Praxis Business School

Indian Bond Market

Present Scenario & Future Road Map

A report

submitted to

Prof. Amit Parakh

In partial fulfilment of the requirements of the course

Fixed Income Securities

On 15th October, 2009

By

Kaushambi Ghosh (B08012)

Nikhil Verma (B08019)

Rupesh Agarwal (B08026)

 INDIAN BOND MARKET
Executive Summary

We studied the Indian bond market to ensure the following outcomes:

1. Gaining adequate knowledge on the development of bond market

2. Studying the present scenario of the segment
3. Assessing future potential of the same

In the pre-independence period restrictions on interest rate long-term loan were

very low and so the only kind of bonds that were available was Govt of India securities. In
the post independence period realising the need for rapid developments of industrial and
need for support to sensitive sectors like agriculture with medium and long term loans
govt formed few institutions to mobilise investments to earn interest. Commercial banks
were not much into mobilisation of investment since they are aware of the disadvantage
of interest regulation plus higher operational cost. Post liberalization of economy cheap
capital was available to commercial banks through other means which made such long
term lending possible for them and within no time they ate much share of domestic
institution since these institution were at a disadvantage of not been able to get cheap
capital due to regulations and hence converted them into commercial banks. Since early
2000's trading on exchanges were allowed keeping in mind that 70-80 percent of domestic
saving of India is invested in fixed income securities. Till date India Bond markets have had
a turnover of one- tenth times that of Equity market in India which ranks third in Asia in
terms of turnover compared to U.S. which has one-fifth of the equities market turnover.
With the launch of trading of interest rate derivatives this market is going to be bigger and
bigger coupled with the above fact since introduction of derivates will allow better risk
management mechanism and instruments for investors. There would be an increase in
municipal bond market side we have the logic that more than three-fourth of Indian
population lives in urban area and it is estimated to increase by almost 8% there is much to
be done in urban infrastructure segment to make it at least just sufficient enough to
handle the pressure and hence the needs for funds and hence need for municipal bond
markets will be there.

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Contents
Executive Summary...................................................................................................................... 2
Introduction ................................................................................................................................ 4
Development................................................................................................................................... 4
Debt Market in India ....................................................................................................................... 7
Wholesale Debt Market Growth for past 8 years ........................................................................... 8
Market Segments ................................................................................................................................ 9
Development and Outlook ......................................................................................................... 10
Key Developments ............................................................................................................................ 11
Corporate Bonds ............................................................................................................................... 14
Factors Limiting the Further Development of Corporate Bond Market ........................................... 14
Securitization ............................................................................................................................. 19
Banks and Insurance Companies: Predominant Investors in Securitized Notes .............................. 22
Regulation Hampers Participation .............................................................................................. 24
Measures to Address Bond Market Liquidity.................................................................................... 25
Measures to Develop the Corporate Bond Market .......................................................................... 27
Conclusion ................................................................................................................................. 28

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Introduction

Development

At the time of its independence in 1947 India had only the traditional commercial banks, all
with private sector ownership. Like the typical commercial banks in other parts of the world,
the banks in India were also not keen to provide medium and long-term finance to industry
and other sectors for their fixed asset formation. The banks were willing to fund basically
the working capital requirements of the credit-worthy borrowers on the security of tangible
assets. Since the government was keen to stimulate setting up of a wide range of new
industrial units as also expansion/diversification of the existing units it decided to encourage
setting up of financial intermediaries that provided term finance to projects in industry.
Thus, there emerged a well-knit structure of national and state level development financial
institutions (DFIs) for meeting requirements of medium and long-term finance of all range of
industrial units, from the smallest to the very large ones. Reserve Bank of India (the central
banking institution of the country) and Government of India nurtured DFIs through various
types of financial incentives and other supportive measures. The main objective of all these
measures was to provide much needed long-term finance to the industry, which the then
existing commercial banks were not keen to provide because of the fear of asset-liability
mismatch. Since deposits with the banks were mainly short/medium term, extending term
loans was considered by the banks to be relatively risky. The five-year development plans
envisaged rapid growth of domestic industry even in the private sector to support the
import substitution growth model adopted by the national planners. To encourage
investment in industry, a conscious policy decision was taken that the DFIs should provide
term- finance mainly to the private sector at interest rates that were lower than those
applicable to working capital or any other short-term loans. In the early years of the post-
Independence period, shortages of various commodities tended to make trading in
commodities a more profitable proposition than investment in industry, which carried
higher risk. Partly to correct this imbalance, the conscious policy design was to increase
attractiveness of long-term investment in industry and infrastructure through relatively
lower interest rates. To enable term- lending institutions to finance industry at concessional
rates, Government and RBI gave them access to low cost funds.

They were allowed to issue bonds with government guarantee, given funds through the
budget and RBI allocated sizeable part of RBI’s National Industrial Credit (Long Term
Operations) funds to Industrial Development Bank of India, the largest DFI of the country.
Through an appropriate RBI fiat, the turf of the DFIs was also protected, until recently, by
keeping commercial banks away from extending large sized term loans to industrial units.

