developing india’s corporate bond market

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Developing India’s CorporateBond Market

Finance and Private Sector Development Unit South Asia Region December 2006

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The World Bank

Finance and Private Sector Development Unit South Asia Region

December 2006


This note was prepared by a team consisting of Varsha Marathe (Finance and Private Sector Development, South Asia Region, World Bank), and Christopher Juan Costain (now in Finance and Private Sector Development, Africa Region, World Bank). Li Lian Ong and Pipat Luengnaruemitchai (both from

the International Capital Markets Department, International Monetary Fund) provided important inputs and contributions on the international experience. The report benefited from a background note on selected issues in the corporate debt market in India prepared by Susan Thomas and Renuka Sane. The peer reviewers were Anjali Kumar (Financial and Private Sector Development), Anita George, Nicholas Vickery (both from the International Financial Corporation), and Nachiket Mor, Neeraj Gambhir (both from ICICI Bank). The report was prepared under the overall guidance of Sadiq Ahmed (Director, Finance and Private Sector Unit and Poverty Reduction and Economic Management, South Asia Region), Barbara Kafka (Director, Operational and Quality Services), Joe Pernia (former Director, Finance and Private Sector Unit, South Asia Region), Simon Bell (Manager, Finance and Private Sector Unit, South Asia Region) and Priya Basu (Lead Economist, Finance and Private Sector Unit, South Asia Region). The team would also like to acknowledge the inputs and encouragement of the Capital Markets Division, Ministry of Finance in finalizing this note.

The team also received helpful comments and inputs from Clemente Luis Del Valle, (Financial and Private Sector Development), P. S. Srinivas (East Asia Finance and Private Sector Unit), Tom Glaessner, Claire Grose, and Thordur Jonasson. Heather Fernandes and Maria Marjorie-Espiritu (Finance and Private Sector Development, South Asia Region, World Bank) designed the report and provided administrative support. Bruce Ross-Larson and his team from Communications Development Inc. edited the report.

Acknowledgements

Currency equivalentsAs of November 2005, US$1 = Rs. 45.26

Contents

Executive summary ............................................................................................................ vii

1. Why does India need a corporate bond market? ............................................................ 1 The size and depth of the debt market ................................................................................................... 1 Patterns in emerging market countries ...................................................................................................1 Patterns in mature market countries ......................................................................................................2 The importance of a corporate bond market ............................................................................................3 India’s model of industrial financing ......................................................................................................3 India’s sources of corporate finance ........................................................................................................4 Pressures for change .................................................................................................................................6 A changing, competitive financial sector ................................................................................................6 New legislation affecting the debt market ..............................................................................................7 New opportunities for financing overseas ..............................................................................................7 Huge infrastructure financing needs ......................................................................................................8 Conclusion ............................................................................................................................................ 8

2. What is holding back the supply and demand? ........................................................... 11 The supply of corporate bonds ............................................................................................................ 11 Government dominance in primary issuance .......................................................................................11 The nonexistent market for high-yield issuance ...................................................................................12 The drivers of demand ............................................................................................................................13 High household savings but low retail participation ............................................................................13 Growth of assets with institutional investors ........................................................................................13 The obstacles to institutional investing ..................................................................................................14 Banks ..............................................................................................................................................14 Insurance companies ...........................................................................................................................16 Pension and provident funds ...............................................................................................................17 Mutual funds ......................................................................................................................................20 Foreign institutional investors .............................................................................................................20 Conclusion .......................................................................................................................................... 21

3. What is holding back the development of the market? ................................................ 23 Long and costly issuance process ......................................................................................................... 23 Lack of innovative debt instruments .................................................................................................... 25 Markets for risk sharing – securitization and derivatives ......................................................................26

Securitization ......................................................................................................................................26 Credit enhancement ............................................................................................................................28 Derivatives ..........................................................................................................................................28 Inadequate secondary market infrastructure ........................................................................................ 29 Exchange traded versus over-the-counter systems ................................................................................29 Trade reporting platform .....................................................................................................................31 Clearing and settlement system ...........................................................................................................32 Gaps and overlaps in the legal and regulatory framework .................................................................... 32 Regulatory jurisdiction and coordination ............................................................................................32 Overlap due to ‘definitions’ of terms in the legal and regulatory framework.........................................33 Creditors’ rights ..................................................................................................................................34 Provisions of the Companies Act .........................................................................................................34 Taxation ..............................................................................................................................................35

4. What does India need to do to develop its corporate bond market?............................. 37 Recommended regulatory reforms ....................................................................................................... 37 Better access for issuers ........................................................................................................................37 Better opportunities for investors ........................................................................................................38 Better regulatory practices ...................................................................................................................39 Recommended market reforms ............................................................................................................ 40 Better corporate credit and trade information ......................................................................................40 Better market infrastructure ................................................................................................................40 Better choice of products .....................................................................................................................41 Better homogeneity in corporate bond securities .................................................................................41 Conclusion .......................................................................................................................................... 42

Annexes 1. Recommended reforms, by responsible agency ........................................................................................432. Key reforms and outstanding issues in the government securities markets ...............................................473. Statistics on issuers in primary markets ....................................................................................................494. Restrictive investment policies and guidelines for insurance and pensions ...............................................515. Use of financial instruments to increase liquidity .....................................................................................536. Report of the High Level Expert Committee on Corporate Bonds and Securitization .............................55

References ..................................................................................................................... 57

List of Figures, Tables, Boxes and Annex TablesFigures1.1 Size and composition of outstanding domestic debt markets in selected emerging developing countries, 2004 ...............................................................................................................................31.2 Resource mobilization by the Indian corporate sector, 1970–75 to 1990–95 ....................................................41.3 Sources of funds for Indian corporations, 1985–2002 ......................................................................................51.4 Debt-equity ratios by sector, 1988–2004 ..........................................................................................................6

1.5 Overseas issuance of equity and debt by Indian corporations, 1992–93 to 2005–2006 US dollars (millions) .........................................................................................................................................72.1 Investments of life insurance companies, 2004 ...............................................................................................173.1 Public and private sector bond issuance through private placements (2001–2006) ..........................................253.2 Issuance size and number of deals in the securitization market, 2000–06 ........................................................273.3 Securitization in the Indian market, by type, 2002–06 ...................................................................................28

Tables1 Summary of recommended regulatory and market reform measures ................................................................ xi1.1 Financial depth and share of corporate bond market in India and selected emerging market countries, 2004 .....................................................................................................................................12.1 Resources raised in the primary markets in India, 1995–2006 ........................................................................122.2 Credit ratings for bonds issued by public sector agencies in 2005 ...................................................................132.3 Retail participation in Indian debt markets, 2003–06 .....................................................................................132.4 Assets under management of local institutional investors in India and selected emerging market countries, 2004 ...................................................................................................................................142.5 Investments of scheduled commercial banks, 1997–2006 ...............................................................................152.6 Distortions between the treatment of bonds and loans in bank regulations .....................................................162.7 Net investments by foreign institutional investors, 1997–98 to 2005–06 ........................................................203.1 Costs for an issuance of Rs. 1 billion through private placement, 2005 ..........................................................243.2 Securitization issuance in India and selected emerging markets, 2001–04 (US$ millions) ...............................263.3 Turnover in secondary markets .......................................................................................................................303.4 Business growth in trades reported at the National Stock Exchanges Wholesale Debt Market .........................30

Boxes2.1 International experience on regulating investments by pension funds .............................................................182.2 International experience with encouraging foreign investment in corporate bond markets ..............................193.1 International experience with auction systems for bond primary market issuance: experience in Latin America ............................................................................................................................233.2 International experience on better dissemination of trading information ........................................................313.3 Examples of regulatory overlap in the debt market ..........................................................................................33

Annex TablesA2.1 Dimensions of the Indian government securities market, 1992–2005 .............................................................47A2.2 Interest rates on various savings instruments end-March 2005 ........................................................................48A3.1 Issuers in India and typical issue characteristics ...............................................................................................49A3.2 Selected indicators of debt markets in India, 2002–06 ....................................................................................49A3.3 List of top 25 issuers in the year 2005–2006. ..................................................................................................50A3.4 Resources raised by banks through private placement (2003–2006) ................................................................50A4.1 Investment guidelines for life insurance companies .........................................................................................51A4.2 Investment guideline for non-life insurance companies ...................................................................................51

Executive summary

A well-developed corporate bond market is essential for the efficiency and stability of a country’s financial system and the overall

growth of its economy. Issuers and investors’ access to the market provides for financial diversification and facilitates necessary financing, which benefits not only AAA-rated corporations but also less well known, sub–investment grade corporations and infrastructure developers. This note examines the state of India’s corporate bond market, identifies constraints that inhibit its size and depth, and suggests reform measures that India needs to take to develop its market into a competitive source of financing for a wide range of issuers and an attractive investment for a wide range of investors. Recommendations are based not only on an assessment of conditions in India, but also on relevant international experience.

The corporate bond market in India, with its volume of outstanding debt amounting to 5 percent of gross domestic product, remains underdeveloped compared with other emerging markets that have similar depth in their financial sectors. A comparison of the size and composition of the domestic debt market in India and seven other prominent emerging market countries puts India ahead of only Mexico in the size of its corporate bond market. At the end of 2004, the corporate bond market was 38 percent of GDP in Malaysia, 21 percent in Korea, and 11 percent in Chile. Furthermore, India’s corporate bond market represents less than a third of the debt stock on issue and mainly comprises issuances with maturity of less than five years. Banks, financial institutions, public sector undertakings, and state government–guaranteed instruments dominate most of the issuance in the corporate bond market.

Why does India need a corporate bond market?Corporate bond markets form a crucial part of a diversified financial system that ensures efficient allocation of resources. When many emerging markets suffered a sudden outflow of capital in the late 1990s, one painful lesson was that their financial systems had relied too heavily on bank lending and paid little attention to developing other forms of finance. It has often been argued that, if corporations in Indonesia and Korea had relied more on domestic corporate bond markets and less on bank financing, the magnitude of losses from the banking and financial crisis of the mid 1990s would have been less severe. Thus, the corporate bond market has a role as an alternative funding source for corporations, which could act as a buffer in the face of sudden interruptions in bank credit or international capital flows. Policymakers in East Asia have started to pay attention to developing a local bond market and these efforts have begun to pay-off.

Corporate bond markets play a critical role for companies in accessing the long-term financing needed for growth. The development of a corporate bond market is particularly important, given that Indian corporations today no longer have access to long-term funding from development financial institutions, and banks are more inclined toward retail lending, where the risks are much lower. Furthermore, the banks’ willingness to make long-term loans is also limited by the asset-liability mismatch on their balance sheets. Since a large fiscal deficit is likely in the near foreseeable future, there is little flexibility left for banks to provide long term funding for infrastructure, industry and agriculture sectors (Mohan, R., 2004b).

Corporate Bond Market Reportviii

Today, companies wanting to borrow long term in local currency to finance expensive investments are faced with a dearth of adequate institutional sources. The absence of a deep and liquid corporate bond market at the longer end of the maturity spectrum causes corporations either to go for rolling shorter maturity borrowings, which tend to be more expensive, or to go for foreign borrowings, which pose exchange-rate risks. The growing reliance on overseas borrowing is already becoming evident with the increased external commercial borrowings and foreign issuance of bonds by Indian firms. Interestingly, there are indications that many lower-rated corporations have also accessed foreign debt in the past two years through the issuance of foreign currency convertible bonds, indicating that offshore markets have a greater capacity to finance Indian firms across the credit spectrum as compared to the domestic bond markets. Development of an active local corporate bond market would allow firms to issue debt securities that match the timing and currency of their cashflows better. This would reduce the corporations’ costs and vulnerabilities associated with balance sheet mismatches and exchange rate risks.

Corporate bond markets are a principal vehicle for corporations to raise long-term financing for infrastructure to support economic growth. The growing need for investment in infrastructure and the huge financing gap that already exists imply that private funding will have to play a significant role. As infrastructure policy and regulatory frameworks emerge and reforms advance, a better-developed financial system, particularly a long-term domestic bond market, can accelerate access to finance by infrastructure projects. If the financial system fails to develop rapidly enough, it will not be able to respond quickly to changing financial requirements, especially for long-term financing, and it is likely to slow down reform in infrastructure and economic growth overall.

What is holding back the supply and demand? Demand and supply issues have fueled the growth of corporate bond markets in many countries. In some countries, such as Chile, the growth of institutional investors fueled demand for corporate debt securities. In

some others, the collapse of other sources of funding led to a rise in the issuance of corporate bonds. The principal issues on the supply side in India are the dominance of government-owned entities as the primary issuers of bonds, lengthy and costly primary issuance process and the absence of high-yield issuances in the current market. The principal issues on the demand side of the Indian corporate bond market,are lack of a diverse pool of institutional investors despite the recent rapid growth of assets under the management of institutional investors. In part this is due to restricted investment guidelines of institutional investors and policy issues related to opening up the pensions sector and allowing greater foreign investment in the bond markets.

Supply-side constraints

The lack of size and depth in India’s corporate bond market is associated partly with the lack of depth in the government bond market and the absence of a yield curve for government bonds, which could serve as a benchmark for corporate bonds. India’s corporate bond market is also constrained by cumbersome primary issuance guidelines. Primary market issuance processes and costs are important factors in the decision of a corporation to access the corporate bond market. Most of the bond issuance in India has moved to the private placement market, because it affords corporations quick access to funds at fairly low cost. Recently, regulators have tried to improve transparency and disclosures in the private placement market through requiring listing of privately placed securities on the exchanges in order for these to be eligible securities for the institutional investors. However, this has resulted in taking away the advantages of private placement avenues for issuers as these securities have now to be listed. Further problems remain in streamlining the disclosure requirements for private placements to the needs of fixed income instruments—making it burdensome for first-time issuers and unlisted firms. A related problem is the nondevelopment of a market for sub–investment grade paper and high-yield securities. India has a strong equity culture that places onerous demands of market discipline (such as requirements for disclosures and corporate governance) on corporations of all credit qualities. Given this culture, the nonexistence of a market for

ixExecutive Summary

high-yield bond issuance is surprising. In comparison, in developed markets, such as the United States, Japan, and the Euro area, the market for sub–investment grade paper is growing rapidly. Deepening of the issuer class across the credit spectrum will provide lower-rated borrowers better access to formal finance and lead to a well-diversified financial system.

Demand-side constraints

On the demand side, the absence of sufficiently developed long-term investors is a major impediment. While the volume of assets under management of institutional investors is growing, institutional investors in the debt market are found to be “too restricted” or “homogeneous.” They mainly hold “safe” paper, such as government securities, government-guaranteed paper, and highly rated corporate paper. Banks, insurance companies, and pension and provident funds are all constrained by regulatory and investment guidelines that require a large portion funds to be invested in government securities. They are allowed little flexibility to invest in nongovernmental, private sector corporations, particularly lower-rated corporations. Existing restrictions have discouraged mutual funds from holding lower-rated, relatively illiquid bonds, as fund managers are unwilling to invest in instruments that may have to be redeemed at any time. Foreign institutional investors have the risk appetite to invest in bonds across the credit spectrum. However, investment caps on their debt investments in the country deter them from holding larger portfolios. Internationally, particularly in mature markets, pension funds and insurance companies have greater flexibility to manage their portfolios and do not have explicit ceilings on debt securities in which these funds can invest. Their investments also include foreign assets.

Current restrictions on investors’ bond market investments do not augur well for innovations in instrument types. Indian bond markets have seen very limited innovations, and most of the issuance tends to be plain vanilla fixed-rate coupon bonds. In contrast, the Latin American markets have used several different structures with relatively long maturities. Lack of these innovations has also stifled third-party enhancement and limited

availability of derivative products, which would allow investors to mitigate credit and interest rate risk. In part, the lack of derivative instruments due to regulatory restrictions has meant that there is no effective market for credit risk in India. Enhancements, and the greater use of derivative products, would broaden market access, as these would enable lower-rated corporations and infrastructure sponsors to tap investments from institutional investors.

What is holding back the development of the market?The microstructure of primary and secondary markets for corporate bonds—such as issuance methods, trading mechanisms, dissemination of transaction information, and the role of intermediaries—critically affect market development. In India, the crucial issues involved in developing the corporate bond market are facilitating speedy and cost-effective primary issuances without compromising transparency and disclosure, elongating the maturity of corporate bond issuances, and improving the liquidity in secondary markets. Moreover, because the corporate bond market functions within a larger legal and regulatory framework, developing the market requires developing that framework as well, by clarifying administrative responsibilities and improving coordination among the various oversight authorities, by facilitating aggregation and disclosure of information about transactions, and by modernizing laws on creditors’ rights, bankruptcy, and corporate governance.

Market microstructure issues

The microstructure of a viable corporate bond market provides trading platforms that allow efficient price discovery, efficient clearing and settlement mechanisms, adequate credit information, and speedy and efficient enforcement laws relating to default proceedings. The absence of market infrastructure to support India’s secondary market for trading bonds is one of the biggest impediments to improving liquidity in that market. Furthermore, liquidity is constrained by the narrow range of financial instruments on offer. New financial instruments, such as credit derivatives and interest rate

Corporate Bond Market Reportx

hedging tools, would help to attract investors to the corporate bond market. For credit derivatives, the main constraint is the absence of enabling guidelines from the Reserve Bank of India; for hedging tools, the constraint is the absence of a suitable money market index for the interest rate swap market to develop (although indications are that this is now beginning to develop).

Another barrier to active trading and pricing in the corporate bond market is the paucity of information on transactions. No one knows exactly how much debt is outstanding on any given date. Data on bond issues, size, coupon, latest credit rating, underlying corporate performance, information on secondary trading and default histories of companies are sparse and usually not available from one source.

Weaknesses in regulation

Weaknesses in regulation, including poor coordination among the various agencies involved in corporate bond market regulation, also fail to support the development of India’s corporate bond market. In the debt markets, the Ministry of Finance, the Reserve Bank of India, and the Securities and Exchange Board of India all have regulatory and supervisory roles that are not sufficiently delineated. The overlap in regulation and the different focus of each authority tends to inhibit the introduction of new products and the needed innovations in market design.

The lack of a bankruptcy code and institutional mechanisms to deal with business failure in a way that is fair to bondholders have also crimped the ability of corporations to issue bonds based on expectations of future cashflows.

What does India need to do to develop its corporate bond market?For issuers, investors, and intermediaries alike, participation in India’s corporate bond market is not likely to take off until they recognize clear economic benefits, often in the form of better costs, lower risks, or better market performance than the status quo, and

they can develop the right attitudes and abilities in an enabling environment. While macroeconomic stability, a well-functioning money market, a government securities market, and an effective legal and regulatory framework all provide a critical foundation on which to build corporate bond markets, many of the elements of an enabling environment are interdependent and normally must be developed or reformed in conjunction with one another. It must also be cautioned that there is no general agreement on which conditions are “necessary” for corporate bond market development, and there is certainly no “one-size-fits-all” recipe.

In India, some of the enabling measures relating to government securities market are already in place or are being implemented. For instance, a relatively liquid benchmark yield curve of up to 20 years already exists for government debt. Furthermore, ongoing efforts to improve the liquidity of the repurchase market—much of which is currently focused on the overnight market—are also important for the corporate bond market. Moreover, although local securities markets can provide an alternative source of funding to the banking sector, especially during banking crises, a sound and well-regulated banking system can be a necessary complement to the development of local bond markets.

Reform strategy

The High Level Expert Committee on Corporate Bonds and Securitization, appointed by the Ministry of Finance to look into the legal, regulatory, tax, and market design issues in the development of the corporate bond market, recommended several measures to strengthen the market infrastructure and the legal and regulatory framework. Recommendations in this note are intended to build the enabling environment in which the corporate bond market can flourish. The proposed measures are grouped into two main categories: regulatory reforms and market microstructure reforms.

