In this post we analyze the demand-side issues that the Indian corporate debt market wrestles with. Our previous post highlighted the supply-side roadblocks in the development of long term debt markets in India and the regulatory measures adopted so far to address these issues. In addition to the supply side constraints on bond issuances, the development of a corporate debt market also needs to be driven by demand-side reforms in institutional investors.
A study of the investment norms for banks, insurance companies, pension funds, and provident funds helps to understand specifics of the investment bottlenecks that may have prevented the development of a well-functioning corporate debt market in India. According to the eligible Statutory Liquidity Ratio (SLR) investments (as per Master Circular – Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) issued on July 01, 2011), banks are required to hold 24% of their liabilities in cash, gold, central and state government investments, thereby leaving non-government bond market instruments completely out of the picture.
For a life insurer it is very important to generate high returns while maintaining asset quality to avoid credit risk. In India, the norms for insurance company investments are made in the Insurance Regulatory and Development Authority (IRDA) Investment Amendment Regulations, 2001, and cover the following businesses: life insurance, pension and general annuities, unit linked life insurance, general insurance and re-insurance. The only section of the Act that allows for long-term, non-government investments are the infrastructure and social sector investments of 15+% and unapproved investments of 15%. Further, according to this Act, the pensions and annuities businesses cannot have any portion of their funds invested in non-government linked investments. Investment regulations governing life businesses require that at least 65% of assets be held in various types of public sector bonds. Funds are permitted to invest in corporate bonds, but the category of “approved investments” only includes bonds rated AA or above. Bonds below AA (which are rare in India), can be held in unapproved assets. Then again, total unapproved assets cannot exceed 15% of the portfolio and are subject to exposure norms limiting exposure to any company or sector. In practice, insurance companies hold less than 7% in unapproved assets. For instance, according to the ICRA, SBI Life’s exposure to equity and unapproved investments has been around 6% only.
A major part of investments (approx. 47%) for life and pension businesses is thus being held in G-Secs and other government approved securities which are relatively safe instruments. Poor appetite for corporate bonds is also on account of the lack of a secondary market – thereby making such an investment a buy and hold play which, considering the long tenor, is decidedly a sub-optimal investment. In other words, the investment norms of insurance companies, banks, pension funds in India are heavily skewed towards investment in government and public sector bonds which acts as a detriment to the corporate bond market development. Without long-term investors like pension funds and insurance companies investing in corporate debt, it is difficult to see how the corporate debt market will take off.
The adverse effect of this legal/regulatory lacuna on corporate debt market is further aggravated by the fact that the high fiscal deficit of the Government of India (GoI) is financed by the issue of GoI bonds or government securities (G-Secs). The fact that the Fiscal Responsibility and Budget Management (FRBM) Act – that required the GoI to reduce its deficit to sub-3% levels by 2009 – has been put in abeyance in the wake of the financial crisis of 2008, implies that the fiscal deficit has been going up and government bond issuances continue to finance this deficit. This has effectively served to further crowd out private corporate debt issuance.
The discussion above highlights a few major issues:
- The high level of G-Sec issuances in the Indian debt market,
- The low level of corporate bond issues; both these issues are inter-related since large government debt issuance on account of high fiscal deficit has a crowding out effect on corporate debt,
- Market preference for very safe AA+ assets with no market for issuances below AA thus creating a very thin debt market; As shown in the following graph, the volume of bonds rated below A is around 5% of the total issue.
The High Powered Expert Committee (HPEC) on corporate bonds and securitisation also popularly known as the Patil Committee, made a few recommendations on enhancing the investor base-an important demand-side issue that was subsequently addressed in part by the SEBI. We detail here the recommendations of the Committee and actions taken thereafter by the SEBI.
In order to enhance the investor base and diversify its profile, the Committee recommended that the investment guidelines of Provident/Pension Funds be directed by the risk profile of instruments rather than the nature of instruments. The Committee also recommended an increase in investment limits for Foreign Institutional Investors (FIIs). In the “Plan for a unified exchange traded corporate bond market” – a report of the internal committee of SEBI in 2006, it is mentioned that the point it to be taken up with the Government and Reserve Bank of India (RBI) wherever relevant – “So as to encourage the widest possible participation for domestic financial institutions, IRDA, the Central Board of Trustees of the Employee Provident Fund Organisation (EPFO) and the Pension Fund Regulatory and Development Authority (PFRDA) should modify their respective investment guidelines to permit insurance companies, provident and gratuity funds, and pension funds respectively to invest/ commit contributions to SEBI registered Infrastructure Debt Funds.”
In July 2011, the EPFO put out requests for proposal while appointing custodians of Securities of EPFO. The document listed the investment guidelines for EPFO fund managers alongside terms and conditions and duties of custodians. Though the prescribed pattern of investment for EPFO favours investments in central and state government securities, it allows upto 30% to be invested in any central government securities, state government securities or securities of public financial institutions (public sector companies) at the discretion of the Trustees. Of this, 1/3rd is permitted to be invested in private sector bonds/securities which have an investment grade rating from at least two credit rating agencies, subject to the Trustees’ assessment of the risk-return prospects.
Demand-side issues remain trickier to resolve as they are tied to a variety of other regulations on investment and an over-arching prescription for “safe investments” i.e. for instruments rated AA and above. Understandably, demand exists only for such instruments and the market caters to this demand, creating in turn a thin-market. A market for high-yield bonds is practically non-existent, suggesting that risk-return profiles are uniform throughout the market, which need not necessarily be the case. Moreover, much of this lack of appetite is also linked to the lacklustre secondary market in corporate bonds. Investors in any market would require an active platform where they would be able to liquidate their assets or square off positions if need be, especially in a high-yield market. In the case of India’s fledgling secondary market in corporate bonds, market activity is highly bunched up at one end of the market at all times, making holding fixed-income securities riskier unless they are being held till maturity.
In keeping with the Patil Committee’s recommendations, investment guidelines that are directed by risk/return profile of investments and investor appetite rather than the nature of investments will help boost demand for a wider range of debt securities and hopefully help in building a deeper, more active market with varied investor profiles. Our next post in this series will aim to uncover a few pertinent secondary-market issues, and their effects on corporate bond market development or lack thereof.