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Banks were expected to provide small term loans to small-scale industrial units on a priority
basis.

Regulated Financial System

Until almost the middle of the last decade the financial system was highly regulated.
Although the DFIs were given freedom to extend term loans to projects, which they
considered support-worthy based on their rigorous technical and financial appraisal, their
interest rate structure was administratively fixed by the RBI along with the other interest
rates in the system. The interest rates charged by the commercial banks were appropriately
aligned in such a way that the project loans were relatively lower than the loans extended
by banks for such purposes as working capital for industrial and other units. Similarly, the
rates that the corporate entities could offer on their bonds were fixed by the Finance
Ministry which used to regulate the capital markets until the independent capital market
regulator viz., Securities Exchange Board of India (SEBI) was set up about a decade ago. The
Finance Ministry, however, used to informally consult RBI before it fixed the interest rates
on corporate bonds. Usually the interest rates on bonds and the interest rates of the DFIs
were such that the corporate units did not have much attraction to raise funds from the
market. There were other factors, which also discouraged corporate sector raising funds
directly from the market. The debt-equity norms on bond funds were more rigorous than
the ones that the institutions allowed in respect of their term loans. While the Finance
Ministry did not permit bond issues of companies that would exceed the debt-equity ratio
of 2:1, the institutions used to extend loans that would result in a debt-equity of up to 3:1 in
respect of highly capital- intensive projects. Further, for the common investors corporate
debt was not attractive in view of the absence of a secondary market for corporate
debentures. Another highly discouraging factor was the high level of stamp duty that the
state governments levied on secondary market transactions in bonds. On account of all
these discouraging factors corporate bond market did not develop and the corporate
borrowers preferred to raise funds by approaching term lending institutions.

Financial Sector Liberalisation

The situation has significantly changed after the financial sector policies were revamped and
deregulation was introduced after 1991. The DFIs no longer have the comfort of the
protective policy climate in which they operated. They no longer have access to
concessional sources of finance like government guaranteed bonds or budgetary support.
Now they have to compete with commercial banks, whose cost of funds is way below that
of the DFIs. With their extensive branch network the banks have access to low cost deposits.
The branch network of DFIs is small and RBI has given them limited access to deposits since
the DFIs are not subject to the statutory liquidity ratio and cash reserve ratio as in the case
of commercial banks. DFIs are finding it difficult to accept the obligations of SLR and CRR on
their entire asset base just to have unfettered access to the deposit market.

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Global competition through more liberal imports has negative impact on the profitability of
several industrial units assisted by the DFIs in the past. Hence the DFIs are getting saddled
with increasing levels of NPAs. Opening up of the Indian economy to comply with WTO
requirements has meant more liberal imports and considerable slow down in 3 fresh
domestic investments. This has adversely affected fresh business of the DFIs and the
demand for term loans has come down sharply. More liberal industrial policy framework has
encouraged mergers, amalgamations, restructuring and rationalisation of production
capacities, leading to productivity improvements and consequently less demand for creation
of additional capacities in various industries. Greater import availability ensures much wider
range of choices (and often better quality), has resulted in declining demand for term
finance from industry.

The DFIs are increasingly realising that their special role as purveyors of development
finance is no longer relevant in the deregulated financial system, which has cut off their
access to low cost funds. DFIs are finding it difficult to remain viable by raising funds from
the market at market related rates and compete with the commercial which have also
started project lending in a big way with the help of the low cost deposit funds. DFIs have
also found that they are not in a position to raise long maturity funds from the market and
have to remain contented with short and medium term maturity bond funds.

They cannot afford to get over-exposed to long gestation projects, as it would lead to
serious asset-liability mismatches. DFIs have therefore started diversifying their activities
into shorter maturity loans. Some of them are seriously toying with the idea of converting
themselves into a commercial bank or have reverse merger with one of the commercial
banks.

Since the DFIs are increasingly withdrawing themselves form project lending it has become
imperative for the government to devise suitable policy frame that will encourage
emergence of alternative supply sources of project finance. In view of the current slackness
in overall investment activity in the Indian economy the dwindling sources from the
traditional suppliers of project finance are not being felt so explicitly. But once the
investment climate improves and demand for long term funds picks up alternative sources
of term finance to industry and infrastructure need be to found. The best course of action
for the government would be to strengthen the capital market and in particular encourage
growth of an active bond market. The capital market can be relied upon to play an effective
role provided a suitable policy frame for the development of an active and highly liquid
nation-wide debt market is put in place. The need for developing a vibrant debt market that
also encourages relatively longer maturity instruments suited for financing infrastructure
projects has been effectively highlighted by a high powered committee in “The India
Infrastructure Report” submitted by it to the Government of India in June 1996.

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Debt Market in India

The debt market in India comprises mainly of two segments viz., the Government securities
market consisting of Central and State Governments securities, Zero Coupon Bonds (ZCBs),
Floating Rate Bonds (FRBs), T-Bills and the corporate securities market consisting of FI
bonds, PSU bonds, and Debentures/Corporate bonds. Government securities form the
major part of the market in terms of outstanding issues, market capitalization and trading
value. It sets a benchmark for the rest of the market. The market for debt derivatives have
not yet developed appreciably though a market for OTC derivatives in interest rate products
exists.