Regulatory reforms

Recommendations are proposed (a) to develop a growing and diverse set of issuers by streamlining procedures

xiExecutive Summary

and reducing costs of issuance, (b) to encourage local institutional investors, such as banks, pension fund managers, and insurers, to participate in the corporate debt market by making investment policies and regulatory guidelines sufficiently flexible for these entities to choose an appropriate risk-return profile within fiduciary constraints, and (c) to strengthen the legal and regulatory framework by clarifying oversight responsibilities among the various regulatory agencies and modernizing laws governing creditors’ rights and corporate governance.

Market reforms

To strengthen the corporate bond market itself, recommendations focus on improving the comprehensiveness and access of information about issues and issuers, the efficiency and reliability of market infrastructure, the range of products available, and the homogeneity of corporate bond securities. The accompanying table summarizes the suggested reform measures and the responsible agency (a more detailed version of this table is in annex-1).

Table 1 Summary of recommended regulatory and market reform measuresReform measure Responsible agency

Regulatory reformsReforms affecting issuers Streamline procedures for public issuance of debt. Shelf registration should be extended for all types of corporate borrowers.

Securities and Exchange Board of India, Ministry of Company Affairs

Strengthen the debenture trustee system by providing protection from default by the company in timely payment of interest.

Securities and Exchange Board of India

Rationalize the stamp duty among different classes of investors and states.

Ministry of Finance, state governments, Reserve Bank of India

Reforms affecting investorsRelax and amend regulations for permitting pension and provident funds to invest in corporate debt.

Ministry of Finance, Income Tax Department, Ministry of Labor, Employee Provident Fund Organization,

Modify the investment guidelines for insurance companies to allow investment in instruments with a rating of less than AA with adequate safeguards to protect the soundness of the investor.

Insurance Regulatory and Development Authority

Relax regulatory caps on banks’ investments in unlisted corporate bonds (currently limited to 10 percent of their total non-SLR investments) as well as the minimum rating requirement needed for investments in corporate bonds (minimum investment grade, i.e., AA and above).

Reserve Bank of India, Ministry of Finance

Provide capital for the interest rate risk in the entire balance sheet, as opposed to just the marked-to-market portion of the book. This would ensure that bonds and loans are given similar treatment from the interest rate risk perspective.


Remove the artificial distinction between investments and advances in the current regulatory regime. Guidelines and rules should be similar for a given credit whether it is held as a loan or as a bond.


Further raise the current corporate bond ceiling for foreign institutional investors in corporate bonds. As a first step, the cap could be relaxed for longer term investment in corporate bond debt markets (over 3 years)

Ministry of Finance, Reserve Bank of India, Securities and Exchange Board of India

Corporate Bond Market Reportxii

Table 1 Summary of recommended regulatory and market reform measuresReform measure Responsible agencyProfessionalize fund management services. The authorities need to ensure that pension and provident funds and insurance companies have access to professional fund management services and put in place adequate risk management systems to preserve the soundness of these investors.

Securities and Exchange Board of India, Insurance Regulatory and Development Authority , Employee Provident Fund Organization

Reforms affecting the legal and regulatory frameworkImprove existing regulatory practices. The regulation of the corporate debt market should be put under the ambit of one regulator.

High Level Committee on Capital Markets, Ministry of Finance, Reserve Bank of India, Securities and Exchange Board of India

Enforce recently amended bankruptcy laws that clearly define creditors’ rights and borrowers’ responsibilities, the promotion of adequate corporate governance practices, and timely and accurate public disclosure of financial information.

Ministry of Company Affairs, Ministry of Finance, Reserve Bank of India, Securities and Exchange Board of India and SEBI

Market microstructure reformsImprove comprehensiveness and access to corporate credit and trade information.

Securities and Exchange Board of India, Ministry of Company Affairs Secondary responsibility: credit rating agencies, National Stock Exchanges, Clearing Corporation of India, Ltd. or Fixed Income Money Market Dealers Association

Improve trading and settlement systems. Efficient systems are critical for providing liquidity, efficient price discovery, and an exit route for debt investments in infrastructure.

Securities and Exchange Board of India, Reserve Bank of India, National Stock Exchanges, Clearing Corporation of India, Ltd., Ministry of Finance

Develop new product structures (e.g., credit enhancement, bond insurance) and hedging mechanisms.

Securities and Exchange Board of India, Reserve Bank of India, National Stock Exchanges, Clearing Corporation of India, Ltd., Ministry of Finance, self-regulatory organizations such as Fixed Income Money Market Dealers Association, Association of Mutual Funds of India, Primary Dealers Association

Permit short selling in government securities, because it will help in refining the pricing mechanism for corporate bonds and help investors hedge their risks effectively.


Remove differential tax treatment between different classes of corporate bonds.

Ministry of Finance, Central Board of Direct Taxes

A plan for action

To put these recommendations into action, it is useful to distinguish measures that can be implemented first and begin to yield benefits immediately from more complex measures that would require implementation over a longer term.

First steps

In the immediate term, reforms relating to the key supply and demand side issues identified in the note could be addressed. This would include:

Improving the primary issuance process, through streamlined disclosures and adoption of a shelf registration process for all corporate issuers, which will enable them to file one consolidated document for several offerings with the regulator.Relaxing investment guidelines for banks and key institutional investors such as pension funds, and insurers. Investment policies and regulatory guidelines for insurance companies, pension funds, mutual funds, banks, and other financial institutions need to be sufficiently flexible for these entities to choose an appropriate risk-return profile within fiduciary constraints. These could be modified based on a consultative

xiiiExecutive Summary

exercise with the market participants and their respective regulators.

Later priorities

The medium to longer-term reforms that require coordination among various regulatory agencies could include:

Improving market infrastructure. On secondary market reforms, improvement in credit and trade information should be a priority for the regulators and self-regulatory organizations. On secondary market infrastructure, while the debate on exchange-traded versus over-the-counter methods of trading is an important one, centralized order flow, reporting, and mitigation of settlement risks through appropriate clearing and settlement arrangements are more critical impediments that need to be addressed. Lessons can be learned from developed market experience with trade execution systems, trading venues, data dissemination, and settlement systems.

Encouraging a market for innovations and new products. This will enable institutional investors to invest in a wider range of instruments and for sub–investment grade corporations and infrastructure providers to access financing. Less regulation of qualified institutional buyers and the facilitation of a diverse institutional investor base are an important reforms that will help bring in risk capacity from overseas.

Adopting a regulatory framework that ensures investor protection and market integrity and contains systemic risk. Key elements of the required framework include the enforcement of recently amended bankruptcy laws that clearly define creditors’ rights and borrowers’ responsibilities, the promotion of adequate corporate governance practices, and timely and accurate public disclosure of information.

Improving existing regulatory practices. The corporate bond market should be put under the ambit of one regulator. Currently, perceived inconsistencies and conflicts between the Reserve Bank of India (RBI) and the Securities and Exchange Board of India

(SEBI) impede confidence in the market. In the medium term, the current practice of RBI’s being responsible for prudential regulationi for market participants in the government securities market should probably continue. In addition, RBI should continue to provide the market infrastructure for government securities trading,ii although the possibility of conflicts of interest should be minimized. In the longer term, these market infrastructure services for the government securities market should be gradually moved out of the Reserve Bank of India. With regard to regulating the market conduct of the government securities market, which covers the behavior of market participants and the overall integrity of the market, the option of moving to a unified regulation of the financial markets could be considered when the larger questions of financial regulatory architecture are resolved.

ConclusionThe list of reforms discussed above is not entirely new nor by any means complete. But the message does bear repeating. Corporate bond markets are important for financial stability as a buffer when other funding sources are affected. The development of a deep, liquid local corporate bond market in India at the longer end of the maturity spectrum could facilitate a competitive source of financing that allows access to a wide range of issuers. It would also benefit the country’s infrastructure investments by tapping into the growing pool of long term funds available with the gradually developing class of institutional investors.

Notesi Such as setting standards (capital requirements, etc.) and supervising

market participants (banks and primary dealers), given that the Reserve Bank of India is entrusted with a variety of functions, including being investment banker to government and formulating and implementing monetary policy, and that RBI needs to be sure that monetary policy is carried out through sound intermediaries (market participants).

ii Such as carrying out the auction system, trade matching system, recording of transactions, and settlement (through the Clearing Corporation of India, Ltd.) etc., as long as the conflict of interest with respect to RBI being a provider of services to the government securities market as well as a regulator of that market can be minimized through ensuring that these services are provided in a transparent manner and that information is available to all market participants uniformly.

1. Why does India need a Corporate Bond Market?

A well developed corporate bond market is essential for financial efficiency and stability and for overall economic growth. Corporate bond

markets form a crucial part of a diversified financial system that ensures efficient allocation of resources and financial diversification. A well-functioning bond market also helps to meet the need for financing, not only for AAA-rated corporations, but also for less well known, subinvestment grade corporations and infrastructure developers.

The size and depth of the debt marketNotwithstanding the sharp rise of stock market capitalization—from less than 33 percent of GDP in 2000 to about 85 percent in 2006—India’s financial sector has traditionally been dominated by banks and bank lending, which were at 37 percent of GDP in

late 2006. The corporate bond market, despite having reasonable financial depth (India’s financial assets were about 173 percent of GDP at the end of March 2005) comparable to or better than many other economies at similar income levels, attained a level of only 5 percent of GDP and trailed many other emerging markets (table 1.1).1 A comparison of the size and composition of the domestic debt market in India with select emerging market countries puts India ahead only of Mexico in the size of its corporate bond market (figure 1.1). Government remains the dominant issuer in India with outstanding government securities reaching 34 percent of GDP in 2004.

Patterns in emerging market countries

When many emerging markets suffered a sudden outflow of capital in the late 1990s, one painful lesson was that their financial systems had relied too heavily

Table 1.1 Financial depth and share of corporate bond market in India and selected emerging market countries, 2004

Country Corporate bond marketa Government securities Bank credit Stock market capitalization

U.S. dollars (billions)

Percentage of GDP


Percentage of GDP


Percentage of GDP


Percentage of GDP

India 37.2b 5.3 235.0 33.8 253.4 36.5 387.9 55.8China 195.9 10.1 287.4 14.9 2318.0 120.0 639.8 33.1Korea 396.7 58.4 171.6 25.2 605.8 89.1 428.6 63.1Malaysia 61.4 51.9 45.2 38.2 123.3 104.2 190.0 160.6Thailand 28.7 17.8 36.2 22.4 123.3 76.3 115.1 71.2Brazil 75.7 12.5 295.9 49.0 166.6 27.6 330.3 54.7Chile 21.9 23.0 20.0 21.0 57.9 60.9 117.1 123.2Mexico 23.8 3.5 153.1 22.5 97.2 14.3 171.9 25.3a. Includes financial institutions and corporate issuers. b. Includes commercial paper issuance and longer term bond issuance.

Source: Bank for International Settlements, International Monetary Fund, Merrill Lynch, and World Bank staff estimates.

on bank lending and paid little attention to developing other forms of finance. Since the financial crisis in East Asia in the late 1990s, it has often been argued that, if corporations in Indonesia and Korea had relied more on the domestic corporate bond markets and less on bank financing, the magnitude of the losses from the banking and financial crisis would have been less severe. The corporate bond market provides an alternative funding source for corporations which could act as a buffer in the face of sudden interruptions in bank credit or international capital flows. Policymakers in East Asia have started to pay more attention to developing local bond markets.

In emerging markets, local bond markets are gradually becoming an alternative source of funding for both governments and corporations. The authorities’ efforts to develop local bond markets, combined with the corporate sector’s efforts to diversify away from refinancing and foreign exchange risks, have contributed to an expansion in local corporate bond markets (with the exception perhaps of countries in Central Europe). In Asia and Latin America, the pull-back in bank credit during the crisis years has also contributed to the increase in corporate bond issuance. In Asia, the dearth of bank financing, as well as the need to restructure balance sheets, has provided an additional impetus for corporate debt issuance.2 In Latin America, the rapid growth of local institutional investors, together with large refinancing needs of the corporate sector in a difficult external environment, have driven increased corporate bond issuance.

In particular, corporate bonds have become a relevant source of funding, accounting for more than 30 percent of total corporate debt in Korea and Malaysia because of the important structural changes implemented after the financial crisis in 1997. In Korea, the government raised the ceiling on corporate bond issuance from two to four times equity capital and eliminated restrictions on investment in domestic bonds by foreign investors. Malaysia’s corporate bond market has grown steadily due to efforts to streamline the bond issuance process, encourage secondary bond market activities, and relax insurance companies’ portfolio limits. The growth of corporate bonds in Mexico is more recent, with the

development of a government bond yield curve that facilitated the pricing of corporate bonds and changes in the bond contracts, together with the growth of private pension funds and other institutional investors (insurance companies and mutual funds). These efforts have resulted in the growth of corporate bonds as a source of corporate finance.

Structural reforms carried out by authorities in various emerging market countries have also facilitated the development of the corporate bond market. These included establishing rating agencies and benchmark yield curves, permitting issuance of unsecured bonds, and liberalizing market eligibility standards. Reforms and policy initiatives to improve the bond market infrastructure have strengthened trading platforms, clearing and settlement systems, and the regulatory environment.

Patterns in mature market countries

Development patterns have differed among countries with mature corporate bond markets. The corporate bond market in the United States has been an important source of funds for the private sector for a long time. The outstanding nonfinancial corporate debt securities in the United States amounted to $32 billion (55 percent of GDP) in 1932 and have increased steadily to about $2 trillion (22 percent of GDP) in 2003. In contrast, Canada, Japan, and most European countries have seen their corporate debt markets develop only in more recent decades. Corporate bond markets in most other advanced economies were virtually nonexistent in 1980. Until the late 1990s, the corporate bond market in some European countries, including Germany, remained insignificant compared with other sources of corporate financing.

Institutional structure has played an important role in the differences in corporate bond market development in these mature market countries. The relative insignificance of the corporate bond market in Europe was mirrored by the corresponding dominance of the banking sector. In contrast, in the United States banks play a very small role in financing large companies and face strong competition from the corporate bond market even for medium-size companies. In Canada, loan financing by nonfinancial

Corporate Bond Market Report2

corporations has declined since the early 1980s as bond and equity financing increased. This new trend coincides with the major Canadian banks’ expansion into the brokerage and investment banking business in the 1980s after legislative changes (Calmès 2004).

The importance of a corporate bond market Finance is a crucial ingredient for economic growth.3 The reforms of the 1990s in India helped accelerate economic growth, pushing gross domestic product up by 5.9 percent in the 1990s, versus 5.6 percent in the 1980s. This section explores the relative importance and efficacy of different sources of financing, the change in financing patterns over time, and the performance of financial intermediaries.

India’s model of industrial financing

Traditionally, countries have adopted either a bank-based financing model or a market-based financing model. In the former model the corporation interacts with the bank, whereas in the latter, it approaches the “public” for finance. However, the distinction between the two models is increasingly becoming blurred, with an increase in universal banking and conglomeration.

Now financial intermediaries offer a range of financial services, such as banking, insurance, and securities trading under one roof.

The model of industrial financing in India has evolved from one based on banks and development finance institutions to one based on a competitive financial sector, following the economic and financial sector reforms in 1991. By design, the prereform financing model was a state-led initiative that emphasized building a financial system with a widespread banking network, not only in terms of the geographical spread and socioeconomic reach, but also in the functional sense, through development finance institutions (DFIs) (Mohan 2004b). In this model of financing, banks catered to short-term working capital and DFIs catered to medium- to longer-term funds for the corporate sector. Since banks had access to low-cost deposits, DFIs were provided concessional sources of finance through government guarantees on their bonds and special access to concessional funds from the Reserve Bank. Corporations could supplement financing from these sources by tapping the capital markets, but the corporations’ access to those markets was restricted through elaborate approval processes, interest rate controls, and limits on the amount of leverage (the debt-equity ratio) that corporations could undertake (Patil 2002).

Figure 1.1 Size and composition of outstanding domestic debt markets in selected emerging developing countries, 2004

Source: International Monetary Fund, Bank for International Settlements, and World Bank staff estimates.

0

20

40

60

0 10 20 30 40 50 60

Government securities as a percentage of GDP

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onds

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DP Korea

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IndiaMexico

�Why does India need a corporate bond market?

The evolution of the corporate financing strategy over the 1980s and 1990s has been influenced by the fiscal position of the government. As fiscal deficits grew, the financial system began to be geared to funding the government’s budgetary needs, thus limiting the ability of the financial system to allocate resources efficiently.4 The financial sector reforms of the 1990s sought to reduce the role of the government in the allocation of resources by creating a competitive financial sector. The key features of the postreform model included dismantling the administered structure of interest rates; gradually withdrawing restrictions on the assets and liabilities of banks and nonbanking financial institutions, enabling them to build their portfolio across instruments of varying risk and tenor; and gradually withdrawing concessional funding to DFIs (Mohan 2004b).

India’s sources of corporate finance

This section looks at the financing pattern for the corporate sector over a period spanning the two models of industrial financing (1970–2005)5. In most developed countries, retentions or internal resources constitute

the most important source of funds for corporations, followed by bank financing6. Corporations in developing countries, in contrast, rely on external finance to a larger extent. For Indian corporations, external finance came largely from the DFIs before 1985 (figure 1.2).

Other sources of external finance, such as equity issues, were negligible until the mid 1980s. The capital markets gained importance in the later half of the 1980s and peaked in the mid-1990s. Both equity and debenture issues thrived during 1985–95 as sources of funds for public and private corporations because of the reforms in the primary issuance pricing controls. However, since 1995, there has been a decline in equity funding and a diversion of corporate debentures to the private placement market, reflecting a decline in the importance of capital markets. In fact, nongovernmental nonfinancial companies have been increasingly relying on internal sources since 1997––and external financing has fallen (figure 1.3). The recent shift to internal resources in Indian corporate funding, however, appears to be a short-term phenomenon arising from the recent poor performance of primary markets7.

Figure 1.2 Resource mobilization by the Indian corporate sector, 1970–75 to 1990–95

* Includes only disbursements by the three principal DFIs: ICICI, IDBI, and IFCI.

Source: Reserve Bank of India and IDBI.

0

100

200

300

400

500

600

700

1970-75 1975-80 1980-85 1985-90 1990-95

Time period

Rs

billi

on

DFI Assistance* Private Equity Issues Debenture Issues

PSU Bonds IssuePSU disinvestment


Equity, as a source of funding for nongovernmental nonfinancial public companies, went up from 3.9 percent of funds from all sources (internal and external) in 1984–85 to a peak of 29.6 percent in 1993–94, but since then it has been declining. Over the past ten years it has been hovering around 10 percent. An analysis of the capital structure of listed companies between 1988 and 2004 indicates that debt financing has grown in parallel with the equity market. Except for a couple of short patches in the mid- and late 1990s, banks and financial institutions have constituted a steady source of funds, contributing roughly 20–25 percent of the funding requirements of nonfinancial companies in the private sector (figure 1.3).

Investments by banks and financial institutions, which represented 2.1 percent of GDP (at current prices) in the

1970s, represented 4 percent of GDP from 1997–98 to 2001–02. In contrast, investments by capital markets, which increased from 0.1 percent of GDP in the 1970s to a high of 1.9 percent of GDP from 1992–93 to 1996–97, fell close to the level of the 1970s between 1997–98 and 2001–02.

Sectoral financing. The pattern of sectoral financing does not suggest that any Indian industry has been starved of bank credit (Mohan 2004a), with the overall nonfood gross bank credit increasing from 19.9 percent of GDP in the 1980s to 21.6 percent from 1997–98 to 2001–02. There is no indication from the sectoral numbers of a lack of bank finance. For example, within individual sectors, the industrial credit as a percentage of the manufacturing GDP registered an increase from 65.6 percent in the 1980s to 71.9 percent in the period from 1997–98 to 2001–02.

Figure 1.3 Sources of funds for Indian corporations, 1985–2002

Source: Reserve Bank of India.

