The government is not leaving any stone unturned in its ambitious plans to spruce up the Indian infrastructure. It has raised its planned infra spending in the current year’s Budget to a massive ₹10 trillion. It has also been hoping that its efforts rub onto the private sector. But the private sector’s participation will not be easy given the need for massive capital spending.
The bond market could help corporates shoulder some of these high-ticket spending and the need to deepen this market, considering how shallow it is compared with developed economies.
Keeping with this theme, the two recent announcements — creation of backstop facility and a clearing house to settle repos in corporate bonds-try to address the core issues of illiquidity and lower participation in the bond market.
India’s government bond market is fairly liquid with high trading volume in the secondary market. In stark contrast, the corporate bond market is riddled with liquidity issues, and issuances are dominated by AAA (‘triple A’) and AA (‘double A’) rated issuers only.
The Reserve Bank of India has allowed tri-party repo in corporate bonds, where one party pledges bonds from the portfolios to borrow funds from another to meet short-term liquidity requirements. Under the central bank tri-party repo framework, third party entities such as stock exchanges and clearing houses act as an intermediary to facilitate services like collateral selection, payment and settlement, etc. However, the scheme has remained a non-starter since its launch in July 2018 because of lack of participation.
Long-term players like insurance companies and pension funds barely participate in the tri-party repo because they hold securities till maturities, while banks have access to various other liquidity windows. This leaves mutual funds as the only participants, who are mainly lenders. Higher haircut—discount on the underlying security before lending--has also been an impediment.
SEBI built on this scheme by allowing setting up of limited purpose clearing corporations. The newly-formed AMC Repo Clearing Limited undertook its first tri-party repo transaction on July 28. What distinguishes AMC Repo from others is that it is set up by mutual fund houses. Hence, it scores high on credibility.
Association of leading fund houses with AMC Repo, which is essentially set up as a fund to provide settlement guarantee in the repo market, is expected to encourage other investors such as insurance companies and banks to participate by putting their bond inventory to use without worrying about counterparty risk.
As participation picks up gradually, it will also help companies as the liquidity value of the securities go up. Success of this initiative hinges on the willingness of market players to participate and of policymakers to continuously communicate with the market for feedback.
Two major areas need attention. Firstly, the eligibility of securities needs to be expanded to include those below AA- (‘double A minus’). One of the stumbling blocks for the market is the lack of issuance of lower-rated bonds due to high cost of borrowing. Secondly, the applicable haircut needs to be reduced at least for top-rated borrowers that frequently issue bonds. While haircut is crucial to compensate for the risk taking, it could be made less harsh so that market players like insurance companies don’t hesitate to participate because of the sacrifice on the collateral value.
The second development pertains to setting up a backstop fund. As part of the budget for 2021-22, the government had announced setting up of such a fund with an aim to instil confidence amongst the participants during times of stress and to generally enhance secondary market liquidity. This was in the background episodes of market dislocation following adverse credit events – first following the IL&FS default in September 2018, and then later in 2020 due winding of six debt schemes by an asset manager.
Corporate Debt Market Development Fund has been set up as an alternative investment fund that would buy investment-grade listed debt securities as per the framework laid by SEBI in order to aid liquidity in times of market stress. The corpus would be made of the contribution made by participating fund houses. Effectively, the fund will be able to provide cover of up to ₹30,000 crore. This is expected to give confidence to fund houses to take exposure to corporate bonds, and thereby fund the country's growth requirements.
As it is with any market development initiative, this too will pick up gradually as asset management companies see merit in taking exposure to credits below AA+ (‘double A plus’). It could also possibly nudge funds specialising in purchasing lower-rated high-yielding debt to up their game.
India remains a bright spot in the global economy. The government’s focus on building roads, ports, and airports entail large sums of funds that could be provided by the corporate bond market. Policymakers have shown greater willingness on market development. Perhaps, it is time for them to make the next move. Introducing market-making in corporate bonds is one of the available options.
Ajay Manglunia, MD & Head, Investment Grade Group, JM Financial