During 2007-08, the government and corporate sector collectively mobilized Rs. 3,722,501
million (US $ 93,132 million) from primary debt market, a rise of 27.24% as compared to the
preceding year (Table 6-1). About 68.77% of the resources were raised by the government
(Central and State Governments), while the balance amount was mobilized by the corporate
sector through public and private placement issues. The turnover in secondary debt market
during 2007- 08 aggregated Rs. 56,495,743 million (US $ 1,413,454 million), 57.04% higher
than that in the previous year. The share of NSE in total turnover in debt securities
witnessed a decline and stood at 5.71% during 2006-07.

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Wholesale Debt Market Growth for past 8 years

All trades Retail Trades

Avg.
No. of Avg. daily Avg. trade daily
active No. of Turnover turnover size (Rs. Turnover Turnove No. of Turnover Turnover Share in total
Month/Year Securities trades (R. mn.) (Rs. mn.) Mn) (US $ mn) r (US $) trades (R. mn.) (US $) turnover (%)

2000-01 1038 64470 4285815 14830 66.48 91891 318 498 1318 28.26 0.03

2001-02 979 144851 9471912 32775 65.39 194097 672 378 1094 22.42 0.01

2002-03 1123 167778 10687014 35983 63.7 224990 758 1252 2995 63.05 0.03

2003-04 1078 189518 13160962 44765 69.44 303318 1032 1400 3317 76.45 0.03

2004-05 1151 124308 8872936 30283 71.38 202810 692 1278 4101 93.74 0.05

2005-06 897 61891 4755235 17547 76.83 106596 393 892 3104 69.58 0.07

2006-07 762 19575 2191065 8980 111.93 50265 206 399 1015 23.29 0.05

Apr-07 98 928 171587 9031 184.9 4293 226 12 30 0.75 0.02

May-07 145 1093 174835 8326 159.96 4374 208 18 60 1.5 0.03

Jun-07 143 1065 173352 8255 162.77 4337 207 38 60 1.5 0.03

Jul-07 184 2089 338146 15370 161.9 8460 385 9 30 0.75 0.01

Aug-07 128 1230 214305 10205 174.2 5362 255 8 40 1 0.02

Sep-07 148 169024 169024 8451 180.97 4229 211 27 40 1 0.02

Oct-07 147 1411 254932 11588 180.67 6378 290 10 40 1 0.02

Nov-07 110 1083 177039 8430 163.47 4429 211 7 20 0.5 0.01

Dec-07 117 1585 328654 17298 207.4 8223 433 12 40 1 0.01

Jan-08 144 2359 427242 18576 181.11 10689 465 27 70 1.75 0.02

Feb-08 118 1497 240439 11449 160.61 6015 286 7 20 0.5 0.01

Mar-08 148 905 153615 8534 169.7 3843 214 36 40 1 0.03

2007-08 601 16179 2823170 11380 174.5 70632 285 211 490 12.26 0.02

Apr-08 122 1016 198928 9946 195.8 4632 232 6 21 0.49 0.01

May-08 137 1200 206563 10428 172.1 4809 240 3 4 0.09 0

Jun-08 190 956 182334 8683 190.7 4245 202 106 203 4.73 0.11

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April-June 449 3172 587825 29057 558.6 13686 674 115 228 5.31 0.04

CAGR -0.066 -0.15 -0.05 -0.03 0.12 -0.03 -0.013 -0.101 -0.116 -0.099 -0.049

Market Segments

The various segments in debt market in India are discussed below:

• Government securities form the oldest and most dominant part of the debt market in
India. The market for government securities comprises the securities issued by the central
government, state governments and state-sponsored entities. In the recent past, local
bodies such as municipal corporations have also begun to tap the debt market for funds.
The Central Government mobilises funds mainly through issue of dated securities and T-
bills, while State Governments rely solely on State Development Loans. The major investors
in sovereign papers are banks, insurance companies and financial institutions, which
generally do so to meet statutory requirements.

• Bonds issued by government-sponsored institutions like DFIs, infrastructure-related

institutions and the PSUs, also constitute a major part of the debt market. The gradual
withdrawal of budgetary support to PSUs by the government since 1991 has increased their
reliance on the bond market for mobilising resources. The preferred mode of raising capital
by these institutions has been private placement, barring an occasional public issue. Banks,
financial institutions and other corporates have been the major subscribers to these issues.

• The Indian corporate sector relies, to a great extent, on raising capital through debt issues,
which comprise of bonds and CPs. Of late, most of the bond issues are being placed through
the private placement route. These bonds are structured to suit the requirements of
investors and the issuers, and include a variety of tailor-made features with respect to
interest payments and redemption. Corporate bond market has seen a lot of innovations,
including securitised products, corporate bond strips, and a variety of floating rate
instruments with floors and caps. In the recent years, there has been an increase in issuance
of corporate bonds with embedded put and call options. While some of these securities are
traded on the stock exchanges, the secondary market for corporate debt securities is yet to
fully develop.