01020304050607080

1984 1987 1990 1993 1996 1999 2002

Time period

Tot

al E

xter

nal S

ourc

es

01020304050607080

1984 1987 1990 1993 1996 1999 2002

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Equ

ity

-100

1020304050607080

1984 1987 1990 1993 1996 1999 2002Time Period

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entu

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-100

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1984 1987 1990 1993 1996 1999 2002Time period

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-100

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1984 1987 1990 1993 1996 1999 2002

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Fina

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Debt and equity. The database of the Center for Monitoring the Indian Economy indicates the relative contribution of debt and equity financing to companies (listed and unlisted) in selected industrial sectors, as measured through their debt-equity ratios (equity at book value) from 1988–2004. There seems to have been some shift away from debt and toward equity in some sectors, particularly financial services and construction. In the manufacturing sector, the average debt-equity ratio declined modestly between 1992 and1997, but this trend reversed after 1997. However, at market value, the manufacturing sector debt-equity ratio declined substantially after 2001 (figure 1.4).

The broad trends of industrial financing in India can be characterized as follows:

Banks remain a major source of funds through both conventional credit and investments (commercial paper, corporate bonds, and, to a limited extent, equity), although the nature of these institutions has changed radically since the 1990s because of the pressures of liberalization and deregulation of interest rates.

Financing from development financial institutions has fallen.The rise of equity as a significant source of finance for the industrial sector was confined to the period 1985–95. Corporate debentures grew during this period (except for 1993–95), and even as equity finance declined in the subsequent years, debt issues thrived through the vehicle of private placement.

Pressures for changeMany pressures are pushing India toward long-term financing through a corporate bond market. These include the growth of a changing, competitive financial sector; the new legislation affecting the debt market; the new opportunities for financing overseas; and the huge infrastructure financing needs.

A changing, competitive financial sector

The earlier section showed that the gradual shrinkage of development financial institutions and the gap created for long-term financing were the most serious issues in

Figure 1.4 Debt-equity ratios by sector, 1988–2004

Source: Center for Monitoring the Indian Economy.

Deb

t Equ

ity R

atio

Mining

0. 00

0. 50

1. 00

1. 50

2. 00

2. 50

3. 00

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4. 00

4. 50

Year

1988

1990

1992

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1996

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FFinancial servicesConstruction ManufacturingElectricity

Corporate Bond Market Report�

the flow of resources to industry. The downscaling of operations of DFIs, together with the sluggishness of capital markets in recent years (between 2001 and 2004), has created a gap at the longer end of the institutional financing spectrum. There is a limit to the role of banks at the longer end because of the mismatch of assets and liabilities on their balance sheets.8 It is expected that a large fiscal deficit will continue in the near future, which will constrain banks from extending longer-term credit to infrastructure, industry, agriculture and other productive sectors (Mohan 2004a). A more detailed analysis of the issues arising from a competitive financial sector and growth of institutional investors is provided in chapter 2.

New legislation affecting the debt market

Over the past two decades, sustained budget deficits required the Indian government to make large issuances of government securities. The government, through the passage of the Fiscal Responsibility and Budget Management Act, is aiming for fiscal consolidation, which is intended to bring the fiscal deficit down to 3 percent of GDP and the revenue deficit to zero. The achievement of these targets can be expected to lead to a significant decline in the share of government securities in the total assets of the financial system. However, after accounting for inflation and expected real GDP growth, the absolute level of net issuance of government securities may not fall much. The Indian market has been used to rising fiscal deficits and large borrowing programs from the government over the years. So it is expected that an active issuance of government paper will continue in the foreseeable future. Banks especially have been investing in government securities much more than the statutory requirements. However, as the fiscal consolidation process proceeds, resources with financial institutions of different kinds will increasingly become available for investment in corporate debt for financing productive activities (Mohan, R.,2004c).

New opportunities for financing overseas

A company that wants to finance an expensive investment would ideally want to borrow long term in

local currency. However, asset-liability mismatches and the seeming preference of banks to take interest rate risk rather than credit risk9 imply that banks frequently offer only short-term loans. While loans of longer maturities may be obtained abroad, such loans are likely to be in foreign money. An active local corporate bond market would allow firms to issue debt securities that are a better match for the timing and currency of their cash flows.

Overseas offerings by Indian corporations through equity and debt instruments have been rising since the liberalization of the Indian economy in 1991. Equity issuances have more or less been stable. Debt issuances by Indian corporations have been more opportunistic to take advantage of low global interest rates. Spreads on emerging market bonds narrowed to historic lows in early 2005 in part because of excess global liquidity. This led global investors, particularly pension funds and insurance companies, to invest in emerging market bonds (figure 1.5).

Within the category of debt issuances, corporations are increasingly using foreign currency convertible bonds (FCCBs).10 The total FCCB issuance from 1999 to 2004 was only US $603.1 million. In 2004–05 and the first eight months of the financial year 2005–06 (April 2005 until


Figure 1.5 Overseas issuance of equity and debt by Indian corporations, 1992–93 to2005–2006

Source: Prime Database.

0

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1990-91 1993-94 1996-97 1999-00 2002-03 2005-06

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November 2005) the issuance has been about $3 billion and $1.9 billion, respectively. In comparison, domestic debt issuance by Indian corporations through the public issuance route constituted $0.9 billion in 2004–05 and no issuance had taken place until December 2005. Most of this FCCB issuance was by manufacturing (mainly the steel and automobile industries) and infrastructure companies (mainly telecommunications). Many lower-rated corporations have also raised money through FCCBs. Overall, even though a wider range of issuers have accessed the domestic market in recent years, it appears that offshore markets have a greater capacity to finance lower-rated credits.

While the reliance of Indian corporations on long-term foreign financing through the issuance of American depository receipts, global depository receipts, and foreign currency convertible bonds has been increasing, it constitutes only 2 percent of the total flow of resources to Indian industry in 2004–05. In contrast, external commercial borrowings by corporations have increased significantly in the past three years and constituted 20 percent of the total flow of resources to Indian industry in 2004–05 (RBI Annual Report 2005). This analysis remains incomplete, however, without examining in greater detail the risks that could arise from increasing external borrowing in an environment of hardening interest rates. Another aspect that needs to be examined from the demand side (the corporations’ side) in greater detail is some quantification of cost of borrowing for the corporate sector in the absence of a corporate bond market.

Huge infrastructure financing needs

With its present state of physical infrastructure, India will find it difficult to sustain an annual GDP growth of over 7 percent over the medium term. There is a massive and urgent need to increase investment in power, roads, ports, airports, railways, urban facilities, and rural infrastructure.

Calculations on financing gaps show that finance will become an ever more important constraint for Indian infrastructure over the medium term. According to the estimates of funding given for the tenth and the eleventh

Five-year Plans, government finance—consisting of gross budgetary support to the central plan, allocations to the states, and internal and extra-budgetary resources of central state-owned enterprises—amounts to roughly Rs. 13,601 billion for the main six infrastructure sectors11 over the period 2001–02 to 2010–11. This, of course, assumes that the government will be able to undertake fiscal adjustment. Even with adjustment, India would still face a staggering financing gap of over Rs. 5,500 billion for the decade ending 2010–11. This is a huge difference between what the country needs and what the government can pay. Success in attracting private funding to help meet this gap will depend on India’s ability to put in place regimes, systems, and practices that consistently encourage private investment and public-private partnerships in infrastructure. This would include a well-developed financial system that can provide access to long-term debt funding.

As infrastructure policy and regulatory frameworks emerge and reforms advance, a better developed financial system, in particular a domestic corporate bond market, can accelerate access to finance by infrastructure projects. A less developed financial system is likely to slow down reform in infrastructure since it cannot respond as quickly to changing financial requirements, especially for long-term resources.

ConclusionThe changing environment that arises from India’s economic and financial growth will place significant financing demands on the Indian financial system. Thus, all the segments of the financial system (banking, equity markets, and debt markets), and in particular the long-term domestic corporate bond market, will need to expand their current roles.

The strategic orientation of this note is the development of the domestic corporate bond market as a key component of the overall financial development in India, creating a viable financing vehicle for a wide range of borrowers, including nongovernmental companies. A priority in this context is to establish a deeper, broader, and more efficient corporate bond market that provides a competitive source of financing across a wide range of tenors and access to a

Corporate Bond Market Report�

wide range of issuers. The development of a deep, liquid local corporate bond market in India at the longer end of the maturity spectrum could facilitate the country’s infrastructure investments by tapping into the growing pool of long-term funds that would be available with the gradually developing class of institutional investors (private insurance companies, provident funds, and the prospective private pension funds).

Several preconditions for the development of a corporate bond market are slowly falling into place. Government bond markets have developed substantially, although a few issues still need to be addressed to have a better functioning government bond market. Annex 2 provides an overview of some of the issues. The progress of reform has been much slower in the corporate bond market. In general, the development of local corporate bond markets has been constrained by the lack of a meaningful investor base with developed credit assessment skills, the high costs of local public issuance, and the lack of liquidity in secondary markets. These constraints are explored in greater detail in the following chapters.

Notes1 Financial depth is measured as the sum of financial assets held by

banks, financial institutions, and insurance companies; the amount of outstanding corporate and government bonds; and the capitalization of the stock market as a ratio to GDP.

2 The drivers for development of corporate bond markets in Asia (the dearth of bank financing, as well as the need to restructure balance sheets) are present in India as well, and yet the corporate bond markets have not witnessed similar growth. The note explores these issues in detail in the later sections.

3 The framework for analysis in this section draws on Mohan 2004a. 4 The reasons for this inefficiency are well documented and include the

combination of an administered interest rate regime and directed credit preventing proper pricing of resources, among other things (Mohan 2004a).

5 Based on India: Role of Institutional Investors in the Corporate Governance of their Portfolio Companies (World Bank 2005).

6 Mayer (1988, 1989, 1990), Corbett and Jenkinson (1994) in Pal, Partapratim, “Stock market development and its impact on the financing pattern of the Indian corporate sector, Research Paper, NSE, 2001.

7 Following a series of scams and price-rigging incidents in the stock markets during the early to mid-1990s, the Securities and Exchange Board of India in 1996 instituted strict entry and disclosure norms for companies accessing the capital markets. This may also have caused a decline in the number of issues and the amount raised in the primary market (Handbook of Statistics on the Indian Securities Market, SEBI, 2004).

8 The inherent difficulty for a bank to provide long-term funding stems from the fact that the deposit liabilities of the bank tend to be of relatively shorter maturity, which could then result in asset-liability mismatches.

9 On the assets side, banks hold large volumes of long-term government paper in tradable form, well in excess of the statutory requirement of 25 percent.

10 FCCBs are bonds denominated in a foreign currency (usually U.S. dollars) that, in addition to offering a return or yield, also offers investors the option of converting their principal investment into equity at a pre-decided price. The price is decided when the instrument is issued.

11 These comprise roads, power, telecommunications, railways, airports, and ports.


2. What is holding back supply and demand?

Demand and supply issues have fueled the growth of corporate bond markets in many countries. In some countries, such as Chile,

the growth of institutional investors fueled demand for corporate debt securities. In some others, the collapse of other sources of funding led to a rise in the issuance of corporate bonds. This chapter analyzes the sources of supply of corporate bonds and gives an overview of the size and nature of the demand for them, as well as the impediments to greater participation of investors in corporate bond markets in India.

The supply of corporate bonds The principal issues on the supply side are the dominance of government-owned entities as the primary issuers of bonds and the absence of high-yield issuances in the current market.

Government dominance in primary issuance

About 80 percent of the primary issuance in the bond market is by public sector entities (financial and nonfinancial). Most of this issuance is raised through the private placement market (table 2.1). In 2005–06 the private placement market witnessed over a 1,000 deals raising Rs 963 billion. On the other hand, the public bond issuance market was very limited with only two issuances in 2005–06 raising Rs 2.45 billion. Interestingly the private placement market has attracted greater number of public sector issuers over the last five years. The top 25 issuers contributed to 67 percent of the private placement market in 2005–06, of which two-thirds were public sector issuers. The largest debt issuers within the public and private sector are financial institutions rather than manufacturing companies. Annex 3 offers a snapshot

of the various issuers, instruments offered, and details on the largest issuers in the corporate bond market in 2005–06. Only two amongst the top 25 issuers are nonfinancial institutions, the Food Corporation of India and Indian Oil Corporation, which are state-owned. This is not a recent trend––a similar pattern of issuance was prevalent even in 1995–96. Amongst the financial institutions issuance by banks in the primary market is on the rise mainly to raise Tier II capital to fulfill capital adequacy requirements.1

Although there is no single reliable number, the total outstanding privately placed debt was approximately $43.7 billion, which is ten times the publicly issued debt (McKinsey 2006). The lack of comprehensive data relating to the debt on issue and the outstanding stock of debt for corporate issuers is a serious handicap in the Indian market today. While data on public issuances by corporations is available, most of the corporate bond issuance over the last few years has been through the private placement market, which has had very little oversight and reporting requirements by issuers and arrangers until about a year ago. Now that the reporting of debt on issue by listed companies has been somewhat streamlined, it is expected to improve gradually. However, data on outstanding debt is still very hard to compile, as there is no comprehensive repository of information to track debt issuance by companies through its entire life cycle—that is, from issuance until redemption.

Unlike equity, where large primary issues have moved to a book building process on the exchanges, most bond issuances today have become part of the private placement market. A little over 90 percent of all issuances in the corporate bond market today are through private placement. This strong shift toward a largely privately placed bond market is simultaneously observed across

all sectors of current issuers and private companies or units. The move away from more transparent modes of issuance toward private placement might indicate high costs of a public issue. A detailed analysis of the costs of issuance is provided in chapter 3.

The nonexistent market for high-yield issuance

Most of the issuance in the corporate bond market in India is credit rated, and most of the issuance is rated AA+ or higher. Large Indian corporations with good credit rating are able to raise money in international markets (although this may expose them to currency risk) and domestic markets with relative ease. India has a vibrant equity market and the existence of a strong equity culture that places onerous market discipline demands (for disclosures and good corporate governance) on corporations of all credit qualities. Hence, the nonexistence of a market for high-yield issuance in India is surprising.

The absence of a market might indicate that lower rated corporations are not able to meet the required

corporate governance practices and timely and accurate public disclosure of financial information. In addition, concerns remain about the efficacy of bankruptcy laws, which clearly define creditors’ rights and borrowers’ responsibilities. (Legal and regulatory issues impinging on development of a vibrant bond market are examined in chapter 3.) However, in recent years, there has been an increase of bond issuances by Indian corporates overseas, particularly through the route of foreign currency convertible bonds (FCCBs) as described earlier, possibly indicating that the overseas markets have a greater risk bearing capacity for all types of Indian credit.

In India, the restriction on institutional buyers by their respective regulators of only investing in investment grade quality securities has led to the corporate bond market being skewed toward having only “investment grade” bonds. For example, table 2.2 shows that most of the issuance by public sector agencies in 2005 was with a credit rating of AA+ and above.

In the United States, for comparison, the market for “A” and higher rated credit is only 43 percent of total outstanding debt, and “AA” and higher is only 16


Table 2.1 Resources raised in the primary markets in India, 1995–2006 Year Public

equity issues (Rs. billions)

Bond issues (Rs. billions) Total resources mobilized

(Rs. billions)

Share (percent) ofprivate placement in

Share (percent)of bondsin total

Public issues

Private placements

Sum of bond issues (3+4)

(2+5) Bonds Total (5/6*100)(4/5*100) (4/6*100)

1 2 3 4 5 6 7 8 91995–96 88.8 29.4 100.3 129.8 218.6 77.3 45.9 59.41996–97 46.7 70.2 183.9 254.1 300.8 72.4 61.1 84.51997–98 11.3 19.3 309.8 329.1 340.5 94.1 91.0 96.71998–99 5.0 74.0 387.5 461.6 466.6 84.0 83.0 98.91999–2000 29.7 47.0 550.7 597.7 627.5 92.1 87.8 95.32000–01 24.8 41.3 524.6 566.0 590.7 92.7 88.8 95.82001–02 10.8 53.4 454.3 507.7 518.5 89.5 87.6 97.92002–03 10.3 46.9 484.2 531.2 541.6 91.2 89.4 98.12003–04 178.2 43.2 484.3 527.5 705.7 91.8 68.6 74.82004–05 214.3 41.0 553.8 594.8 809.1 93.1 68.5 73.52005–06 273.8 2.5 963.7 966.1 1240.0 99.7 77.7 77.9

Note: Private placements from 2000-01 onward are issues with maturity and optionality of at least a year. Private placements for earlier years include all issues irrespective of maturity or optionality.Source: Prime Database Ltd.

13What is holding back supply and demand?

percent (Merrill Lynch 2004). In Japan and the Euro area, as well as Britain, lower-rated credits, particularly sub–investment grade, constituted the fastest growing component of the market. One of the explanations for the low incidence of high-yield issuance in emerging market countries relates to the pattern of corporate development in these countries, which have seen relatively less reorganization and takeovers than in the United States (De Bondt and Marques-Ibanez 2004). In the United States, the spurt in the growth of high-yield issuance has been due to the corporate restructuring in the 1980s requiring large amounts of debt financing, which was aided by leveraged buy-outs (IMF 2005).

The drivers of demandThe principal issues on the demand side of the corporate bond market are the low retail participation despite high household financial savings and the recent rapid growth of assets under the management of institutional investors.

High household savings but low financial savings

Though India’s saving rate as a percent of GDP has been consistently higher than that of most other countries with comparable income, it has fallen short of the East Asian countries (India 28 percent; China 44 percent; Malaysia 43 percent; Korea 32 percent; Thailand 31 percent; and Indonesia 23 percent) (World Bank 2005b). In India while the household savings are high the level of financial savings are quite low with less than half of household savings invested in financial assets. The main financial instruments popular with the households are bank deposits, provident funds, insurance, income-oriented mutual funds, and postal savings schemes. Households are averse to directly investing in the markets and rarely play a significant role in the corporate bond market (table 2.3). This aversion is exacerbated in part by poor liquidity of fixed-income instruments in the secondary markets and in part by the high rates offered on small savings schemes and the perceived safety of these instruments compared with corporate bonds (Patil 2002).

Growth of assets with institutional investors

One of the drivers for demand of corporate debt is the rapid growth of assets under the management of institutional investors, which leads them to look for different avenues to invest. In Latin America, the growth of pension funds has been one such driver for increased demand for corporate debt. In India, while growth of assets under management of institutional investors is taking place, investors in the debt market are believed to be “too restrictive” or “homogenous”2 —that is, they mainly hold high-rated “safe” paper—which limits the investable universe of corporations to large companies with strong

Table 2.2 Credit ratings for bonds issued by public sector agencies in 2005

Rating AIFI INF PSUs SFIs SLUsNA 44 4 8 7NR 2 5 10AAA 71 1 4.9(SO)AA+ 29AA 7 3(SO) 1(SO)AA- 1(SO) 1,1(SO)A+ 3 1(SO)A 3 1 4.3(SO) 2(SO)A- 2 1 1(SO) 3(SO)BBB+ 2 2(SO) 1(SO)LAAA 4 1(SO)LAA+ 1LAA 2 2(SO)LA+ 1(SO)LA 1PR1+ 1 1PR1 1(SO)

Note: AIFI: All India Finance Institutions; INF: Infrastructure; PSUs: Public Sector Undertakings; SFIs: State Financial Institutions; SLUs: State Level Undertakings.Source: Prime Database Ltd.

Table 2.3 Retail participation in Indian debt markets, 2003–05

No. of trades Traded value(Rs. billions)

2003–04 1400 3.322004–05 1278 4.12005–06 892 3.1

Source: NSE Fact Book, 2006

credit fundamentals or government-guaranteed paper. This observation is supported in the earlier discussion of supply side trends, wherein issuance is largely dominated by public sector issuers and high-rated private corporate issuers. This implies that the buyer market is important as a target for reforms to develop the bond markets in India. In mature markets, the investor base for bonds is generally well-diversified, with banks, mutual funds, hedge funds, pension funds, and insurance companies providing a broad demand base for bonds. A diversified investor base with varied demand requirements, maturity profiles, and risk preference is important to ensure high liquidity and stable demand in the market.

