
prefer not to say 0.0 0
Total responses: 39
6) Occupation? Chart Wizard
Percen Respo
tage nses
Business 5.1 2
Home Maker 0.0 0
Banker 2.6 1
Engineer 5.1 2
IT Professional 15.4 6
Student 59.0 23
Accounting 0.0 0
Financial Adviser 5.1 2
Marketing & Sales 2.6 1
Teacher 0.0 0
Doctors 0.0 0
Professional (CA CS CFA) 0.0 0
others 5.1 2
Total responses: 39
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45. `
7) Family income? ( per annum) Chart Wizard
Percentag Respo
e nses
below 1Lac 2.6 1
1Lac - 5Lac 43.6 17
5Lac - 10Lac 38.5 15
above 10Lac 15.4 6
Total responses: 39
8) Who does financial planning for your house? Chart Wizard
Percenta Respons
ge es
I go to a financial adviser. 41.0 16
I do it myself. 43.6 17
I seek my friend(s) help. 10.3 4
I need help on financial planning 5.1 2
Total responses: 39
9) Do you or any one in the family has the following financial product? Chart Wizard
Percentage Responses
38
Life Insurance. 21.3
28
Mediclaim Policy. 15.7
30
Shares. 16.9
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