• In addition to above, there is another segment, which comprises of short-term paper

issued by banks, mostly in the form of certificates of deposit (CDs). This segment is,
however, comparatively less dominant.

• The Indian debt market also has a large non-securitised, transactions-based segment,
where players are able to lend and borrow amongst themselves. This segment comprises of
call and notice money markets, inter-bank market for term money, market for inter-

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corporate loans, and market for ready forward deals (repos). Typically, short-term
instruments are traded in this segment.

• The market for interest rate derivatives like FRAs, IRSs is emerging to enable banks, PDs
and FIs to hedge interest rate risks.

Development and Outlook

The Indian financial system is not well developed and diversified. One major missing
element is an active, liquid, and large debt market. In terms of outstanding issued amount,
Indian debt market ranks as the third largest in Asia, next only to that of Japan and South
Korea. Further, in terms of the primary issues of debt instruments, Indian market is quite
large. The government continues to be a large borrower unlike South Korea where the
private sector is the main borrower. If we compare the size of the Indian GDP with the
outstanding size of the debt flotation, Indian debt market is not very much underdeveloped.

The gross domestic savings rate in the Indian economy is reasonably satisfactory at around
23%. According to RBI’s annual studies on savings, about 78% of the aggregate financial
savings of the household sector were invested in fixed income assets. The average Indian
household has great appetite for debt instruments provided they are packaged properly.
The main financial instruments popular with the households are bank deposits, provident
funds, insurance, income-oriented mutual funds, and postal savings schemes. However, the
share of fixed income instruments that could be traded in the secondary markets is
negligible. The main reason for this is the absence of an active secondary market in debt
instruments. Investors are not willing to invest in tradable instruments as they lack required
liquidity. It is thus a typical case of “chicken and egg problem”. Since there are not enough
number of issues and the floating stock in the secondary market is very small there is hardly
any trading in them. Currently almost 98% of the secondary market transactions in debt
instruments relate to government securities, treasury bills and bonds of public sector
companies. The quality of secondary market debt trading is very poor if we compare it with
the quality of the secondary market in equities.

Debt markets lack the required transparency, liquidity, and depth. With reference to the
usual standards or yardsticks of market efficiency the Indian debt markets would not score
more than 30% of the marks that the Indian equity markets would score.

The US has one of the most active secondary markets in both government and corporate
bonds. The trading volume in the US debt market is said to be on an average ten times the
size of the equity trading. In India the average daily trading in debt during the last year was
about one tenth of the average daily trading in equities. These comparisons bring out the
underdeveloped nature of the Indian debt markets. The secondary debt market suffers from

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several infirmities. It is highly non-transparent compared to the equity market. It is highly
fragmented since the ownership titles of government securities are fragmented in 14 offices
of the RBI, which acts as a depository for the government debt including the treasury bills. A
seller from New Delhi cannot trade in Mumbai market since security held in RBI office in
New Delhi cannot be easily transferred to Mumbai office of RBI and vice-versa. Since the
current small order book stands fragmented city-wise the price discovery process does not
throw up the best possible prices.

Key Developments

Union Budget 2008-09:

Finance Minister in his Budget speech of 2008-09 proposed some measures to expand the
market for corporate bonds such as:

• Take measures to develop the bond, currency and derivatives markets that will include
launching exchange-traded currency and interest rate futures and developing a transparent
credit derivatives market with appropriate safeguards;

• Enhance the tradability of domestic convertible bonds by putting in place a mechanism

that will enable investors to separate the embedded equity option from the convertible
bond and trade it separately

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 The Finance Minister also announced that supplementing the measures announced in
respect of the corporate debt market, it was proposed to exempt from TDS, corporate
debt instruments issued in demat form and listed on recognized stock exchanges.

The announcement regarding enhancing the tradeability of domestic convertible bonds is

yet to be implemented.

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Corporate Bonds

Factors Limiting the Further Development of Corporate Bond Market

In actual fact, although corporate bonds can be issued publicly, most issues in the corporate bond
market are not really bonds but private placements, and most issues are not made by corporations.
Public issues are bonds offered to a wide range of investors and which conform to the regulatory
standards required of public issues of bonds. They require a prospectus approved by SEBI, and have
to be open at a fixed price for a month to allow investors—particularly retail investors—to subscribe
Private placements can be made to a maximum of 50 “Qualified Institutional Buyers” (professional
investors). And require much less documentation. The small number of investors makes it relatively
easy to renegotiate terms. Typically, for example, a change in interest rates will lead to a
renegotiation of the coupon on a placement during the currency of the issue. This makes private
placements very flexible.

Public issues are rare because of excessive disclosure requirements—new SEBI proposals
are designed to simplify the process. Disclosure requirements for public issues are viewed
by potential market participants as excessive:

• Prospectuses for bond issues are reported to be several hundred pages long.

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• Against international practice, disclosure requirements are identical, irrespective of
whether the company is already listed or not.