The assets under management in India are still relatively small as a percentage of GDP. In Latin America growth of pension funds has been a big driver for the demand for corporate bonds (table 2.4). The small size of the pension funds could be explained in part by the delay in implementation of pension reforms, which would have brought in private sector pension funds with the flexibility to invest in a variety of instruments including corporate debt.3 While the mutual fund industry in India has grown rapidly over the past decade, it has to compete with attractive assured returns from government schemes. This is possibly the single most important impediment to growth of the industry in smaller towns and in attracting the longer-term individual investor (ADB 2003).

The obstacles to institutional investingThe rest of this chapter discusses the participation of various types of investors in the Indian corporate bond

market and the obstacles that impede their participation in the development of a deeper and broader corporate debt market.

Banks

Investment categories and their relative share to total investment of banks. Investments by banks comprise two broad categories: government and other approved securities (SLR investments); and commercial paper, shares, bonds, and debentures issued by the corporate sector and public sector undertakings (non-SLR investments). Investments in government securities and other approved securities amounted to a little over 30 percent of assets and 83 percent of total investments of banks at end-March 2005. According to regulation, banks have to invest 25 percent of their net demand and time liabilities in SLR investments. However, banks held as much as 38 percent of their net demand and time liabilities in government and other approved securities in 2004–05, as these are perceived as relatively high-return, low-risk assets. These securities have zero-risk weighting in calculations of regulatory capital adequacy ratios, which is a significant attraction for banks at a time when profitability remains low and banks are under pressure to raise these ratios (Basu 2005).

Despite significant preemption of investments to government securities, banks remain the largest investors in corporate bonds in India in value terms, with an investment of about Rs. 1,137 billion, accounting for about 13 percent of total investments of banks at end-March 2005 (table 2.5). This, however, could also be viewed as a consequence of the narrowness of the investor


Table 2. 4 Assets under management of local institutional investors in India and selected emerging market countries, 2004

(as a percentage of GDP)Type of institutional investor Indiaa Chile Mexico ThailandPension fundsb 2 61 42 14Mutual funds 5.5 13 35 13Insurance companies 12 20 20 12Total assets under management of institutional investors 20 91 16 23a. Figures pertain to end-March 2004 except for pension funds where latest numbers are for 2003.b. Figures pertain only to the corpus of the Employee Provident Fund, as data on other exempt provident funds is not publicly available.

Source: International Monetary Fund, World Bank staff estimates.


base in the market and the still early development of institutional investors in India, as discussed subsequently in this section. In the case of banks, apart from the general risk aversion, certain regulations impede greater participation in secondary corporate bond markets.

Regulatory differences between bonds and government debt securities and between bonds and bank loans. Indian banks prefer to give loans to corporations than to invest in debt securities. This is partly due to the current accounting norms and partly due to regulatory requirements on corporate bond investments. When bonds (government as well as corporate) form a significant proportion of banks’ balance sheets, as in India, the question of their valuation becomes significant. With financial systems becoming largely market-based, there have been increasing requirements for bonds to be marked to market value, making their apparent worth more volatile. In India, the same bond may be marked to market4 if regarded as part of a trading portfolio but valued at cost if held as a long-term investment (and many banks often hold bonds to maturity). While corporate bonds are required to be marked to market, a preferential treatment for government securities allows banks to exceed the 25 percent limit under the Held to Maturity (HTM) category, provided that the excess comprises only SLR securities. As interest rates rose in the early part of last year and banks faced losses due to large holdings of government securities in their

portfolio, banks were allowed to shift SLR securities to the HTM category, and no fresh non-SLR securities were permitted to be included in the HTM category during the year 2004–05.

In addition to the differences in regulatory treatment between government securities and corporate bonds, the capital requirement and market valuation norms are not symmetrically applied to loans made to corporations. Some banks believe that the requirement to adopt an internal rating system before investing in bonds issued through private placement is a deterrent—the procedures are time-consuming and involve a lot of approvals and technicalities. Thus, banks prefer to finance corporations’ requirements through loans, since direct lending has less stringent procedures and capital requirements. Moreover, a bank has full control in setting the terms of a loan to a corporation, whereas a bond is a more standardized commodity over which the bank has less control. Another issue that skews the incentive in favor of loans is the credit quality of the corporate that is financed. A bank is required to invest only in bonds that are of investment grade quality, while loans can be made (and regularly are made) to corporations of varying credit quality.

The Reserve Bank of India’s recent guidelines restrict banks’ investment in unlisted non-SLR securities to 10 percent and require minimum investment grade

Table 2.5 Investments of scheduled commercial banks, 1997–2006(Rs. billions)Type of investment Mar-06 Mar-05 Mar-04 Mar-03 Mar-02 Mar-97SLR investments of scheduled commercial banksGovernment securities 6,919.46 6,840.05 6,391.43 5,362.14 4,317.53 1,588.90Other approved securities 139.48 162. 91 181.00 192.81 217.53 316.24Total 7,058.94 7,002.96 6,572.43 5,554.95 4,535.06 1,905.14Non-SLR investments of scheduled commercial banksShares and mutual fund investments 229.32 260.49 215.04 165.23 59.14 12.52Commercial paper 41.66 38.91 37.70 40.07 84.97 6.85Bonds/debentures 1,054.52 1,136.95 1,123.70 1,131.69 665.89 166.31Others 0.00 66.33 51.18 45.70 0.00 0.00Total 1,325.50 1,436.35 1,376.44 1,336.99 810.00 185.68Memo: Conventional bank credit 15,070.77 11,004.28 8,407.85 7,078.56 5,897.23 nana: not availableSource: Reserve Bank of India; Trends and Progress of Banking in India, various issues

rating. This prevents banks from investing in bonds of lower-rated corporations (infrastructure companies are typically lower-rated corporations). This also applies to loans to state governments and to state-level enterprises. Until recently, all state government bonds were issued as a basket with sovereign credit rating. However, state-level enterprises that had the same credit quality as the state government had bonds that reflected the “actual” rating of the state government. If this rating was not of investment grade quality, then the bank could not invest in the bond. This led to situations where the bank held bonds of the state government, but not bonds of enterprises of the same state government. Therefore, while banks stand ready to make loans to corporations, they keep away from active participation in the corporate debt market. The distortions between treatment of bonds and loans caused by the regulatory regime are summarized in table 2.6.

Lack of incentives to trade in the market. One of the most interesting issues in the lack of development of the corporate bond market in India is the inability to separate interest rate risk from credit risk, thereby limiting the pool of investors. Even before the advent of interest rate swaps in the developed markets, one of the main ways that banks would participate in the bond market was through floating rate notes. Floating rate notes for the

bank market require an interbank index, which does not exist in India. To have an active interbank market, one needs to have heterogeneity among banks, which only partially exists in India (heterogeneity would allow some banks to focus on raising deposits and others on arranging financings, which are then syndicated). Another reason why an interbank market does not exist is because banks mainly lend to the government, and so “retail” banks have no need to lend to “money center” banks or through bonds.

Insurance companies

The advent of private insurance companies. Before 2000, India’s life insurance industry was a public sector monopoly. Life insurance was monopolized by the Life Insurance Company of India (LIC). General insurance was monopolized by the General Insurance Company of India (GIC) which was split into four subsidiaries in 2000 that were delinked from GIC, while GIC was converted into a reinsurance company. Since liberalization of entry in 2000, 13 private life insurers (10 of which have foreign participation) and 9 private general life insurers (5 of which have foreign participation) have entered the market. The Life Insurance Corporation of India is still the dominant (nearly monopolistic) entity in the Indian insurance


Table 2.6 Distortions between the treatment of bonds and loans in bank regulationsRegulation Bonds LoansMinimum rating criteria External credit rating required. Minimum investment

grade.None.

Limits on holdings Cannot invest in unrated securities. Limit on holding of unlisted securities (10 percent of the portfolio).

None.

Accounting treatment Marked to market if in Held-for-Trading and Available-for-Sale category. Hold-to-Maturity category (HTM) does not require mark to market. However, banks are now prohibited from adding fresh investments in corporate bonds in HTM category.

Accrual basis-essentially similar to HTM category for corporate bonds.

Loan loss provisioning In case of a 90-day overdue for interest or principal, it is to be classified as a nonperforming investment (NPI). Provisioning for NPI similar to provisioning for nonperforming assets. This is in addition to marked-to-market loss as per market rates.

Detailed norms for recognition of asset as nonperforming. Provisioning guidelines as per the category of asset, that is, sub-standard, doubtful, and loss.

Capital requirement Capital for market risk on investments as per RBI prescribed methodology. In addition capital is to be provided for on a risk weighted assets basis.

Capital provision on risk-weighted assets.


sector, with a little over 95 percent of the gross premium underwritten in the life insurance business.

Restrictive investment guidelines. All over the world, insurance companies are among the largest participants in the corporate bond market. Insurance companies in Chile, Mexico, and Peru, for instance, hold around 50, 28, and 15 percent of outstanding corporate bonds, respectively (International Monetary Fund 2005). In contrast, Indian insurance investment still largely adheres to rigid rules of investment set by regulation. The total investment portfolio of insurance companies in India was about Rs. 3,869 billion at the end of March 2004. Of this amount, about 57 percent was invested in government and other approved securities, in excess of the prescribed 50 percent by the investment guidelines issued by the Insurance Regulatory and Development Authority. For life insurance companies, out of the total 35 percent that is earmarked for investments based on exposure and prudential norms, investments in “approved” securities are capped at 20 percent. The remaining 15 percent is the category called “other than approved investments,” which typically includes private sector bonds and equity investments. The approved investment category is biased toward investments in bonds of state-owned financial institutions and highly liquid treasury bills. For non-life insurers, the limit on “other than approved investments” is capped at 25 percent (see annex 4).

The actual investment by life insurance companies in “other than approved” securities, which typically include corporate bonds and debentures, was only about 5 percent in 2004 (figure 2.1). For non-life companies this category of investments reached only about 12 percent against the allowed 25 percent.

A large number of investments by life insurance companies are in the form of long-dated loans to industrial estates and development institutions or cooperatives in India. Most of the nongovernment securities investments by insurance companies are made in bonds issued by state-owned specialized financial institutions, such as the National Thermal Power Corporation or the Power Finance Corporation (which have a AAA rating), or in the housing finance sector. The

low level of “other than approved” investments and the preference for government-owned institutions together indicate the low risk-taking outlook of the insurance companies. The guidelines also lay down a minimum credit rating of “AA” for investments in debt paper. This automatically excludes investment by insurance companies in debt paper of private infrastructure sponsors and other lower-rated companies.

Recently, some flexibility for investments by insurance fund managers has been allowed, particularly as applied to the rule of “buy and hold.”5 Earlier regulation was biased in favor of the “buy and hold” principle. As a result, fund managers were not able to get out of holding bonds, even where the entity was clearly headed toward bankruptcy. This encouraged fund managers to stay away from making investments in most corporate debt, other than those that had the guarantee of either the central or state government. More recently, insurance companies have been more active in buying corporate bonds. However, these are still done within the constraints of the bonds being rated as investment grade.

Pension and provident funds

Until 2004, the mandatory pension system mainly consisted of an essentially pay-as-you-go system for federal and state governments and Employees’ Provident

Figure 2.1 Investments of life insurance companies, 2004

59%

11%

25%

5%

Investment in Gsecand other securities

Infra and social sectorsInvestment subjectto exposure norms

other than approvedinvestments

Funds for other formal sector employees, with about 21 million contributors and over 4 percent of GDP in assets. The central pension and provident funds invest almost wholly in debt of federal or state governments or public sector enterprises.

To correct issues related to the fiscal cost of government pensions, the unattractiveness of the Provident Fund programs, the limited contribution of the formal pension schemes to capital market growth, and the lack of pension coverage outside the formal sector workers, the Government decided to set a legal framework for private, defined-contribution, pension schemes for new government employees and other contributors.

Currently, reforms in the pension sector have been stalled due to political opposition to moving to a defined contribution scheme and investing in the stock markets. Contributions made by the new central government recruits (who joined after 2004) are being managed through an interim arrangement

within the MoF which invests only in government securities. But when the Pension Fund Regulation and Development Authority (PFRDA) is established to regulate the New Pensions Scheme contributors, the design of pension fund management under the proposed defined contribution scheme will include a centralized administrative structure alongside competitive fund management.6 Pension fund managers will be constituted as specialized institutions that hold assets and provide services on a fee basis, an approach that will help distinguish their activities from the parent entity or sponsor, better controlling potential conflicts of interest and facilitating regulation and supervision.

Thus the pension market in India is still effectively under government control. While private provident funds are allowed, the returns are regulated as the provident funds have to strictly adhere to the investment guidelines prescribed by government. Penetration of pension funds is very low and covers only about 12 percent


Box 2.1 International experience on regulating investments by pension funds

Many countries still maintain tight regulation over asset allocations by institutional investors to prevent excessive risk taking, but this may be a double-edged sword. In Mexico, factors such as the restrictions and limits placed on pension funds (which sometimes require a corporation to be rated specifically by Standard and Poor’s in order to be investable), the lack of high-quality corporations (only about ten local “blue chips” are considered investable), the risk aversion of local investors, and the shortage of interested players have hindered liquidity in the secondary corporate debt market. As a result, the general portfolio composition in the pension industry currently consists of around 85 percent of investments in federal government bonds. That said, states and municipalities, which were previously reliant on development banks for financing, have also been active in the local bond market. This has added breadth to the market and improved the transparency of operations, improving the credibility of, and interest in, these securities.

In Brazil, tight regulatory requirements have prevented investors other than local buy-and-hold pension and mutual funds from participating actively in the market, limiting demand for corporate issues. In Chile and other markets, regulatory restrictions that prevent banks from doing repurchases with corporate bonds also represent an obstacle for the development of a liquid secondary market. The corporate bond market in Colombia remains very small, partly because of the lack of demand for lower-rated debt from pension funds. Although pension funds in Colombia are, in theory, able to invest in securities rated A-minus or above, in practice, they tend to require a AAA rating, especially for big issues. As a result, local corporations that are not AAA-rated have been reluctant to issue new securities locally. In Malaysia, life insurance companies, which are important players in fixed-income markets, cannot invest more than 15 percent of their portfolio in unsecured bonds and loans and can only invest in highly rated corporate bonds.

In contrast, pension funds in mature market countries have substantially greater flexibility to manage their portfolios. While some developed countries apply minimum requirements on pension funds’ investment on government securities, most do not have explicit ceilings on debt securities in which pension funds can invest (see OECD 2004 ) However, pension funds in these countries are required to follow “prudent man rules”—that is, assets should be invested in a manner that would be approved by a prudent investor (Roldos 2004b).


of the workforce. All these factors have led to underdevelopment of the pension fund asset base which is now at about 4.5 percent of GDP (McKinsey, 2006) as compared to international standards (United States 66percent ; Chile: 60 percent; Brazil: 40 percent).

Restrictive investment guidelines. The Employees Provident Fund and Public Provident Fund are also repositories of large amounts of long-term finance. According to regulation, provident funds are required to invest a minimum of 25 percent of their incremental accretions each year in government securities, 15 percent in state government securities, and 40 percent in bonds from public sector undertakings, with a maximum of 10 percent in rated private sector debentures. Today, a significant portion of pension and provident funds are deployed in government securities, which remain locked in

for two reasons. First, once a government security is subscribed, regulations mandate that it be held to maturity. Second, investment guidelines also mandate that interest received from government securities be reinvested in those securities.

Thus, the investment profile of pension funds is highly regulated, with a bias toward government securities. Recently, the investment guidelines for provident funds have been somewhat liberalized with the announcement of investment in private sector shares and debentures. However, this reform has yet to be implemented fully. A survey of pension fund investment guidelines in some of the Latin American countries suggests that, while significant exposure to government debt is stipulated, there is considerable freedom for these funds to invest in a mix of financial instruments with varying risk-return profiles. Since

Box 2.2 International experience with encouraging foreign investment in corporate bond markets

Foreign investors are an important source of demand for local securities, and several emerging markets have opened up their local markets in an attempt to widen and diversify the investor base. Although there may be differences in investment strategies among different types of foreign investors, market participants perceive foreign investors as playing a supportive role in local markets (Roldos 2004a). Furthermore, foreign investors usually impose positive pressure for developing robust market infrastructure and transparent market practices. At this stage, however, foreign participation in local debt markets in Asia and Latin America remains limited, despite efforts to open up their markets to foreign investment. As a result, the investor base for local debt instruments continues to be dominated by domestic institutional investors.

International experience suggests that market liberalization alone is insufficient for increasing foreign participation. Colombia’s restrictions on holdings by foreign investors had clearly been a barrier to the development of the local corporate bond market. The situation in Korea is less clear. Even though foreigners are allowed to invest in all types of listed bonds in Korea’s local market, they currently hold only about 0.4 percent of listed domestic bonds (compared with foreign participation of over 40 percent in the Korean stock market). The situation may be partly due to the lack of a developed repurchase market and hedging instruments. In Brazil, the existence of withholding taxes and the threat of discretionary increases in other taxes, such as proposed in the Financial Operations Tax Act, act as a strong deterrent to foreigners from buying domestic securities. In contrast, foreign interest in Mexico’s longer-term government bonds rose sharply in 2004, as the local market started to realize the benefits from ongoing reform efforts—to establish a credible benchmark yield curve, improve transparency, and promote liquidity in the market. Similarly, in Malaysia, foreign investor interest in the local markets has been higher, with the government taking new initiatives to make investments into local markets easier and more attractive and to improve market infrastructure.

In most mature markets, there are few restrictions on foreign investment in local bond markets. This openness, together with established market infrastructure and governance, pushed foreign participation rates in local debt markets significantly up in the past decade. For example, in June 2003, 46 percent of long-term U.S. Treasury securities and 16 percent of outstanding corporate debt securities were held by foreigners (U.S. Treasury 2004) These shares have doubled in the past ten years. Similarly, in Australia in 2000, about 45 percent of government bonds were held by nonresidents, up from about 25 percent in 1994. Nonresident holdings of private sector debt are closer to 10 percent.

Note: See Burger and Warnock (2004) for a discussion on the determinants of foreign participation in local-currency bond markets.


the early 1980s, pension funds have become important players in the capital markets of many Latin American countries because of the radical reforms those countries made to their social security systems. However, pension funds are subject to quantitative restrictions, including a list of authorized assets, diversification rules, conflicts of interest regulation, valuation rules, and so on.

Mutual funds

Public and private sector mutual funds are a growing force among institutional investors, with total assets under management for mutual funds reaching Rs. 1,496 billion as of March 31, 2005 (5.5 percent of GDP). Two-thirds of these funds are typically debt investments (the majority of which are money market instruments and gilts). Mutual funds have been the main cause of growth in corporate debt issuance in the primary market in 2004, and it is estimated that they trade about 30–40 percent of their portfolio, which could be an important source of activity in the secondary debt market.

Despite the rapid growth of assets under management by mutual funds, their overall impact on the corporate bond market is limited because these vehicles mostly focus on liquid assets, such as money market instruments, government securities, Treasury bills, and equities. Existing restrictions have discouraged mutual funds from holding lower-rated, illiquid corporate debt instruments, as fund managers are unwilling to invest in such instruments, which may be redeemed at any time. At this time, mutual funds are only investing in AAA or AA+ debt. There is presently no high-yield bond fund of Indian assets, and corporations rated below AA—which constitute the bulk of local companies in the infrastructure sector—are unable to issue debt on

Table 2.7 Net investments by foreign institutional investors, 1997–98 to 2005–06(Rs. billions)

1997–98 1998–99 1999–00 2000–01 2001–02 2002–03 2003–04 2004-05 2005-06Debt 2.7 –8.3 5.1 –6.4 6.6 3.5 55.3 17.59 –73.34Equity 4.5 –5.5 100.7 101.4 80 24.8 434.3 441.23 488.01

Source: Center for Monitoring the Indian Economy.

reasonable terms. This is despite evidence that risk-adjusted rates of returns of these lower-rated bonds exceed those of AAA corporations.

Foreign institutional investors

Foreign institutional investors (FIIs) are required to allocate their investment between equity and debt instruments in the ratio of 70:30. However, it is also possible for such an investor to declare itself a 100 percent debt FII, in which case it can make its entire investment in debt instruments. In that case, the foreign institutional investors can invest in debentures (including nonconvertible and partly convertible debentures), bonds (including dated government securities, treasury bills, and other debt market instruments).

Foreign corporations and foreign individuals are not eligible to invest through the 100 percent debt route. The overall investment limit under the 70:30 route in dated government securities and Treasury bills is US$1.55 billion. The FII investments in corporate debt have a ceiling of US$0.5 billion.7 More than 300 FIIs invest in Indian equities, while the number of FIIs investing in Indian domestic debt is less than 20. The table above shows the share of equity and debt in FII investments in India since 1997. It is evident that Indian equities are favored by FII (table 2.7).

While the appetite of FIIs for securities across the credit spectrum is high, the investment caps act as a significant deterrent for these investors and pose a constraint on the growth of the corporate debt market. This restriction potentially represents a missed opportunity to develop the market and facilitate the financing of the infrastructure sector, as emerging market debt spreads continue to compress and


investors search for yield in local markets (box 2.2). Thus far, anecdotal evidence from market participants indicate that the demand for Indian corporate bonds by FIIs far exceeds the cap of US$500 million. Market analysts believe that the opening of the corporate bond market to foreign investors would generate a high degree of interest, similar to that already seen in the local equity market.

ConclusionA broader base of investors is a key component for deepening securities markets. Continuing pension system reforms, which if implemented successfully can play an important role not only in resource mobilization and providing longer term income security, but also, in expanding the institutional base to support the development of long-term savings instruments and deepen the capital markets. Similarly, the insurance industry can also participate more actively in the capital markets by increasing penetration – 80 percent of India’s population is without any insurance coverage. These reforms should be coupled with changes in investment policies and regulatory guidelines to make these sufficiently flexible for insurance companies and pension funds to choose an appropriate risk-return profile within fiduciary constraints.

To sustain the rapid growth in assets of mutual funds and to attract a diverse set of retail investors, mutual funds will need to offer a wide range of mutual fund products with different investment objectives and strategies (for example mutual funds could offer products that cater to different risk-return and liquidity needs through investments in liquid securities, or through investments in illiquid assets such as real estate, or high-yield issuances). The key point being that as financial markets innovate constantly, mutual fund

regulatory regimes should accommodate changes such as new forms of funds or asset classes while providing a clear legal basis for fund operation and regulation, so that the growth of the industry is not hindered. Finally, for foreign institutional investors who have the appetite and ability to bring in risk capital that is needed for better economic growth, the current absolute ceiling on investments in the corporate bond market could be further increased with future limits being fixed as a percentage of gross issuance in the previous year and with relaxations for longer term investment in corporate bond debt markets (over 3 years).

Notes1 The Basel Capital Accord introduced in 1998 sets minimum capital

requirements for banks at 4 percent tier I capital and 8 percent total capital (tier I and tier II capital) in relation to risk weighted assets. Tier II capital is supplementary capital which consists of undisclosed reserves, general loan loss provisions, and hybrid instruments that combine characteristics of debt and equity and are available to meet losses and unsecured subordinated debt.

The total amount raised by banks through the primary issuance market was Rs. 105.52 billion in 2004–05 and Rs. 66.23 billion in 2003–04 (details in annex 3).

2 Based on discussions with a subset of investment bankers, brokers, and corporations.

3 Pension reforms currently envisaged in India will be based on the establishment of a defined contribution scheme with members offered a variety of investment options, including the equity market, fixed-income instruments, and so on. The current asset allocation of existing provident funds is heavily biased toward central and state government securities.

4 The Reserve Bank of India regulation requires that at least 75 percent of the investment portfolio should be marked to market. Banks value their portfolios according to a model for valuation that is prescribed either by the RBI or the Fixed Income and Money Market Dealers Association, FIMMDA. The market values of bonds have to be estimated at a regular frequency to ensure that the correct capital is set aside in keeping with the current risk management principles.

5 Once a security is subscribed to, regulations mandate that they be held to maturity.

6 Although political opposition to private fund managers could mean that the initially the pension system will be managed only by state-owned fund managers.

7 The investment ceiling on foreign institutional investors has been increased from $0.5 billion to $1.5 billion, as announced in the 2006 Union Budget Speech.

3. What is holding back the development of the market?

The elements of the microstructure of primary and secondary markets—such as issuance method, trading mechanisms, dissemination of transaction

information, and the role of intermediaries—are important for market development. In India, the crucial issues involved in developing the corporate bond market are: facilitating speedy and cost-effective primary issuances without compromising transparency and disclosure, ways and means of elongation of maturity of corporate bond issuances, improving the liquidity in secondary market, and improving institutional mechanics. This chapter focuses on the process and costs of bond issuance, the types of instruments issued, the nature and liquidity of the secondary market, and the legal and regulatory framework for corporate bond markets.

Long and costly issuance processThe high costs associated with corporate debt issuance, such as the costs of meeting new disclosure laws and direct issuance costs, have deterred market development. In effect, the high issuance costs hinders the development of local corporate bond markets by discouraging the supply of bonds, particularly from smaller corporations,

since they then opt for bank loans, which tend to be cheaper given the high liquidity in the banking system, although the liquidity is now reducing due to high credit growth in the last year. Raising debt through a public issuance in India entails substantial costs associated with regulatory compliance, advertising, and intermediation costs to brokers and underwriters.

Raising debt is also a lengthy process—the minimum time for clearance of offer documents by the regulator is 21 days. In contrast, approval by the regulator takes just five days in Korea (for secured and guaranteed bonds). Furthermore, shelf registration,1 which facilitates frequent and quick issuance of debt securities, is not available to all corporate issuers in India, but only to specially designated public financial institutions. The primary market for equity in India has developed highly efficient screen-based on-line auction mechanisms for the sale of shares. The corporate bond market does not yet use these transparent and low-cost procedures, which help to reach investors all over the country. Latin America, in contrast, has moved toward auction systems in which corporate bond offerings are executed in a fair, open, and transparent manner (box 3.1).

Box 3.1 International experience with auction systems for bond primary market issuance: experience in Latin America

The use of underwriting and auctions for corporate bond issues differs by region. Bond issues in Asia are underwritten and distributed by an investment bank or a syndicate of brokerage houses, similar to the traditional process used in the U.S. domestic and Eurobond markets. Historically, the issuance process was similar in Latin America, but has now migrated to an auction-based system, patterned after government bond auctions. Under this procedure, corporations choose a lead manager (placement agent) for the offering, and institutional investors make direct bids for specific amounts of bonds at various prices. Under a “Dutch auction” mechanism, all bonds are awarded to bidders at a single cut-off price that gives the borrower its desired volume of issuance. Under these auction-based systems, there is no need to form syndicates to spread underwriting risk or to assist the lead manager in the selling effort. Lead managers have been forced to accept this issuance methodology by a concentrated, powerful group of institutional investors who want to ensure that corporate bond offerings are executed in a fair, open, and transparent manner (IMF 2005c).

International experience in reducing bond issuance costs varies across emerging market countries—with only some countries like Chile or Malaysia being successful in streamlining processes and reducing costs. In Brazil, bringing an issuer to market is relatively expensive. The costs of local issuance (encompassing fiduciary agents, lawyers, registration, rating agencies, and bank fees) make it prohibitively expensive to issue debentures in amounts lower than 50 million reais ($20 million). In contrast, the cost of placing debt in Chile’s local market is one seventh of that paid for a placement in international markets (see Cifuentes, Desormeaux, and Gutierrez 2002). Bond issuance costs in each category (for example, investment banking fees, regulatory fees, or legal fees) tend to be higher in Mexico than Chile; however, Mexico does not impose issuance tax on securities.

In Poland, a number of regulatory and cost obstacles make private placements the only cost-efficient way to issue corporate bonds. For example, a prospectus has to be issued for each bond issue, ruling out medium-term notes programs. Prospective issuers must wait a long time for the approval of the authorities, in addition to paying high fees for issuances. Similarly, the cost of public issuance in Hong Kong SAR is estimated to be four times that of a private placement. In contrast, Malaysia’s Securities Commission introduced a series of measures to streamline the capital-raising process. These have minimized the time and work required

in the issuance process and lowered the cost of bond issuance to below that of bank loans. Not surprisingly, bond issuance has dominated bank lending as a source of funding in Malaysia since 1997 (IMF 2005c).

Unlike the public issuance of corporate bonds, the private placement market in India offers competitive rates and quick access to the market with relatively less regulatory interface (table 3.1). As a result, this segment accounts for over 90 percent of debt placement in India.2 However, recent guidelines that require compulsory listing of all privately placed debt on the stock exchange and detailed listing agreements with the exchange have greatly increased the disclosure requirements and costs for private placement, mainly affecting first-time issuers. For large corporations, which either have an equity listing or are frequent issuers in the bond market, the main costs pertain to incremental disclosures, rating fees, and arranger fees. In India all debt issuances for Rs.1 billion or larger have to be rated. Even smaller issues have to be rated if the securities are to be placed with institutional investors, such as banks, insurance companies, and pension fund managers. The cost of the rating is roughly ten basis points (or 0.1 percent—one basis point is one-hundredth of a percentage point) of the size of the issue rated. Stamp duty on the issuance of debt securities varies depending on the type of investor. Furthermore, stamp duties vary between different states in the country depending on where the charge for the mortgage is created. The total cost for a frequent issuer


Table 3. 1 Costs for an issuance of Rs. 1 billion through private placement, 2005 (in Rs.) Type of cost One-time cost Annual costRating 1,000,000 100,000Listing (National Stock Exchange) 7,500 50,000Trustees 50,000 50,000R&T agent 25,000 25,000Arranger fees 2,500,000 - Stamp duty on secured debentures (assuming mortgage in Mumbai)a 1,000,000 - Total cost 4,582,500 225,000Percentage of total value of issuance 0.46 0.02a. In case of unsecured debentures the stamp duty would be 0.375 percent of the amount issued. The stamp duty also varies depending on the state in which

the mortgage is created.Note: The above costs are indicative. All costs other than stamp duty are subject to negotiation.Source: World Bank staff estimates based on interviews with investment bankers

25What is holding back the development of the market?

for an issue size of Rs. 1 billion is a little under 50 basis points, which apart from being speedier than public issuance is also cost-effective.

One of the most commonly cited deterrents against a public issuance route is the amount of time elapsed between the decision to source public funding and the actual receipt of the funds, which increases the uncertainty of pricing. Most market participants estimate that it takes two to three months to obtain financing. A private placement is much faster, but does not compare favorably with international markets, where the time from making a decision to obtaining funds can be as little as 48 hours.

An interesting feature of recent primary issuances has been the ability of issuers of all credit quality to raise funds through foreign currency convertible bonds (FCCBs). This route has become attractive in terms of both lower price (because of the low overseas interest rates and a relatively strong rupee last year, although this trend has now been somewhat reversed) and easier terms (because of the low cost of arranging the issuance and the avoidance of rating and cover charges). Furthermore, FCCBs can also be raised within a month, while pure debt takes longer to raise in India.

Thus, these features characterize the primary issuance market for corporate bonds in India:

Large private corporations in India prefer to borrow money from international debt markets because of more rapid processing and lower costs of financing.When corporations do borrow from the market, the mode of issue of debt is in the form of private placements rather than a public issue of debt.The average size per issue has grown since the 1990s. This shows that the market is willing to absorb a larger amount of debt per issue now. Nonetheless, the number of private corporations accessing the domestic market for funds, witnessed a drop in 2003–04, before recovering. Interestingly, over the past five years the number of public corporations tapping the privately placed bond market has seen a growing trend (figure 3.1).

Lack of innovative debt instrumentsA well-developed debt market like that in the United States, Euro area has a variety of debt instruments. These include convertible bonds, fixed-rate bonds, floating-rate bonds, high-yield bonds, zero-coupon bonds, inflation-indexed bonds, securitized bonds (such as asset-backed securities, mortgage-backed securities, collateralized bond obligations, collateralized loan obligations, collateralized mortgage obligations, and collateralized debt obligations), subordinated bonds, and perpetual bonds, also called annuities.

Figure 3.1 Public and private sector bond issuance through private placements (2001–2006)

Source: Reserve Bank of India.

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The Indian debt market today tends to issue mostly fixed-rate coupon bonds. In the past, convertible bonds were issued on a small scale by Indian companies as zero-coupon bonds, although these are no longer available as the pricing guidelines for conversion prescribed by SEBI do not make these attractive for investors. While bonds of varying maturities have been issued (there is a 30-year government bond), Indian corporations issue debt securities having maturities of five to seven years on average. There are also bonds that are issued with a 15-year maturity, however, with coupon resets every three years. In contrast, in other emerging Latin American markets several different structures are used, including floating rate notes and bonds with interest and principal payments. Latin American corporations issue coupon bonds for maturities extending to 30 years, which in some cases is longer than the maximum tenor of local government securities.

Markets for risk sharing-securitization and derivatives

India generally lacks innovative debt instruments. With the right policy and regulatory environment, derivatives and securitization instruments and mechanisms for risk transfer and sharing can offer substantial benefits for the long-term financing needs of infrastructure developers. Annex 5 provides a comparison of the availability of such instruments in India and other developing countries.

Securitization

Although the first securitization deal took place in the Indian market in 1991,3 the market for securitization

picked up only after 2000.4 Indian securitization began with the ring-fencing of a portfolio of auto loans and has been predominantly an asset-backed market.5 Issuance has been predominantly of AAA rated notes, as investor appetite for lower-rated tranches is almost non-existent. The market is characterized by a limited investor base, comprising of a mutual funds and a few private sector banks. While the securitization market in India is growing significantly, it is still way behind the securitization issuances in Korea and other developed countries where securitization issues cover a wide spectrum of instruments ranging from the traditional asset-backed and mortgage-backed securitization to collateralized loan obligations, collateralized mortgage obligations, and collateralized debt obligations (table 3.2).

There are a number of reasons for the slow growth of the Indian securitization market. In the initial stages of development of the securitization market, the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 intended to promote securitization did not have its intended effect, perhaps as the Act sought to cover three disparate areas: securitization, security enforcement, and corporate reconstruction. The Act did not allow a special purpose vehicle to be set up for a single transaction and instead required a securitization company to be registered with Reserve Bank of India with provision of minimum capital. Setting up a separate company entailed costs and made securitization transactions unviable.

The “bankruptcy remoteness” of the securitization company was lost (which was the main aim of the Act),


Table 3.2 Securitization issuance in India and selected emerging market, 2001–04 (US$ millions)Country 2001 2002 2003 2004Korea 30,230 26,783 26,356 19,247Malaysia 1,412 751 266 350Thailand 0 141 20 38Chile 421 40 343 775Brazil 1,050 1,150 2,025 1,070India 562 304 1,138 2,456Note: Data include domestic and international securitization issuances.

Source: IMF, Prime Database, ICRA estimates.


as the asset being sold down would be linked to the bankruptcy of the securitization company and other portfolios purchased by the securitization company instead of the originator. Therefore while the Act has been used for non-performing assets by way of selling these assets to asset reconstruction companies, it has not provided the solutions to issues faced in securitization of standard assets, as result of which, most securitization transactions for standard assets are carried outside the purview of the Act.

Moreover, ambiguity over the status of pass-through certificates issued in securitized transactions has prevented investment by most of the large investors, such as provident funds, and nationalized banks. Because these certificates are not recognized as securities, these are not listed on the exchanges, thereby limiting the tradability of the certificates. The government is now considering an amendment to the securities law to classify pass-through certificates issued by special purpose vehicles as “securities.” This provides pass-through certificates with the same legal standing as debt instruments and will make these eligible for inclusion in the approved list of securities for provident funds, charitable trusts, and many statutory bodies.

In addition to these structural reasons, issues relating to taxation (stamp duty), and foreclosure laws need to be addressed to increase the interest of issuers as well as investors. The difference in stamp duties across states and the lack of clarity relating to incidence on stamp duty on the transfer of certain types instruments have limited the market towards certain states (who have reduced stamp duties proactively) and to those receivables that do not incur onerous stamp duty costs. Foreclosures in India are time-consuming and costly. While banks and financial institutions have been provided avenues for speedier recovery of assets in the event of a default, special purpose vehicles set up for securitization transactions do not enjoy the same benefit, thereby rendering the recovery process time-consuming and costly. Notwithstanding the difficulties in carrying out securitization transactions under the provisions of the Act, the securitization market has been witnessing a healthy growth over the past three years (figure 3.2).

Amongst the various types of securitization transactions, the ABS market has seen the largest growth with issuances of about Rs. 223 billion in FY05, almost three times the volume in 2004 (figure 3.3). The mortgage backed securities market has not seen as much growth over the last few years, despite significant expansion in the underlying housing finance business, due to various legal and regulatory barriers.6 The market for corporate loan securitization and other pooled structured finance products is still in a nascent stage in India. As the pool of investors in structured finance products are limited to a handful of institutional investors who have a lower risk appetite (due to a variety of reasons discussed in the note), investment decisions of investors are often influenced by the “base rating” of the underlying corporate exposures in a collateralized debt obligation pool and not on the rating that the instrument achieves.

In February and October 2006, the Reserve Bank released guidelines for the securitization of standard assets. The guidelines codified a number of prevailing market practices with some stringent requirements on capital and profit recognition. While the immediate impact of the guidelines slowed down the market, in the long run these are a move in the right direction. The

Figure 3.2 Issuance size and number of deals in the securitization market, 2000–06

Source: ICRA 2006.

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new guidelines are also expected to pave the way for mezzanine investors in the securitization which would be a welcome development.

Credit enhancement

Credit enhancements play an important role in enhancing financial intermediation by bridging the gap between borrowers—especially those with inadequate credit ratings—and certain investors who would only be allowed or interested in investing in bonds with a higher credit rating. Third-party credit enhancement or credit guarantee (also known as bond insurance) by a third party for issuers with non–investment grade rating provides an important avenue for lower-rated issuers to tap the market.7 From the point of view of the issuer, credit guarantee would help lower funding costs and broaden market access and the investor base.8 From the investors’ perspective, credit guarantee provides additional comfort or protection against default risk and can also enhance liquidity in the secondary market. Furthermore, with a credit-enhanced rating, many issuances are able to qualify under the guidelines of pension and insurance funds and othe conservative investors.

Currently, there are no institutions that provide such credit guarantee products in India. In more developed markets, credit guarantee services tend to be provided by specialized credit guarantee companies. For example, in the United States, four major credit guarantee companies called the “monolines” mainly provide credit guarantee facilities. The credit guarantee market has been recording a substantial growth in the last two decades in the United States. In India, third-party credit enhancement has not developed because of the lower maturity of the market, the lack of market intermediaries such as the monoline insurers (which have deep financial ability and risk capital to provide such services), and the lack of reliable credit default histories (which is at a very nascent stage of development in India today) needed to appropriately price credit guarantee products. Even if a lower-rated borrower were to use this product, it would not be economical for it to do so unless the savings resulting from reduced interest cost exceed the cost of guarantee. There have been very limited instances of credit-enhancement for bond issuances in India, mainly in municipal financing with bilateral or multilateral funding (from the U.S. Agency for International Development, for example, or the World Bank).


Figure 3.3 Securitization in the Indian market, by type, 2002–06

Note: ABS: asset-backed securitization; MBS: mortgage-backed securitization; CLOs: collateralized loan obligations; PG: partial guarantee.