• There is no provision for shelf registration—whereby a program of tranches can be

covered by a single prospectus. The issue process is reportedly slow, taking several months,
which, with high marketing and other costs, makes public issues very expensive. The slow
process also makes issues risky, as the price is fixed throughout the offer period. In contrast,
documentation for private placements is minimal, although requirements have been
increased in recent years. Placements can be issued quickly with book building and pricing
usually completed within a day. In line with recommendations of the Patil report, SEBI has
agreed new listing agreements with stock exchanges—in August 2008 they were issued for
public comment.

Key features include:

(i) Companies publicly-listed on an Indian exchange would be required to make only

minimal additional disclosures for a public issue or a private placement
(ii) Unlisted companies would be required to make more substantial disclosures,
though less than those required for an equity issue

Private Placement Issues are Small Private placement issues are generally quite small,
averaging about USD20 million. Because private placements are quite small, corporate
issuers tend to make several separate placements, sometimes on the same day. Because
there are a limited number of investors available, the separate issues will all, practically
speaking, go to the same lender, usually under similar terms. The result is that many of the
“bonds” are actually syndicated loans—as the largest investors for private placements are
banks.

Corporate bonds are usually issued by the private sector, banks, and public companies.
Issuance in 2006–07 was USD35 billion over 1,678 issues. Public entities accounted for 42%
of the value and 8% of the number of issues. They were also relatively large, averaging
USD107 million. Private financial companies—largely banks raising money for lending
purposes— represented 35% of the value and 39% of the volume. Private, nonfinancial
corporate issuers represented only 23% of value, but 53% of the volume, indicating an
average value of only USD10 million (Figures 16, 17). Private sector and nonfinancial
issuers—normally major participants in other corporate bond markets—are only a small
proportion corporate bonds in the Indian market, in terms of value.

Private placement issues are generally quite small, averaging about USD20 million. Because
private placements are quite small, corporate issuers tend to make several separate
placements, sometimes on the same day. Because there are a limited number of investors
available, the separate issues will all, practically speaking, go to the same lender, usually
under similar terms. The result is that many of the “bonds” are actually syndicated loans—

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as the largest investors for private placements are banks. Corporate bonds are usually
issued by the private sector, banks, and public companies. Issuance in 2006–07 was USD35
billion over 1,678 issues. Public entities accounted for 42% of the value and 8% of the
number of issues. They were also relatively large, averaging USD107 million. Private
financial companies—largely banks raising money for lending purposes— represented 35%
of the value and 39% of the volume. Private, nonfinancial corporate issuers represented
only 23% of value, but 53% of the volume, indicating an average value of only USD10 million
(Figures 16, 17). Private sector and nonfinancial issuers—normally major participants in
other corporate bond markets—are only a small proportion corporate bonds in the Indian
market, in terms of value.

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Corporate demand is limited for genuine bond finance (as opposed to loans disguised as
bonds). Traditionally companies have borrowed from banks to meet financing needs. Bank
credit continues to dominate corporate funding, accounting for 90% of financial assets, with
state-owned banks representing 70%—a declining but still dominant share.

The main source of finance for smaller companies is from former “development banks,”
which have emerged from state-owned development banks but are now private and profit-
oriented. They finance themselves not through deposits—from which they are generally
barred—but through debt issues. Development banks are active in the private placement
market, borrowing wholesale to lend to smaller corporations. Private placements have
dominated debt issuance and banks—even a single bank—will often absorb an entire issue.
The decision as to whether to issue a bond or take a loan is determined by tactical, not
strategic, factors:

• At various times the RBI has prohibited banks from lending at rates below their published
lending rate—but the prohibition did not apply to investments in private placements.
Therefore, a bank that wanted to offer a very tight rate to a highly rated corporate borrower
would present the loan as a bond.

• Interest rate expectations may influence the choice—when rates are falling, as they have
been for several years, borrowers will prefer a variable rate loan and lenders a fixed-rate
bond.

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• Large bank loans are required to pass an internal approval process, usually by the board or
a board committee. Private placement investments are not subject to the same scrutiny (or
delay), again, giving banks an incentive to grant loans but present them as bonds.

• Loans are not subject to stamp duties, whereas bonds are, making loans desirable for tax
sensitive borrowers.

• Loans may be preferable for banks because they are not marked-to-market—this will
change under Basel II rules, which are due to begin implementation in 2008. Bonds not held-
to-maturity are marked-to-market. But, in the absence of reliable secondary market prices;
there is scope for manipulation and window dressing.

Similarly, corporations tend to regard loans and bonds as interchangeable. This occurs to
some extent in most markets. But in India there is a strong focus on managing or arbitraging
micro features. The level and complexity of stamp duty encourages the arbitrage-based
approach to corporate finance so decisions are often tax-driven rather than strategy-driven.
There is a stated, but as yet unscheduled, intention to reform the stamp duty, probably by
introducing a standard national rate with a maximum rate, as recommended in the Patil
report.

The distribution of corporate bonds issued by rating indicates that the number of sub-
investment grade issues is minimal and the proportion below AA is small—7.5% by value in
2007–08. Only the largest corporations are likely to achieve an AAA rating. Others are thus
excluded from the bond market and obliged to rely on bank finance. Recent figures suggest
the proportion of lower-rated bonds may be increasing in particular the proportion of sub-
investment grade bonds following the SEBI’s relaxing its rules relating to lower-rated bonds.