Source: ICRA.

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Derivatives

The development of financial instruments, such as credit derivatives and interest rate hedging tools, to increase liquidity in the secondary markets has also been constrained in India. Globally credit derivatives are among the fastest growing products, and especially credit default swaps which make up a majority of credit derivatives. Credit default swaps more than doubled to US$ 26 trillion in the first half of 2006 from a year ago. In the Indian context, although derivative instruments were introduced in July 1999 in the money/foreign exchange market in the form of forward rate agreements and interest rate swaps, credit derivatives are yet to be introduced as the Reserve Bank of India has not yet issued the enabling guidelines.9

Derivatives can be traded on organized exchanges or in over-the-counter markets. Typically, given the variety of needs and specifications in fixed income derivatives, these tend to be traded over the counter, although recently benchmark securities have helped standardize these products on exchanges as well. Globally, 26 percent of the US$ 53 trillion exchange-traded derivatives were fixed income derivatives (both on short-term interest rates and long-term government bonds) in 2004. In India, after introduction of interest rate derivatives in 1999, banks could undertake simple forward-rate agreements and interest rate swap contracts for their own balance sheet management and for market-making purposes, provided they ensured adequate infrastructure, risk management systems, and internal control systems.

The interest rate derivatives market has grown significantly in the last few years and is predominantly an over-the-counter market, with the outstanding notional amount at around Rs. 6.4 trillion in 2004.10 However the interest rate derivatives market is still considered in its early stages in terms of depth and sophistication. Participation in this market remains limited mainly to about 15 select foreign/private sector banks and primary dealers and the market is predominantly an inter-bank market with overnight index swaps being the most

actively traded derivative. The absence of a suitable money market index for the interest rate swap market is also another constraint in developing the market (although indications are that this is now beginning to develop).

In 2003, an attempt by the securities regulator to start exchange-traded interest rate futures failed to take off. The reason for this being that commercial banks, which are by far the largest players in the bond market, can use exchange-traded derivatives only for hedging. Since banks hold a large stock of government securities in their portfolio, they need to be able to take trading views for a vibrant market to develop. With only hedging positions allowed by the Reserve Bank of India, they could have only sold the derivative contracts, thus making the market extremely one-sided, and as a consequence the market never took off. However, banks are permitted to take trading positions in the over-the-counter derivative market, indicating the lack of a level playing field between the OTC and ETD markets.11

Inadequate secondary market infrastructureThe infrastructure to support the secondary debt market, in which bonds are bought and sold after their initial issuance, includes trading systems, which allow efficient price discovery, and reliable clearing and settlement arrangements. Although market liquidity is hard to measure, the liquidity of corporate bonds in both developed and emerging markets is relatively low.

Exchange-traded versus over-the-counter systems

In many countries, the majority of bonds are traded on over-the-counter markets. An over-the-counter market refers to a decentralized market where securities are typically traded over the telephone, facsimile, or electronic platform, as opposed to an exchange, which is an organized market and may be either floor-based or electronic. Organized markets usually have more disclosure requirements (IMF 2005c).

Secondary corporate bond trading in India, like in most other markets, is done through over-the-counter trading between the counterparties directly or intermediated by brokers, although the securities are listed on exchanges. The quantum of trades carried out through the exchange is negligible, despite attempts by the Securities and Exchange Board of India (SEBI) to mandate trading of corporate bonds through the exchange. In any case about 98 percent of the secondary trading is in government securities (table 3.3).

Once trades are executed, they are reported for information disclosure. Since most of the dealers in the corporate debt market are also members of the Wholesale Debt Market of the National Stock Exchange—a platform originally set up for reporting trades in government securities—trades are reported on that platform.

As of December 1, 2003, the exchange had registered 75 trading members on the Wholesale Debt Market. Table 3.4 shows the business growth on the Wholesale Debt Market. Most of the trade data here pertains to government securities trading, which has witnessed a steep fall over the last three years since the introduction of a competing platform called ‘Negotiated Dealing System’ set up at the initiative of the Reserve Bank of India.

At a more conceptual level there is a need to think through the secondary market microstructure issues. As debt markets are very different in nature from equity markets there is a need to examine feasibility of setting up inter-dealer electronic broking platform. The primary limitation seen today with secondary debt market is that the current framework is in essence an equity framework that puts emphasis on the need for an exchange trading environment. But for the debt market, there is a need to recognize that due to the illiquid nature of corporate bonds,12 it requires the active participation of dealers not only to provide liquidity but to act as the main source of distribution. This then requires a more decentralized micro-structure, with over the counter market transactions making up for an important part of the secondary market activity. However, the limitations that arises in this context is a rather undefined recognition of over the counter transactions within the current


Table 3.4 Business growth in trades reported at the National Stock Exchanges Wholesale Debt Market, 1995 to 2006

Year No. of trades Avg. daily volume Avg. trade size(Rs. billions) (Rs. billions)

1994–95 1,021 0.3 0.061995–96 2,991 0.4 0.031996–97 7,804 1.5 0.051997–98 16,821 3.8 0.061998–99 16,092 3.6 0.061999–2000 46,987 10.3 0.062000–01 64,470 14.8 0.062001–02 144,851 32.8 0.062002–03 167,778 36 0.062003–04 189,518 44.8 0.072004–05 124,308 30.3 0.072005–06 61,891 17.55 0.08Source: NSE Fact Book, 2006

Table 3.3 Turnover in secondary marketsIssuer Turnover in secondary market (Rs. billion)

2002-03 2003-04 2004-05 2005-06Government 19,557 24,334 21,894 25,804Corporate/nongovernment

360 423 417 227.14

Total 19,917 24,757 22,311 26,031Source: Reserve Bank of India, Securities and Exchange Board of India


securities regulatory framework, makes it very difficult for such dealer structure to develop. There is a need to address this issue to develop a market microstructure for the corporate debt market, that will be acceptable to majority of the participants in this market, that is, institutional investors.

A number of emerging market countries are trying to encourage more exchange-based trading of bonds because exchange trading is seen as being more transparent and allowing a wider range of investors better access to the market, some countries encourage investors to trade bonds on the exchange to promote competition in the secondary market. For example, in Peru, the government encourages trading on the exchange by exempting interest income tax for fixed-income securities traded there. In some countries, institutional investors (for example, private pension funds) are restricted to trading securities only on the exchange because of the better transparency. However, it is still quite early to determine the success of exchange-based trading of corporate bonds.

The existence of a large number of illiquid corporate bonds poses a challenge to institutional investors that are required to evaluate their portfolio holdings at current market prices. Some securities are not traded for extended periods of time. In Mexico and Korea, the systems of “price vendors” are established. Institutional investors “purchase” the price quotes from these price vendors who provide price quotes for all securities using their pricing methodologies. In Chile and Peru, the pension fund regulators produce their own “price vectors” for the valuation of portfolios, and there are increasing pressures to have a standardized

methodology that can also be applied to mutual funds. In other countries, institutional investors use either prices supplied by their regulators, self-regulatory organizations (Thailand, India), or average quotes from securities companies (Malaysia) (IMF 2005c).

Trade reporting platform

Over the counter trading often makes trading data more difficult to aggregate and report publicly. The United States is an exception, where over-the-counter trading data on all secondary bond transactions are collected and disseminated through the National Association of Securities Dealers’ centralized reporting system TRACE (Transaction Reporting and Compliance Engine). The information is made available to the public on a variety of websites. A variety of other countries with mature or emerging bond markets are developing similar or alternative methods to improve the dissemination of trading information.

Although there is no single reliable number, the total outstanding privately placed debt in India was approximately $43.7 billion, which is ten times the publicly issued debt (McKinsey, 2006). The lack of comprehensive data relating to the debt on issue and the outstanding stock of debt for corporate issuers is a serious handicap in the Indian market today. While data on public issuances by corporations is available, most of the issuance over the last few years has been through the private placement market, which has had very little oversight and reporting requirements by issuers and arrangers until about a year ago. Now that the reporting of debt on issue by

Box 3.2 International experience on better dissemination of trading information

Corporate bond market microstructure plays an important role in determining market liquidity. The market microstructure includes trade execution systems, trading venues, trading commissions, disclosure of contracted price and volume information, and market regulations. Robust and efficient trading, as well as proper data dissemination systems, promote market integrity and improve the liquidity and efficiency of the price discovery process (Madhavan 2000). In most emerging markets, information about transactions on the exchange is well disseminated. Transparency requirements for listed bonds traded on the over-the-counter market differ across countries. With some exceptions, information is made publicly available with delays ranging from minutes to a day. For example, information is provided to regulators in Malaysia; to the stock exchange and subsidiaries in Mexico; and to self-regulatory organizations in Korea (KSDA), Thailand (Thai BDC), Japan (JSDA), and the United States (NASD) (see IOSCO 2002 and 2004.


listed companies has been somewhat streamlined, it is expected to improve gradually.

Nevertheless, data on outstanding debt is still very hard to compile, as there is no comprehensive repository of information to track debt issuance by companies through its entire life cycle, that is, from issuance until redemption. As a result, investors lack sufficient, timely, and reliable information on bonds. Data on bond issues, size, coupon, latest credit rating, underlying corporate performance, secondary trading experience, and default histories of companies are sparsely available and are usually not available from one source.13 This has muddied the corporate debt market and created barriers to active trading and pricing.

One of the recommendations of the High Level Committee on corporate bonds and securitization, set up by the Ministry of Finance pertains to establishing a system to capture all information related to trading in corporate bonds as accurately and as close to execution as possible, and disseminate it to the entire market in real time. The committee also recommended that it would be cost effective to use the existing infrastructure available with the national exchanges for dissemination of information related to trading in corporate bonds. The Committee favored creation of multiple reporting platforms to cater to the needs of the various kinds of market players—institutional, retail, and so on—with SEBI taking the responsibility of approving the reporting platforms and ensuring coordination among such multiple reporting platforms. However, in a recent decision, SEBI seems to have preferred a monopoly trade reporting platform with one of the exchanges being chosen to perform the aggregating and reporting function of corporate bond trading.

Clearing and settlement system

Robust clearing and settlement systems are a crucial element to bond market development because they help enhance the efficiency of bond trading and reduce their associated risks. In addition, bond market liquidity is closely linked to the reliability of bond clearing and settlement systems. Investors will only trade bonds if they are confident of the settlement of their trades (IOSCO 2002).

In the case of the equity market, the clearing corporations of the national stock exchanges stand as the central counterparty and absorb the credit and settlement risk. For settlement of the securities in the trade, the clearing corporation is linked to the securities depositories which take care of the book-entry settlement of trades and for settlement of payments between the trade participants, the services of participant banks are used to complete the transaction.

However, secondary corporate bond trades in India are bilateral, which means that each counterpart to the trade takes on counterparty credit risk and settlement risk. Securities settlement is effected directly by participants through their securities depository. A positive aspect of the settlement system is that most bonds are held in dematerialized form as a consequence of regulatory requirements that institutional investors and banks hold all new issuances of corporate bonds in dematerialized form. Dematerialization has meant a huge reduction in costs to both corporations and buyers of corporate bonds, in terms of the costs of moving paper and the risk of fraud or other loss. However, bonds that were issued prior to 2000 can still be held, traded, and settled in physical form for counterparties other than banks, which adds to the risks of settlement. The lack of a central counterparty to mitigate these risks is viewed as one of the major deterrents to increased secondary bond trading in India. On the other hand trades in government securities carried out or reported on the Negotiated Dealing System get the benefit of a delivery versus payment mechanism and a settlement guarantee system since a dedicated clearing and settlement corporation with links to the NDS and, more recently, the real time gross settlement system, exists.

Gaps and overlaps in the legal and regulatory frameworkWeaknesses in regulation, including poor coordination and overlapping jurisdiction among the government’s various regulatory agencies, and weaknesses in laws concerning creditors’ rights and corporate governance all come in the way of developing a corporate bond market.


Regulatory jurisdiction and coordination

In the debt markets, the Ministry of Finance, the Reserve Bank of India (RBI), and the Securities and Exchange Board of India (SEBI) all have regulatory and supervisory roles that are not sufficiently delineated. The overlap in regulation and the different focus of each authority tend to inhibit development

of new products and innovation in the design of debt markets. RBI (Government Securities Market) and SEBI (Corporate Bond Market) sought to clarify the demarcation of their responsibilities following an amendment to the securities legislation in 2000. However, some amount of market fragmentation remains because regulatory jurisdiction is still based on the maturity of debt instruments. RBI regulates the issuance of money market instruments, and

Box 3.3 Examples of regulatory overlap in the debt market

Definitional issues

The authority to regulate transactions in corporate debt instruments has been clearly left within the purview of the Securities Contract Regulation Act and the Securities and Exchange Board Act. These legislation are silent as to the authority of the SEBI to regulate repo transactions however the SCR Act does include within the definition of the term “securities” the ability to regulate “rights and interest in securities”—which could, in a broader sense, be taken to include repo transactions. Now that the RBI Act has been recently amended to specifically confer on the RBI the authority to regulate repo and reverse repo transactions in corporate securities in addition to the regulation of such transactions in government securities, it would appear that RBI also has the authority to regulate repo and reverse repo transactions of banks and financial institutions in the context of corporate debt securities.

The RBI Act defines securities to mean government securities and confers on the RBI the power to “regulate all agencies” dealing with government securities. However, under the SCR Act, the term “securities” has been defined to include government securities. This creates a potential conflict of authority between the RBI and the SEBI as they are both empowered to regulate the same type of security. In order to ascertain whether or not there is an effective overlap of jurisdiction, the applicability of these definitions needs to be ascertained. The proviso to Section 45W(1) of the Reserve Bank of India Act clarifies that directions of the Reserve Bank relating to securities, derivatives, money market transactions, and so on. shall not relate to the procedure for the execution or settlement of trades on stock exchanges recognized under the SCR Act. In the SCR Act, the term has been included in the list of securities that can be traded on a SEBI regulated exchange. Thus the SEBI has the authority to prescribe rules and regulations as to the manner in which government securities are to be traded on one or more of its exchanges. This authority therefore relates to matters pertaining to exchange trading in defined securities. The RBI Act and in particular Chapter IIID seems to have a broader import. Under this Chapter the authority of the RBI to regulate securities has been granted with a view to appropriately empower the RBI to regulate these types of securities in the larger interests of the financial system of the country. In scope this seems to be a larger mandate. However in practice there appears to be an overlap between the ability of the RBI and the SEBI to regulate securities. Unless this is resolved by clearly establishing each entity’s scope of regulation, it is likely that considerable confusions as to the extent of what each entity can legitimately regulate will continue to exist.

The exchange-traded secondary debt market.

Included in the general powers of the SEBI is the power to regulate all stock exchanges and other securities markets. This is a wide power that would ordinarily enable SEBI to regulate any securities trading platform whatsoever. The RBI has established a separate trading platform with order-matching facility for trading money market instruments and government securities—the negotiated dealing system or NDS. Since the NDS is a securities market in itself, it would appear that the SEBI would have the right to regulate the NDS. This, however, is not the case and the regulation of the NDS is left entirely to the RBI. The powers recently conferred on the RBI under the newly introduced Chapter IIID support this position but the uncertainty as a result of the overlap between the power of the RBI and SEBI need to be addressed and resolved. Further, the negotiated dealing system is restricted to those entities that hold current accounts and securities with RBI (banks, primary dealers, financial institutions, and so on). Currently, market participants, such as brokers and provident funds, who play an active role on the National Stock Exchange’s Wholesale Debt Market are not yet part of this system. This results in fragmentation and inefficient price discovery.


SEBI regulates the issuance of longer-term corporate debt instruments. Such a division prevails in many countries. Oversight of mutual funds (normally under SEBI’s purview but coming under RBI’s control as they offered money market investments) was subject to regulatory overlap until 2000, when it was decided that money market mutual funds would be regulated by SEBI. Some of the regulatory confusion also arises due to the fact that while SEBI is the primary regulator of the markets, the primary investors (banks) and primary dealers are regulated by RBI. Consequently, the various regulations and stipulations relating to banks’ participation in the corporate debt market as required by the Reserve Bank of India on these controlled entities has a significant impact on the market. The specific regulation and stipulations have been discussed in the earlier chapter relating to demand issues. Overlaps and jurisdictional issues will increase as financial markets become more complex and open, thereby increasing the challenge of regulating and supervising them.

Overlap due to ‘definitions’ of terms in the legal and regulatory framework

There appears to be considerable overlap in applicability of terms such as “securities,” “repos,” “bonds,” “derivatives,” and so on that have been used in multiple legislations. Furthermore, it is evident that, particularly where there are multiple authorities that have the ability to regulate a similar space, the practice of defining terms inclusively leads to lack of clarity. An examination of the entire legislative landscape is warranted, and once the legislators have a clear idea of the manner in which the regulatory jurisdiction needs to be carved up between the SEBI and the RBI, it is important that appropriate amendments be made to the definitions of the various terms that have been used loosely across statutes. If possible, the same term should not be used to define instruments over which multiple authorities have regulatory jurisdiction unless absolutely necessary and in such event a clear hierarchy of control could be laid down in order to avoid overlaps of jurisdiction. If possible, where two authorities exist with similar power over different segments of the debt market, care should be taken

to ensure that the terms used to describe the scope of authority are distinct in order to avoid confusion.

A few other examples of this overlap, which result in diffusing regulatory authority and uncertainty for market participants, are provided in box 3.3.

That said, there is a recent example of better interagency coordination in rule setting. For instance, SEBI recently issued guidelines on the issuance and trading of privately placed corporate debt, which were prepared in consultation with RBI. RBI, in turn, issued investment guidelines for investors such as banks and primary dealers to complement SEBI’s actions on regulating the private placement market. This coordination in rule setting was meant to encourage more transparency in the issuance of privately placed corporate debt. This coordination was achieved through the Technical Subcommittee of the High Level Committee on Capital Markets and through RBI participation in SEBI committees set up to examine issues in the debt markets.14

Creditor’s rights

A key legal weakness of the corporate bond market is the payoffs obtained by bondholders in the event of default. In industrial countries, an extensive bankruptcy code exists, with well-functioning institutions. When a company fails to pay out cashflows on time, the management team of the company is displaced, the company is sold off, and the residual value is given to the bondholders. Such processes do not exist in India. Bondholders have to plan for near-zero recovery in the event of default.

The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, has made some progress on rapid repossession of collateral for secured credit. However, this is a narrow concept, which does not address the deeper issues of the bankruptcy code. In a modern setting, bond issuance should be a senior claim on the cashflows of the company and not associated with specific assets. One of the key weaknesses of SARFAESI is that it is focused on the interests of institutional bondholders. It does not adequately address the claims of individual bondholders.


The lack of a bankruptcy code and institutional mechanisms to deal with failure in a way that is fair to bondholders has crimped the ability of corporations to issue bonds based on expectations of future cashflows. The low recovery rates of the present institutional arrangements have served to exacerbate credit spreads and have led to credit rationing for most corporations.

Provisions in the Companies Act

The Companies Act governs the ways and means through which companies can source funds. There are several aspects of the Companies Act that have a direct influence on corporations accessing debt, either as loans or as securities:

Every new loan can be made only after a No-Objection Certificate is obtained from the earlier lender. Furthermore, every loan has to be registered with the Registrar of Companies within 30 days.Today, no single creditor has the right to call for a change in management despite evidence of oncoming bankruptcy. This requires a change in company law.A ceiling is imposed on the coupon rate that a corporation can issue on a bond. These ceilings are decided as part of “deposit rules” (which is a part of the Companies Act) jointly with RBI. Technically, the Companies Act has primacy in this matter. These ceilings have been changed three times since 1975. If these ceilings are set such that the difference between the corporate bond coupon rates and the government bond rates do not match the investors’ perception of credit risk of the corporation, then the investors would have a disincentive to purchase the corporate bond. This disincentive can be exacerbated by nontransparency about corporate bond prices and the high cost in obtaining knowledge about the interest rates and credit premiums for corporations.