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Securitization

Securitisation is a form of financing involving pooling of financial assets and the issuance of
securities that are repaid from the cash flows generated by the assets. It is a financing tool
involving creating, combining and recombining categories of assets and securities into new
forms. Assets, loans, receivables, etc. from multiple originators and often from more than
one seller, are pooled and repackaged, underwritten and sold in the form of asset-backed or
other securities.

Securitisation allows banks and financial institutions to keep these loans off their balance
sheets, thus reducing the need for additional capital; provides them with alternative forms
of funding risk transfer and a new investor base. Further, it facilitates better matching of
assets and liabilities and the development of the long-term debt market. Funding costs are
lowered as a result of movement of investments from less efficient debt markets to more
efficient capital markets through the process of securitisation.

There is considerable potential in the securities market for the certificates or instruments
under securitisation transactions.

The development of the securitised debt market is critical for meeting the humungous
requirements of the infrastructure sector, particularly housing sector, in the country. In
India, the market for securitised debt remains underdeveloped. Despite two major
initiatives, namely, the amendment of the National Housing Bank Act, 1987 (NHB Act) in
2000; and enactment of the Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest Act, 2002 (SARFAESI Act), the market has not picked up
mainly because of lack of facility of trading on stock exchanges. This is because
securitisation transactions under the NHB Act are not covered under the definition of
“securities” in the SCR Act. As a result, buyers of securitised financial instruments have few
exit options.

India began securitization early among Asian markets, with transactions going back to the
early 1990s. Growth accelerated from 2000, reaching INR580 billion (USD12.5 billion) in
fiscal 2007/08. However, the securitization market has not yet taken off. Volumes tend to
be low and asset types limited. Volumes appear to be mainly influenced by tax or regulatory
arbitrage considerations rather than by underlying financial factors. The market is also
subject to regulatory, legal, and tax uncertainties. Auto loans were the mainstay of the
securitization market in the 1990s. Since 2000, residential mortgage backed securities
(RMBS) have also contributed to market growth, though RMBS activity has slowed
significantly during the last 2 years, as a focus on asset-backed securities (ABS) has claimed
the biggest share of the market— in FY2007 accounting for 63%, followed by CDO/CLO at
32%. In 2007/08 there was a further shift toward CDO/CLO issues— representing 54% of the
total. Together with ABS (45% of the total) these two asset classes made up 99% of

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securitization volumes. Credit card securitization has been limited, partly because of stamp
duty costs, but also because the credit card market in India—while showing rapid growth—
remains small. There have also been limited future flow securitizations, such as toll receipts,
and some infrastructure financing. Demand for infrastructure financing in India is now
recognized and it is expected that securitization of receivables from those projects should
expand rapidly.

Accordingly, after extensive consultations with major institutional participants and market
experts, the Budget 2005- 06 proposed to “amend the definition of ‘securities’ under the
SCRA so as to provide a legal framework for trading of securitized debt including mortgage
backed debt”. In pursuant to this, the Securities Contracts (Regulation) Amendment Bill,
2005 was introduced in the Lok Sabha in December, 2005 and referred to the Standing
Committee on Finance.

The Committee submitted its report in May, 2006. Based on recommendations of the
Committee, a revised Bill was introduced and passed by the Parliament in May 2007. The
Securities Contracts Regulation Amendment Act, 2007, providing for legal framework for
trading of securitized debt, was enacted on 28th May, 2007.

The amendment, inter alia, provided for:

• Including securitization certificates or instruments under the definition of “securities” in

clause (h) of section 2 of the SCRA;

• A disclosure based regulation for issue of securitized certificates or instruments and the
procedure therefore.

The objective of the amendment was to provide a trading platform for securitized
instruments under the regulatory purview of SEBI. Now that the securitized debt are
“securities” under the SCRA, the entire institutional, supervisory and regulatory architecture
of securities law is applicable to these instruments also.

As the nature of the securitized assets suggests, originators have mainly been banks and
nonbank financial institutions. The originators include former development banks that have
been privatized and which have become major players in the consumer lending market, and
housing finance companies. ICRA estimates the top five originators account for about 80%
of issuance. There has also been some securitization of corporate loans, again with
substantial credit enhancement. These have included single loan securitizations. The
preference for asset-backed securities (ABS) in India mirrors the pattern in Korea and the
Philippines. Mortgage-backed securities (MBS), which are more significant in Malaysia and
Singapore, have been less significant in India.

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Securitization was generally small in emerging East Asian markets in 2001, amounting to less
than 0.2% of GDP, including India. By 2006 a number of the region’s economies—Korea,
Malaysia, Philippines, and Singapore—had expanded securitization levels considerably to
between 1.5% and 4.0% of GDP). In t Korea, Philippines, and Malaysia, they did this through
policies designed to recapitalize the banking sector. In India, reasonable growth brought
securitization volumes to roughly 1% of GDP.