In sum, although corporate law in India provides a certain degree of control in determining the rights of creditors in India, many uncertainties continue. To further understand the changes that need to be made to

remove restrictions on corporate bond development, the Companies Act needs to be examined more thoroughly, which is beyond the scope of this policy note.

Taxation

Finally, the heterogeneous tax treatments across different debt securities (issued by the same corporation) create financial distortions and make it difficult for investors to price different instruments. An added complication from the investors’ side is with-holding tax (tax deduction at source). With-holding on corporate bonds is deducted on accrued interest at the end of the financial year according to prevalent tax laws. A with-holding tax certificate is issued to the registered owner at the end of the fiscal year end with interest payment made on the interest payment date, to the registered holder, after deducting the with-holding tax due. When multiple trading takes place in a corporate bond, physical exchange of cash needs to take place to account for the with-holding tax. Investors who are subject to with-holding find it difficult to sell the bond to those investors who are not subject to such a tax. In 2000, in an effort to encourage secondary trading of government securities a similar with-holding tax which was prevalent at that time, was abolished. Similarly, there is a need to exempt interest payments on corporate bonds and securitized assets from the requirement of with-holding tax to encourage a deeper and liquid bond market in India (Patil Committee Report, 2005).

Notes1 Shelf registration in India is allowed through an umbrella prospectus,

whereby a company files one consolidated offer document with the securities market regulator for the entire amount it proposes to raise over the next 12 months, allowing the company to make more than one offering within the stipulated period.

2 In most jurisdictions, while extensive disclosure guidelines tend to apply to public issuances, private placements are usually exempt from such stringent rules. In the United States, many issuers prefer to use Rule 144A for placing securities privately to “qualified institutional buyers,” which exempts them from registration, detailed disclosures, and costs related to preparing financial statements, according to the U.S. Generally Accepted Accounting Principles.

3 The first transaction in India of around Rs. 200 million of car receivables was placed by Citibank with GIC Mutual Fund.

4 The section on securitization draws on the analysis carried out by Fitch Ratings and ICRA in their special reports on securitization transactions.

5 Asset categories frequently being securitized now include auto loans, two-


wheeler loans, commercial vehicles, construction equipment, residential mortgages, and credit products (single loan sell-downs, and CDOs/CLOs) (Fitch Ratings 2006).

6 Apart from stamp duties and other registration charges levied on the value of underlying assets, ineffective foreclosure laws and provisions of the Income Tax Act, 1961, and the Transfer of Property Act render securitization transactions unfeasible to a large number of investors.

7 Although credit insurance is important for the overall bond market, credit insurance for financing infrastructure projects has been more difficult and has been used in a few developing countries (such as in Chile for the toll road program) and often in conjunction with official insurers, such as the Multilateral Investment Guarantee Agency or the Inter-American Development Bank.

8 The issuer enhances its creditworthiness by purchasing a credit guarantee and receives the credit rating, usually AAA, of the credit guarantee company. Unless the savings resulting from the reduced interest costs exceed the cost of the guarantee, this form of credit enhancement is not useful for the issuer.

9 The Reserve Bank of India, in its recent report on the Trends and Progress of Banking in India, sees factors such as depth of the bond market, new regulations seeking risk weightage commensurate with credit ratings, and further consolidation of the banking industry as

being some pre-conditions for development of the credit derivatives market in India.

10 Between end-March 2002 and end-March 2006, contracts and derivatives transactions of the banking system increased at an annual compound growth rate of 55.5 percent. Consequently, the share of contracts and derivatives (notional principal) in total off-balance sheet exposures of the banking system increased from 82.5 percent to 92.7 percent during the same period. The combined share of the 15 banks active in this market in total off-balance sheet exposures steadily increased from 73.8 percent in March 2002 to 82.3 percent in March 2006 (Trends and Progress in Banking, 2005–06).

11 Rajwade, 200612 Non-fungible in nature, small size of issuance series, and so on.13 However, it is also recognized that the corporate debt market worldwide

has historically suffered from limited disclosure and lack of credit rating information. Only in recent years has some transparency been introduced (for example, in the Eurobond market and, very recently, in the United States).

14 The Technical Subcommittee included representatives from RBI and SEBI. The High Level Committee on Capital Markets was established by the Ministry of Finance in 1992 in an effort to improve regulatory and supervisory coordination among all the major financial regulators (RBI, SEBI, and IRDA).

4. What does India need to do to develop its corporate bond market?

Participation in India’s corporate bond market cannot be forced or declared, but it can be encouraged by an enabling environment

(Harwood 2000). For issuers, investors, and intermediaries alike, an enabling environment has several key components:

Recognized economic benefit, often in the form of better costs, lower risks, or better market performance than the status quo.Positive attitude toward participation, which for issuers includes willingness to disclose information and for investors includes willingness to take risks and trade, because of perceived benefits from being in the market. Ability to participate, because all participants have the skills and the right industry structure to engage in market activities.

The development of an enabling environment for the corporate bond markets also requires a few necessary “preconditions.” Macroeconomic stability, a well-functioning money market, a government securities market, and an effective legal and regulatory framework provide a critical foundation on which to build corporate bond markets. That said, many of the elements of an enabling environment are interdependent and normally must be developed or reformed in conjunction with one another. It must also be cautioned that there is no general agreement on which conditions are “necessary” for corporate bond market development, and there is certainly no “one-size-fits-all” recipe.

In India, some of the measures relating to the government securities market are already in place or are being implemented. For instance, a relatively liquid benchmark yield curve for government debt, of up to 20 years, already exists. Furthermore, ongoing efforts by the authorities

to broaden and improve the liquidity of the repurchase market—much of which is currently focused on the overnight market—are also important for the corporate debt market. Moreover, although local securities markets can provide an alternative source of funding to the banking sector, especially during banking crises, a sound and well-regulated banking system can be a necessary complement to the development of local bond markets.

As part of its market reform strategy, the Securities Exchange Board of India has set up a committee to look into the development of the bond market. Additionally, the High Level Expert Committee on Corporate Bonds and Securitization, which was appointed by the minister of finance to look into the legal, regulatory, tax, and market design issues in the development of the corporate bond market, has submitted its report. The Government has accepted the report and is in the process of implementing the recommendations (annex 7).

With these strategic assessments in mind, this policy note draws together a variety of recommendations that could facilitate a ‘Roadmap’ for developing India’s corporate bond market. The recommendations are grouped into two main categories: those involving regulatory reforms and those for market microstructure reforms.

Recommended regulatory reformsThree types of regulatory reforms are proposed to affect the issuers, the various classes of investors, and the laws and regulations governing the corporate bond market.

Better access for issuers

A growing and diverse set of issuers with both the size and credit quality necessary to appeal to institutional


investors is needed for the sustained growth of the corporate bond market. A variety of measures can encourage more corporations to enter the bond market as issuers:

Medium-size and small corporations should adopt high standards of transparency and corporate governance to strengthen their credit ratings and facilitate market access. From the regulator’s side, the procedures for public issuance of debt should be further streamlined, drawing on lessons from countries such as Korea, where regulatory approval takes just 5 days (against 21 days in India). Another area that needs to be revisited is the definition of private placements, which focuses on the number of investors1 rather than on their quality and capacity to demand the type of information and performance indicators from issuers. By formally recognizing a QIB (Qualified Institutional Buyer) market as the primary target for private placements and secondary trading, the regulator could feel comfortable in providing much more flexibility on the standards of disclosure and corporate governance, and allow those elements to be more of a contractual nature between investors and issuers.

Extending shelf registration to all types of corporate issuers would also facilitate quick, timely, and cost-effective access of issuers to the markets. Such an arrangement is widely used in developed debt markets, such as the United States, United Kingdom, Korea, and Singapore. For example, regulators could consider an extension of shelf registration of prospectuses to all companies that offer debt instruments to qualified institutional buyers, rather than only to public financial institutions. Alternatively, the regulators could adopt practices similar to those in the Eurobond market. Issuers who tap the market frequently are permitted to use a short-form listing agreement and are given regulatory approval as a condition to an offer closing. As a result, an issue could be launched more easily with the documentation and approvals to follow. Over the medium term, the debenture trustee system needs to be strengthened by providing

protection from default by the company in timely payment of interest.2 This could encourage retail investment in corporate bonds.Rationalization of the stamp duty among different classes of investors and states. Stamp duty is usually a deterrent for primary issuance of bonds and other securitization transactions and needs to be streamlined to make it uniform across different states.

Better opportunity for investors

Local institutional investors, pension fund managers, insurers, as well as banks should be encouraged to play a major role in the development of the corporate debt market. Investment policies and regulatory guidelines for insurance companies, pension funds, mutual funds, banks, and other financial institutions need to be sufficiently flexible for these entities to choose an appropriate risk-return profile within fiduciary constraints. This will also help professionalize fund management. In parallel, the authorities need to address shortcomings in the accounting methodology, as well as the low level of skills in fund management in some pension and provident funds. The following measures could be considered for institutional investors:

Regulations for permitting pension and provident funds to invest in corporate debt should be relaxed and amended. This will help lengthen the maturity of corporate debt. Furthermore, the move toward a private pension system and a defined contribution scheme would give pension fund managers greater flexibility in investing their funds. Ideally, the longer-term investment horizon of pension funds should help fulfill the funding needs of the infrastructure sector.

The investment guidelines for insurance companies should be modified to allow investment in instruments with a rating of less than AA. At present these investments are counted toward “unapproved” investments. Such a modification, in conjunction with development of credit enhancement products, should enable insurance companies to invest in a wider range of credits.

39What does India need to do to develop its corporate bond market?

Given the early stage of market development, where long-term institutional investors are not yet active, the banking system could play an important role in the development of the corporate debt market. Regulatory caps on banks’ investments in unlisted corporate bonds could be relaxed (currently limited to 10 percent of the total investments permitted outside their statutory liquidity ratio), as could the minimum rating requirement needed for investments in corporate bonds (currently AA and above).

As discussed in the earlier sections, the regulatory regime for banks puts onerous requirements if a corporate credit is held as an investment (that is, as a tradable security) instead of as a loan. Market participants feel that the regulations should recognize the advantage of holding of corporate credit assets as investments because of their tradable nature. Two measures would be helpful in this regard:

Capital for market risk should be provided for the overall interest rate risk in the balance sheet, rather than just the marked-to-market portion of the book. This would ensure that bonds and loans are given similar treatment from the interest rate risk perspective.

The artificial distinction between investments and advances in the current regulatory regime needs to be removed. Guidelines and rules should be similar for a given credit, whether it is held as a loan or as a bond.

Competitive pressures are likely to force banks and other financial intermediaries to develop diverse instruments to address the needs of investors and issuers. Increased emphasis on better risk management and the adoption of the new Basel Accord over the medium term are likely to cause banks to economize their capital by providing instruments as alternatives to extending and warehousing loans. Measures that facilitate banks’ move to the investment banking and brokerage business are likely to both help improve banks’ profitability and contribute to the development of securities markets, particularly corporate bond markets.

The current corporate bond ceiling needs to be further raised for investments by foreign

institutional investors in corporate debt. As a first step, the cap could be relaxed for longer-term investment in the corporate debt market (over three years).The liberalization of limits on mutual fund investments to allow the development of closed-ended fund products. This would encourage investments down the corporate debt spectrum. Existing restrictions on lower-rated instruments could be relaxed. This could perhaps encourage development of high-yield bond fund of Indian assets and corporations rated below AA, which constitute the bulk of local companies in the infrastructure sector.

The authorities need to ensure that pension and provident funds and insurance companies have access to professional fund management services and put in place adequate risk management systems to preserve the soundness of these investors.

Better regulatory practices

Better regulatory practices are crucial for market development. The principal recommendation on regulatory practices is to clarify oversight responsibilities among the various agencies that are now involved in regulation.

The regulation of the corporate debt market should be put under the ambit of one regulator. Currently, perceived inconsistencies and conflicts between the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) are seen as important impediments to building confidence in the market. An examination of the entire legislative landscape is warranted, and once the legislators have a clear idea of the manner in which the regulatory jurisdiction needs to be carved up between the SEBI and the RBI, it is important that appropriate amendments be made to the definitions of the various terms that have been used loosely across statutes. If possible, the same term should not be used to define instruments over which multiple authorities have regulatory jurisdiction unless absolutely necessary and in such event a clear hierarchy of control could be laid down in order to avoid overlaps


of jurisdiction. If possible, where two authorities exist with similar power over different segments of the debt market, care should be taken to ensure that the terms used to describe the scope of authority are distinct in order to avoid confusion.

In addition, for effective functioning of the bond markets, the authorities must adopt a regulatory framework that ensures investor protection and market integrity, while containing systemic risk. Key elements of the required framework include the enforcement of recently amended bankruptcy laws that clearly define creditors’ rights and borrowers’ responsibilities, the promotion of adequate corporate governance practices, and the timely and accurate public disclosure of financial information.

In the short run, RBI’s responsibility for prudential regulation3 of the government securities market should probably continue, given that RBI is also entrusted with being investment banker to government, formulating and implementing monetary policy, and ensuring that monetary policy is carried out through sound intermediaries (market participants). In addition, RBI could continue to provide the market infrastructure for government securities trading, such as carrying out the auction system, the trade-matching system, the recording of transactions, and settlement (through the Clearing Corporation of India, Ltd.). However, inherent conflicts of interest should be minimized with respect to RBI’s being a provider of services to the government securities market as well as a regulator of that market. To achieve this result, RBI will need to ensure that its services are provided in a transparent manner and that information is available to all market participants uniformly.

In the medium term, these market infrastructure services for the government securities market should be gradually moved out of RBI. With regard to market conduct regulation of the government securities, which covers the behavior of market participants and market integrity issues, these functions should be moved to SEBI. In the longer run, as the larger questions of financial regulatory architecture are resolved, the option of moving to a unified regulation of the financial markets could be considered.

Recommended market reformsTo strengthen the corporate bond market itself, recommendations focus on improving the comprehensiveness of and access to information about issues and issuers, the efficiency and reliability of market infrastructure, the range of products available, and the homogeneity of corporate bond securities.

Better corporate credit and trade information

Information plays a critical role in corporate debt market development. More effort needs to be put into collecting and disseminating data on the size, coupon, and latest credit rating of bond issues, as well as the underlying corporate performance and default history of companies and the scope of secondary trading (particularly pre-trade information on investors’ access to best quotes and post-trade information dissemination). This could be undertaken either by a specialized agency or one of the self-regulatory organizations in the capital market. However, to kickstart the process, the regulators (SEBI and the Ministry of Company Affairs) could require listed and unlisted companies to provide certain minimum information on all outstanding securities by these issuers to the National Stock Exchanges, Clearing Corporation of India Limited, or Fixed Income Money Market Dealers Association. This information should then be made accessible to the public through a frequently updated Website.

Better market infrastructure

Efficient trading and settlement systems are critical to provide an exit route for debt investments in infrastructure. India needs to upgrade its trading and settlement systems. Several Asian and Latin American markets have adopted sophisticated settlement systems and put in place mechanisms for recourse (through guarantee funds or compensation funds) in settling transactions, and their experiences could provide some useful lessons.4 In particular, a mechanism that will allow both listed and unlisted bonds to be cleared and settled by a central system could be explored. This will help improve order flow and reduce market fragmentation.

41What does India need to do to develop its corporate bond market?

In developed markets it is common for bond issues to be listed on an exchange, which allows for transparency and disclosure, but trading occurs off the trading floor in the over-the-counter market. The chief reason that bond market trading is concentrated in over-the-counter markets is that the diversity of debt securities—in maturity, coupons, and credit risk—tends to result in limited trading of most corporate debt issues, and thus a dealership trading system can improve liquidity.

Better choice of products

Government should encourage financial intermediaries to offer new product structures (for example, credit enhancement, bond insurance) that enable sub–investment grade corporations and municipalities to access financing. RBI and SEBI should consider regulatory reforms that would help develop hedging tools for investors and traders, for example, credit derivatives, bond futures, and options. The development of fixed-income derivative instruments is very important for the debt market. The liberalization of the investment regime for financial institutions to take positions in derivatives—subject to strict risk management and reporting requirements—would improve liquidity in the market and encourage the development of a broader range of instruments. Presently, while financial institutions such as insurance companies and banks are only allowed to use derivatives for hedging purposes, investment by financial institutions in rupee assets can be hedged through the currency market only up to the market value of the investment.

Short selling, an often suggested reform measure for the Indian debt market, needs to be allowed in government securities, as it will help in refining the pricing mechanism for corporate bonds and help investors hedge their risks effectively. For example, investors could hedge the interest rate risk more effectively by locking in the credit spread on a corporate bond by going short on a government bond with similar maturity.

The market for securitization in India holds great potential and should be tapped for infrastructure projects. To date, the growth of this market has underperformed, largely because of high stamp duties and the previous absence of

a legal framework. However, the asset-backed securities market is expected to grow strongly with expanding pools of assets, such as mortgages, lease receivables, credit card receivables, and consumer loan receivables. More important, the proposed amendment to the Securities Contract Regulation Act that makes pass-through certificates amenable to listing and trading will provide a much-needed boost for securitization activity.

Banks could play an innovative role in project financing through longer-term credit enhancements, take-out financing, special purpose vehicles, and guarantees of corporate bonds. A typical long-term project faces the highest risk in initial years, and cashflows usually stabilize after five to seven years. The initial risks could be taken by banks and financial institutions through medium-term lending, and as cashflows become secure, the loans could be securitized and sold to institutions that have a longer-term liability structure. Packaging and selling a mix of loans involving all kinds of assets (including loans to relatively small and medium-size enterprises) is another type of securitization that would be a useful innovation for improving access to finance. A necessary condition for this process of asset securitization is the evolution of a deep and liquid corporate bond market.

Better homogeneity in corporate bond securities

Currently, there is a lack of homogeneity across corporate debt securities. While foreign investors are interested in the local corporate debt, it is difficult for them to make adjustments for regulatory risk when determining relative value. For instance, different taxes may apply to different debt instruments issued by the same corporate. As a result, debt of the same tenor issued by one company could have very different yields before adjusting for regulatory effects, making comparisons very difficult. Some degree of standardization and homogeneity in bond contracts would facilitate the pricing of credit risk, with regulations implemented to ensure a minimum set of guidelines for such contracts. From the investors’ side, there is a need to exempt interest payments on corporate bonds and securitized assets from the requirement of with-holding tax to encourage a deeper and liquid bond market in India.


ConclusionThe list of reforms discussed above is not entirely new nor by any means complete (a matrix of recommended reforms, highlighting actionable areas, is in annex 1). But the message does bear repeating. Corporate bond markets are important for financial stability as a buffer when other funding sources are affected. The development of a deep, liquid local corporate bond market in India at the longer end of the maturity spectrum could facilitate a competitive source of financing that allows access to a wide range of issuers. It would also benefit the country’s infrastructure investments by tapping into the growing pool of long-term funds available with the gradually developing class of institutional investors.

Notes1 Private placements are defined under the Companies Act as issuing

programs targeted to less than fifty investors.2 The debenture trustee has a fiduciary responsibility to protect the interest

of the debenture holder and is expected to enforce security in the event of default by the issuer company to the bondholders.

3 Setting standards (for example, capital requirements) and supervising market participants, such as banks and primary dealers.

4 Similar settlement guarantee for secondary trades is provided in India, although it is limited to trades that are struck on the exchange trading system. As most corporate debt trades are negotiated over the phone, the settlement guarantee does not extend to such trades, thereby increasing the settlement risk in the corporate bond market.

Annex 1. Recommended reforms, by responsible agency

Reform measures Responsible agencyRegulatory reforms

(a) LegalandRegulatoryFrameworkImprove existing regulatory practices for market development. The regulation of the corporate debt market should be put under the ambit of one regulator. Currently, perceived inconsistencies and conflicts between the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) are seen as important impediments to building confidence in the market.