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Banks and Insurance Companies: Predominant Investors in

Securitized Notes

Insurers are subject to restrictive investment mandates, and thus securitized assets are
structured to achieve very high ratings and, often, to minimize prepayment risk. To gain
these ratings, successful issues require very substantial levels of credit enhancement.
Methods of enhancement have included:

(i) direct recourse to the originator (often structured as put options);

(ii) originator or third-party guarantees;
(iii) over-collateralization;
(iv) cash collateral and reserves.

Until recently, securitizations with subordinated tranches were not offered in India and
remain a rarity.

This is because there is:

(i) little investor demand for such lower-rated notes;

(ii) There was no capital penalty for originating banks retaining the first-loss
tranche. RBI guidelines have removed the latter reason and the market is now
seeing some use of subordinated tranches.

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India currently does not have credit insurance or an active market for credit derivatives,
meaning these risk management tools are unavailable for structuring deals and the use of
credit default swaps to create synthetic securitizations is impractical. Regulatory
responsibility within the securitization market is unclear. But the strong involvement of
banks means that the RBI’s regulatory actions will have a significant impact. For example,
RBI recently published regulations on the capital provision required for securitizations by
banks.

These are similar to, but stricter than, Basel II requirements.

There are several distinguishing features of India’s securitization market:

• As a common law jurisdiction, India does not require specific legislation to permit the
formation of special purpose vehicles (SPVs).

• This gives considerable flexibility, but at the same time means that many features are left
unclear until decided by case law.

• For tax reasons, SPVs are set up as single-purpose trusts, rather than corporate entities as
is common in other jurisdictions.

• Arbitrage considerations are regarded as crucially important and the tax and regulatory
environment helps decide whether to securitize, far greater than in other markets. As an
example, the recent RBI rules on capital provision led to a number of direct assignment
deals (that is, transfers of cash flows but without an SPV) since the new rules specifically
applied only to transactions involving an SPV.

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Regulation Hampers Participation

Regulatory responsibility in India’s bond markets is fragmented—and there is the perception

among market participants that they are also at cross-purposes. Corporate bonds are
regulated by SEBI, which is responsible for authorizing the public issue prospectus and for
setting standards regarding private placements. It also regulates some of the participants—
the brokers (who have all but disappeared from the market) and mutual funds. Other
participants are subject to different regulators. Banks and primary dealers are regulated by
the RBI, insurance companies (including the Life Insurance Corporation of India) by the
Insurance Regulation and Development Agency and provident/pension funds by their own
regulator.

The bankruptcy system is time-consuming and inefficient, although the law is based on
United Kingdom law and, as such, is judged to be reasonably clear. There are, however,

(i) Significant political pressures against declaring enterprises insolvent;

(ii) Serious delays in the court process—several years are the quoted time for
resolution of insolvencies.

In practice bankruptcy is hardly an issue in the corporate bond market because

(i) Very few issues are rated below AA;

(ii) The terms of the private placement (and the small number of investors) mean it
is easier to renegotiate terms if necessary, rather than to go through the legal
processes for insolvency.

Banks, life insurance, and pension funds are required to hold a minimum of 25% of their
time deposit liabilities in government securities—the Statutory Liquidity Requirement (SLR).
Only holdings in excess of the SLR requirement can be traded and repurchased. Bank
holdings have declined as a proportion of total government bond issuance over time as
interest rates have fallen and loan demand has risen. However, in absolute terms, 2006 was
the first year in which banks’ holdings of government bonds fell.

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Measures to Address Bond Market Liquidity

Deep and liquid bond markets provide a safety valve when access to bank credit tightens—
by providing an alternative source of financing. To address the lack of bond market liquidity,
authorities could:

(1) Relax exchange controls on bonds to facilitate investment by foreign investors and
broaden the domestic investor base;

(2) Ease investment mandates on contractual savings institutions that encourage funds to
hold bonds to maturity;

(3) Develop exchange and OTC derivatives and swap markets;

(4) Consolidate the outstanding stock of government bonds.

1. Relax exchange controls on bonds to facilitate investment by foreign investors and

broaden the domestic investor base:

The restriction on foreign holdings of bonds is anomalous, in that it is more onerous

than the corresponding restrictions on foreign investment in equities, on foreign direct
investment, and on foreign investment in derivatives. The potential benefit achieved by
allowing more foreign interest—especially trading interest—would encourage greater
liquidity and investor diversity in the government bond market. Recently the RBI has
repeatedly relaxed the restrictions during 2008 substantially increasing the aggregate
holdings permitted for foreign investors. However, indications are that foreign investors
have not taken up the allowances of corporate debt available to them. The limitations
and distortions in the market have forced some Indian corporate issuers with a global
presence who want access to foreign investors have to issue in the Euro market or
elsewhere rather than domestically. This contributes to further fragmenting already
limited liquidity.

2. Ease investment mandates on contractual savings institutions to hold bonds to

maturity:

Banks are active traders of government bonds but the SLR limit means that a
considerable part of their stock of assets cannot be traded. The result is to reduce the
profitability of the banking system. Institutional investors are the main support for

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corporate bond markets in most jurisdictions. Life insurance and pension sector
institutions are subject to strict investment mandates, which means their ability to
invest in non-government debt instruments is limited. To avoid the risks of a too-rapid
easing of investment mandates, relaxation should be controlled and phased.