Ministry of Finance, Reserve Bank, and Securities and Exchange Board of India

Adopt a regulatory framework that ensures investor protection and market integrity, and contains systemic risk. Key elements of the required framework include the enforcement of recently amended bankruptcy laws that clearly define creditors’ rights and borrowers’ responsibilities, the promotion of adequate corporate governance practices and timely and accurate public disclosure of financial information.

Ministry of Company Affairs, Ministry of Finance, Reserve Bank, and Securities and Exchange Board of India

(b) PrimaryIssuancerelatedreformsStreamline procedures for public issuance of debt, drawing on lessons from countries like Korea, where regulatory approval takes just 5 days (against 21 days in India).


Distinguish regulatory requirements applying to the wholesale market – such as qualified institutional buyers (QIBs) – from those applying to the retail market. Similarly, disclosure requirements for privately placed debt could be differentiated based on the whether it is a new issuer or an existing issuer company.


Extend shelf registration to all types of corporate issuers to facilitate quick, timely and cost-effective access of issuers to the markets. Regulators could consider an extension of shelf registrations of prospectuses to all companies that offer debt instruments to qualified institutional buyers, rather than only to Public Financial Institutions.

Securities and Exchange Board of India, Ministry of Company Affairs

Strengthen the debenture trustee system by providing protection from default by the company in timely payment of interest. This could encourage retail investment in corporate bonds.


Rationalize the stamp duty among different classes of investors and states. Stamp duty is usually a deterrent for primary issuance of bonds and other securitization transactions and needs to be streamlined to make it uniform across different states.

Ministry of Finance, State Governments, Reserve Bank of India


Reform measures Responsible agency(c) InvestorrelatedreformsRelax and amend regulations for permitting pension & provident funds to invest in corporate debt. Need to expedite the move towards a private pension system and a defined contribution scheme would give pension fund managers greater flexibility in investing their funds.

Ministry of Finance, Income Tax Department, Ministry of Labor, Employee Provident Fund Organization

Modify the investment guidelines for insurance companies to allow investment in instruments with a rating of less than AA with adequate safeguards to protect the soundness of the investor.

Insurance Regulatory and Development Authority

Relas regulatory caps on banks’ investments in unlisted corporate bonds (currently limited to 10 percent of their total non-SLR investments) as could the minimum rating requirement needed for investments in corporate bonds (minimum investment grade, i.e. AA and above).


Provide capital for market risk for the overall interest rate risk in the balance sheet as opposed to just marked-to-market portion of the book. This would ensure that bonds and loans are given similar treatment from the interest rate risk perspective.


Remove the artificial distinction between investments and advances in the current regulatory regime. Guidelines and rules should be similar for a given credit whether it is held as a loan or as a bond.


Facilitate banks’ move to the investment banking, brokerage business. In light of various competitive pressures and adoption of the Basel Accord in the medium term, such measures are likely to both help improve banks’ profitability and contribute to the development of securities market, in particular, corporate bond markets.


Raise the current corporate bond ceiling for FII Investments in Corporate Debt. As a first step, the cap could be relaxed for longer term investment in corporate debt market (over 3 years).

Ministry of Finance, Reserve Bank of India, Securities and Exchange Board of India

Liberalize mutual fund investments to allow the development of closed-ended fund products. Existing restrictions on lower rated instruments could be relaxed.


Professionalize fund management services the authorities need to ensure that pension/provident funds, insurance companies have access to professional fund management services and put in place adequate risk management systems to preserve the soundness of these investors.

Securities and Exchange Board of India, IRDA, EPFO

3 Market microstructure reformsImprove corporate credit and trade information. More effort needs to be put into collecting and disseminating data on bond issues, size, coupon, latest credit rating, underlying corporate performance, information on secondary trading (particularly pre-trade information related to investors having access to best quotes as well as post-trade information dissemination) and default histories of companies.

Securities and Exchange Board of India and the Ministry of Company Affairs. Secondary Responsibility: Credit Rating Agencies, National Stock Exchanges, CCIL, or FIMMDA

45Annexure

Reform measures Responsible agencyMake trading and settlement systems more efficient to provide for liquidity, efficient price discovery, and an exit route for debt investments in infrastructure.

Securities and Exchange Board of India, Reserve Bank, Stock Exchanges, CCIL, Ministry of Finance

Develop new product structures (e.g., credit enhancement, bond insurance) and hedging mechanisms.

Securities and Exchange Board of India, Reserve Bank, Stock Exchanges, CCIL, Ministry of Finance, Self-Regulatory Organizations like FIMMDA, AMFI, PDAI etc.

Allow short selling in government securities as it will help in refining the pricing mechanism for corporate bonds and help investors hedge their risks effectively.


Remove the tax differential between different classes of corporate bonds.

Ministry of Finance, Central Board of Direct Taxes

Annex 2. Key reforms and outstanding issues in the government securities markets

1992: Introduction of auction system for price discovery

1993: Introduction of 91-day Treasury bills for managing liquidity and benchmarking

1994: Issuance of zero-coupon bonds

1995: Primary dealer (PD) system set up; DvP settlement system introduced; floating-rate bonds issued

1997: Technical Advisory Committee set up, permitting repurchase in government securities. Allowing foreign institutional investors to invest in government securities; system of ways and Means advances introduced for government of India; capital-indexed bonds introduced

1999: Introduction of over-the-counter interest rate derivatives, like IRS/FRAs,

2000: Introduction of Liquidity Adjustment Facility (LAF) to manage short-term liquidity mismatches

2002: Operationalization of Negotiated Dealing System (NDS) and CCIL. Trade data on NDS made available on RBI website for transparency

2003: Introduction of trading of government securities on stock exchanges, permitting nonbanks to participate in repurchase market; exchange-traded interest rate futures introduced

2004: Introduction of the Real Time Gross Settlement System, which facilitates liquidity management; DvP III mode of settlement enabled to permit net settlement of both funds and securities leg (the DvP III mode of settlement has also permitted the rollover of repurchases); Market Stabilization Scheme introduced, which has expanded the instruments available to the Reserve Bank for managing the surplus liquidity in the system.

Table A2.1 Dimensions of the Indian government securities market, 1992–2005Item 1992 1996 2002 2003 2004 2005Outstanding stock (Rs. in billions) 769 1375 5363 6739 8243 8953Outstanding stock as ratio of GDP (percent) 14.68 14.20 27.89 27.29 30.09 28.94Turnover/GDP (percent) – 34.21 157.68 202.88 87.78 72.99Average maturity of the securities issued during the year (in years) – 5.70 14.90 15.32 14.94 14.13Weighted average cost of the securities issued during the year (percent) 11.78 13.77 9.44 7.34 5.71 6.11Minimum and maximum maturities of stock issued during the year (in Yyears)

N.A. 2–10 5–25 7–30 4–29 5–30

PD share in the turnoverA. Primary market 70.46 65.06 50.84 36.02B. Secondary market – 22.04 21.72 24.25 26.7

* CCIL: Clearing Corporation of India, Limited.

Note: Turnover is the total of outright (volume*2) and repurchase (volume*4) turnover.

Sources: RBI, Report on Currency and Finance, various issues; RBI (2003) [not cited].


Outstanding issues in the development of a government securities market

Absence of a robust benchmark yield curve for government bonds: While the government has issued long term securities, the relatively small average size of each benchmark securities issuance coupled with limited trading activity has meant that there is really no risk-free benchmark reference rate to peg the longer tenor section of the yield curve. To create a reliable government bond benchmark yield curve, the size of each benchmark security needs to be sufficiently large, usually a significant multiple of the average transaction size. Starting in 2003, the Reserve Bank of India (RBI) has made efforts to consolidate issuances with the aim of concentrating liquidity in a small number of benchmark issues. However, more active steps need to be taken for consolidation.

The government debt market is wholesale in nature; the limited trading that does take place is done bilaterally over the telephone through brokers, or on the Negotiated Dealing System (NDS). This results in a non-transparent market with poor-price discovery where only the parties to trade have information about the trade. The lack of trading in the government debt market may be attributed to two other factors. First, institutional investors such as pension funds and insurance companies are mandated to hold Government securities until maturity, thus hindering active trading. Second, while interest rates in India are largely deregulated, certain structural rigidities hinder efficient price discovery in various markets. This inflexibility can be explained by regulated

interest rates on small saving schemes offered by Government which are not explicitly linked with the market determined risk free curve. Retail investors prefer to invest in instruments such as postal savings and provident funds where returns are artificially pegged at much higher rates (see Table 12 below), than to invest in the debt market, especially given the lack of awareness on the risk-return profile of the Government securities and the relatively higher cost of trading in the retail segment of Government securities.

Notes1 While the size of the gross borrowing requirement is large, the market’s

absorptive capacity is small and this puts constraints on the size of individual issues leading to a number of small issuances of benchmark securities. This in turn affects liquidity of the benchmark securities.

2 Recently, the National Stock Exchange (NSE) in its Wholesale Debt Market segment has come up with an innovative formula to devise a 20-year yield curve. While it functions as the only “quasi-reference” rate for long term corporate paper, it has not sufficed to trigger a more active bond market for long tenor debt securities.

3 NSE does provide a platform for trading, but it is mainly used for reporting deals which have been executed and thus it remains a negotiated market.

Table A2.2 Interest rates on various savings instruments end-March 2005

Saving Instrument Rates (%)Postal Savings 6.25–7.5National Saving Scheme 8.5EPF 9.5PPF 8.0G-Sec 4.69–5.73T-bill 4.36–4.37

Note: Rates for 1 to 5 years duration except EPF; as of Dec 2004

Source: Reserve Bank of India, State Bank of India, National Stock Exchange and Department of Posts

49Annexure

Table A3.1 Issuers in India and typical issue characteristicsIssuer Instruments Maturity InvestorsPublic sector units Bonds, Structured

Obligations5–10 years Banks, Insurance Companies, Provident

Funds, Mutual Funds, Individuals, CorporatesCorporations Debentures 1–12 years Banks, Mutual Funds, Individuals, Other

CorporatesCorporations, primarydealers

Commercial Paper 15 days to 1 year Banks, Financial Institutions, MutualFunds, Individuals, Corporates, FIIs

Scheduled commercialbanks, select financialinstitutions (underumbrella limit fixed byRBI)

Certificates of Deposit 15 days to 1year, whereasfor FIs it is 1year to 10 years

Banks, FIIs, Corporations, Other Corporates,Trusts, Associations, FIs, NRIs, Individuals,Mutual Funds

Public sector units MunicipalBonds

0–7 years Banks Corporations, Trusts, Funds, Associations,FIs, NRIs, Individuals, OtherCorporates

Source: Indian Securities Market, A Review, 2004, National Stock Exchange Limited (NSEL).

Annex 3. Statistics on issuers in primary markets

Table A3.2 Selected indicators of debt markets in India, 2002–06(Rs.billions)Issuer Amountraisedfromprimarymarket

2002–03 2003–04 2004–05 2005–06Government 1,820 1,982 1,456 1,600Corporate/nongovernment 531 527 595 966Total 2,351 2,509 2,051 2,566Source:Prime Database, Reserve Bank of India (RBI), National Stock Exchange (NSE), Securities and Exchange Board of India (SEBI), World Bank staff estimates.


Table A3.3 List of top 25 issuers in the year 2005–2006.Company Issuance

Rs billionIndustrial Development Bank of India 68.5Power Finance Corporation Limited 56.7Housing Development Finance Corporation 55.2Rural Electrification Corporation 52.2Food Corporation of India 45.8ICICI Bank Ltd. 39.7National Bank for Agriculture and Rural Development 33.3State Bank of India 32.8Export-Import Bank of India 28.6Indian Oil Corporation 22.3Power Grid Corporation of India Ltd. 20.0National Housing Bank 19.1Infrastructure Development Finance Company 18.5Housing and Urban Development Corporation 16.1Small Industries Development Bank of India 15.2Citicorp Finance (India) Ltd. 14.2Gas & Power Investment Company Limited 13.1Indian Railway Finance Corporation Ltd. 13.0Mahindra & Mahindra Financial Services Ltd. 12.1HDFC Bank 12.0National Highways Authority of India 11.9LIC Housing Finance Ltd. 11.0Syndicate Bank 10.0UTI Bank 10.0CitiFinancial Consumer Finance Ltd. 10.0Total 641.3

Source: Prime Database

Table A3.4 Resources raised by banks through private placement (2003–2006)Category 2003–04 2004–05 2005–06

No. of issues Amount raised No. of issues Amount raised No. of issues Amount raisedPrivate sector banks 63 2,895 44 6,180 24 7,834Public sector banks 16 3,728 43 9,039 73 22,317Total 79 6,623 87 15,219 97 30,151

Source: RBI Trends and Progress Report, 2005, 2006

Annex 4. Restrictive investment policies and guidelines for insurance and pensions

Table A4.1 Investment guidelines for life insurance companiesS.No Type of Investment Percentage i) Government Securities 25%,ii) Government Securities or other approved securities (including (I) above) Not less than 50%iii) Approved Investments as specified

a) Infrastructure and Social Sector Not less than 15%b) Others to be governed by specified Exposure/Prudential Norms Not exceeding 20%

iv) Other than in Approved Investments to be governed by specified Exposure/Prudential Norms Not exceeding 15%

Source: Insurance Regulatory and Development Authority (IRDA)

Table A4.2 Investment guideline for non-life insurance companiesS.No Type of Investment PercCentagei) Central Government Securities being not less than 20% ii) State Government securities and other Guaranteed securities including (i) above being not less

than 30%

iii) Housing and Loans to State Government for Housing and Fire Fighting equipment, being not less than

5%

iv) Investments in Approved Investments as specified in Schedule IIa) Infrastructure and Social Sector Not less than 10%b) Others to be governed by specified Exposure/ Prudential Norms Not exceeding 30%

v) Other than in Approved Investments to be governed by specified Exposure/ Prudential Norms Not exceeding 25%

Source: Insurance Regulatory and Development Authority (IRDA)


Table A4.4 Maximum exposure to an asset for pension funds in Latin American countries Argentina Chile Colombia Peru UruguayGovernment Debt 50% 50% 50% 40% 60%Time Deposit 28% 50% 50% 30% 30%Bonds 28% 45% 20% 49% 15%Stocks 35% 37% 30% 35% 25%’Mortgage Bonds 28% 50% 30% 40% 20%Foreign Investment 10% 12% -- 10% --Close-End Investment Funds 14% 5% 10% 15% --Futures and Exchange Risk Coverage 2% 9% -- 10% --

Source: Organization for Economic Cooperation and Development (OECD)

Table A4.3 Investment guidelines for pension funds S.No Investment Pattern Percentage amount

to be investmenti) Central Govt. Securities; and/or units of Mutual Funds which have been set up as dedicated

funds for investment in Government securities and which have been approved by SEBI25%

ii) a) Govt. Securities; created and issued by any State Government; and/or units of such Mutual Funds which have been set up as dedicated funds for investment in Govt. Securities and which have been approved by Securities and Exchange Board of India (SEBI)

15%

b) Any other negotiable securities the principal whereof and interest thereon is fully and unconditionally guaranteed by the Central Govt. or any State Government

15%

iii) a) Bonds/Securities of ‘PFIs’, Public sector companies’ including public sector banks 30% b) Short duration Term Deposit Receipt (TDR) issued by public sector banksiv) To be invested in any of the above three categories decided by their trustees 30%v) The trust, subject to their assessment of risk-return prospects, may invest up to 1/3rd of (iv)

above, in private sector bonds/securities, which have an investment grade rating from at least two credit rating agencies.

Source: EPFO guidelines

Annex 5. Use of financial instruments to increase liquidity

Country Repos and Reverse Repos Short selling Securities Borrowing

and lendingBond Futures and

OptionsInterest Rate

SwapsIndia Yes No Yes No Yes

Brazil Yes No No No NoChinese Taipei Yes No No No YesSingapore Yes Yes No Yes YesSouth Africa Yes Yes Yes Yes YesArgentina Yes Yes No Yes YesHungary Yes Yes Yes Yes YesKorea Yes Yes Yes Yes YesThailand Yes Yes Yes No

Source: The development of corporate bond markets in emerging market countries, IOSCO publication, May 2002.

Annexure

Annex 6. Report of the High Level Expert Committee on Corporate Bonds and

Securitization

Pursuant to the announcement made in the Union Budget 2005–06, the Ministry of Finance appointed a High Level Expert Committee to examine issues impeding the growth of a market for corporate bonds and securitization. In its recently submitted report, the committee’s recommendations have addressed the problems identified in the bond market through two sets of reforms: first through addressing removal of hurdles in the legal framework that determines regulation of the securities market and second through addressing issues of market microstructure. Some of the positive reform measures recommended by the committee relate to:

Recognizing pass-through-certificates issued by securitization Special Purpose Vehicles as securities under the Securities Contract Regulation Act, which enables these instruments to be listed and traded thereby improving liquidity.Abolishing differential treatment of tax deduction at source on bonds for different investors; Expanding the scope for investment by provident, pension, and gratuity funds and insurance companies in corporate bonds on the basis of a rating system, rather than the category of issuers similar.Allowing a separate higher limit for foreign institutional investors for investment in corporate bonds. The earlier limit was a ceiling of $ 0.5 billion, which has been proposed to be increased to $ 1.5 billion. Removing the differential stamp duty across various state governments on debt instruments, although the stamp duty is a matter of jurisdiction of individual state governments and the issue will need to be taken up with each state government.

Enhancing the issuer base through reducing and simplifying the time and cost of public issuance

and the disclosure and listing requirements for private placements.Setting up a system of market makers, developing the secondary market through a trade reporting system, and improving the clearing and settlement system to address market microstructure issues..

While the committee has recommended several measures that help address the market infrastructure issues and a few legal and regulatory issues, the key issue relating to the development of a sophisticated debt market—product diversification—has not been adequately addressed. One of the key lacunae in the bond markets today is the lack of product innovation, which addresses the risk management concerns of the various institutional investors and creates the right incentives to participate in the bond markets. In this context, one of the most interesting issues in the lack of development of the corporate bond market in India is the inability to separate interest rate risk from credit risk, thereby limiting the pool of investors.

Until a year ago, this inability to distinguish types of risk did not affect market participants, as interest rates fell from over 12 percent to less than 5 percent. Commercial banks, which are the main players in the debt market, have virtually stopped trading in debt, because with the rise in interest rates they need to mark-to-market their bond portfolio and provide for notional losses. Mutual funds, another set of active participants, have been staying away since a fall in bond prices erodes their underlying portfolios. At the root of both these trends is the absence of any derivative to hedge the interest risk and credit risk in a rising interest rate scenario. Specifically, the needed products are credit derivatives, interest rate derivatives, and interest rate futures. While credit derivatives do not exist in the Indian debt market, interest rate derivatives and futures had a very short


existence. Part of the reluctance of the regulators to push for derivative products could be the lack of clear regulatory structure in a multivenue trading market (exchange-traded versus over-the-counter markets). A key issue that needs to be addressed in this context is how to ensure that responsibilities for regulation and enforcement in the secondary markets result in consistent treatment of all trades, irrespective of their origin, and that trading should be under a single, clear regulatory remit.

A related area of concern is the introduction of order-matching trading platforms. The Patil Committee report recommends that banks and institutions be given the freedom to set up their own trading-cum-

clearing and settlement system that would facilitate over-the-counter deals, since “the efforts of SEBI and the stock exchanges to bring the trading to the stock exchange platforms have not yielded desired results.” This recommendation of setting up ‘inter-dealer electronic broking platforms’ could help better address the particularities of corporate bonds, as debt markets are very different in nature from equity markets. However, the legal framework for securities market does not recognize any organized platform for trading and settlement, unless it is registered as an exchange. There is a need to address this issue in greater detail to develop a market microstructure for the corporate debt market that will be acceptable to majority of the participants in this market, that is, institutional investors.

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The World Bank

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developing india’s corporate bond market

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