3. Develop derivatives and swaps markets:

Bond market liquidity is not necessarily about trading itself, but in using risk
management tools to alter the risk profile of a portfolio. However, tools such as derivatives,
bond lending and borrowing, repurchase agreements (repos) and swaps, as well as OTC
credit derivatives and credit insurance, are not available in the bond market. Developing
derivatives and swap markets is a critical measure for broadening the investor base and for
increasing liquidity in both government and corporate bond markets. It is also crucial to
funding massive infrastructure investment needs and providing corporations with the tools
they need to manage the risks associated with India’s financial globalization. These markets
allow a wider dispersal of risk as derivatives and swaps help reduce costs, enhance returns,
and allow investors to manage risks with greater certainty and precision. Derivative and
swap markets also help address exchange and interest rate risks. The development of these
markets needs to be underpinned by improving regulatory, legal, and infrastructure
frameworks.

Discussions about reintroducing exchange-traded derivatives have focused on the technical

aspects. It has been proposed that bond indexes—both corporate and government—be
created and futures and options on the same be introduced along the same lines of what
has been permitted in equity. The possibility of introducing exchange traded single bond
futures and exchange traded credit derivatives is also being explored. In the February 2008
budget speech, the Finance Minister proposed to develop derivative markets by:

• launching exchange-traded currency and interest rate futures;

• developing a transparent credit derivatives market with appropriate safeguards.

However, sentiment in India has been moving against derivative markets—restrictions on
commodity derivative markets and recent events in global credit derivative markets will
probably reinforce that sentiment.

4. Consolidate the outstanding stock of government bonds:

Despite some passive consolidation especially at the long end the government market
remains fragmented with many relatively small stocks. There is now a budget provision to
finance the consolidation of the outstanding stock of government bonds. RBI should thus
move away from its policy of passive consolidation (which has not led to significant
improvements in the number and size of issues) to a more active but market-driven

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retirement of small issues, with the aim of creating a limited number of large benchmark
issues along the yield curve.

Measures to Develop the Corporate Bond Market

Reforming stamp duty and disclosure for public offers are additional measures that can help
develop the corporate bond market.

1. Reform the stamp duty: The stamp duty is a significant barrier to the development of
both the corporate bond and securitization markets. Stamp duties are typically 0.375% for
debentures and, as they are strictly ad-valorem, there is no volume discount. The rate of
duty varies depending upon location (various states have set their own rates). Recently
official comments have suggested that individual states have agreed to waive stamp duties
but this has yet to be announced as official policy. Rates also vary with the nature of the
issuer; and with the nature of the initial purchaser (for example, promissory notes bought
by commercial and some other banks are subject to only 0.1% duty, compared with 0.5% if
issued to other investors). Interest payments are taxable as income and capital gains are
taxable. Plans are being drawn up to ensure a uniform low rate across all states and to cap
the maximum amount payable, but the timescale is unclear.

2. Reform disclosure for public offers of corporate bonds: Issuers consider the current
process expensive and risky. Existing regulations could be reformed to allow for disclosures
that are appropriate for public issues into a largely professional market by entities that are
already well-known to the investment community. Regulations could also be changed to
allow techniques such as shelf registration. The public issue process is also unduly long to
allow for postal submissions—a recent proposal by the RBI to allow online applications
might help by shortening the time an issuer is on risk. SEBI proposals, when implemented,
should address some of the burdensome nature of issuance by rationalizing disclosure
requirements especially for companies already listed.

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Conclusion

As markets develop, there is a lot to be learned from sharing experience with other financial
centres. While this is widely practiced in equity markets information sharing needs further
development in the bond markets. Every capital market has unique features derived from
history, culture, and legal structures, but increasingly they also have common features.
Equity markets, for example, now almost all follow some version of an electronic order
display and execution system. But too often, in learning from others, developing markets try
to mimic the more advanced markets of Europe and North America. Structures that suit vast
and complex markets in developed countries with greater variety of instruments and
investors are less appropriate (or excessively expensive) for less-developed markets. There
is thus a strong case for looking to neighbouring emerging markets at similar stages of
development for guidance. Doing so may suggest innovative solutions to problems that have
been tried successfully in similar markets, provide support for local market innovations
based on their success elsewhere, and allow markets to avoid other’s mistakes.

India has developed a number of unique features in its bond market—for example its CBLO
system and the successful electronic trading platform—which could usefully be studied by
its neighbours, many of which suffer from limited repo markets or which have (like India)
tried unsuccessfully to move bonds on to electronic platforms. At the same time, in the
development of its corporate bond market, India can no doubt learn from its neighbours’
disclosure policies, bankruptcy processes, consolidation of government benchmark issues,
and regulatory structures. Bond market associations are also less well-developed than their
equity market counterparts, which benefit from international gatherings and regional
associations like the World Federation of Exchanges. The Asian Bond Markets Initiative
could play an instrumental role in helping address this shortfall.

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