I. CORPORATE BOND MARKET: A GLIMPSE
“Two broader types of securities issued in the financial market of an economy are Equity and Debt. Equity is a perpetual liability because it signifies an owner’s legal claim after all liabilities are met, upon the assets of the entity in which the equity share is held. Bonds are debt securities, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity. Depending on the issuer of bonds, it can be classified as Govt. Securities, i.e. bonds issued by the Central / State Govt. of an economy, and Corporate Bonds, i.e. bonds issued by private and public corporations. Debt instruments can also be categorized in terms of their maturity, nature of interest, special features embedded in it, etc. Short term debt instruments, issued by the Central Govt. and by corporates, are respectively known as Treasury Bills and Commercial Papers. Similarly, securities issued with a maturity of more than one year are known as dated securities. The original maturity of a debt security may range from 1 year to 30 years.”
When Governments, Financial Institutions, Companies, and other entities want to raise long term finance, without diluting their shareholdings (or, indeed, when cannot issue shares), they turn to the bond markets and can raise money without having to pay it back maybe for decades. Corporate borrowers issue debt securities to meet their financing requirements. The corporate bond market provides an alternative means of long-term resources, an alternative to bank financing, to corporate. The size and growth of this market depend upon several factors, including financing patterns of companies. A liquid corporate bond market can play a crucial role in supporting economic development as it supplements the banking system to meet the requirements of the corporate sector for long-term capital investment and asset creation.
In simple words, The bond market (also debt market or credit market) is a financial market where participants can issue new debt securities, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, but it may include notes, bills, etc. Corporate Bonds are Bonds issued by private or public sector companies in order to borrow funds from the market.
II. TYPES OF CORPORATE BONDS:
A. Fixed-Rate Bond/ Straight Bond/Plain Vanilla Bond:
“A fixed-rate bond is a bond that pays the same level of interest over its entire term. The benefit of owning a fixed rate bond is that investors know with certainty how much interest they will earn and for how long. As long as the bond issuer does not default or call in the bonds, the bondholder can predict exactly what his return on investment will be. A key risk of owning fixed-rate bonds is interest rate risk or the chance that bond interest rates will rise, making an investor’s existing bonds less valuable.”
“For example, let’s assume an investor purchases a bond that pays a fixed rate of 5%, but interest rates in the economy increase to 7%. This means that new bonds are being issued at 7%, and the investor is no longer earning the best return on his investment as he could.”
B. Floating Rate Bond:
A floating-rate note (FRN) is a debt instrument with a variable interest rate. The interest rate for an FRN is tied to a benchmark rate. These types of bonds may have some Floor or Cap attached on it, representing that even if the benchmark rate change by any value, the coupon rate even if floating but will always lies within the range of Floor and Cap rate. Some of the well-known benchmark rates used in the Indian market are MIBOR, Call Rate, T-bill rate, PLR, etc.
C. Zero-Coupon Bond:
Zero-Coupon Bonds (ZCBs) are issued at a discount to their face value and the principal/face value is repaid to the holders at the time of maturity. Instead of paying any periodic coupons, the ZCB holder gets the price discount at the beginning itself. Therefore, ZCBs are alternatively known as Deep Discount Bonds.
D. Bond with Embedded Option:
“A bond may have an option (Call or Put) embedded in it, giving certain rights to investors and/or issuers. The more common types of bonds with embedded options are Callable bond, Puttable bond, and Convertible bond. A callable bond gives the issuer the right to redeem or buy back them prematurely on certain terms. The call option can be an American or a European option. The purpose of such an option is to reduce the cost of the issuer in the regime of falling interest rates. On the other hand, the Puttable bond gives the investor the right to prematurely sell them back to the issuer on certain predefined terms. Puttable bond safeguards the interest of bondholders when interest rates rise in the market. Convertible bonds, alternatively known as Hybrid Securities, give the bondholder the right to convert them into equity shares on certain terms. Such a bond can be fully or partly convertible. In case of partly convertible, investors are offered equity shares for the part which is redeemed and the other part remains as a bond.”
E. Tax-Free Bonds:
Tax-free bonds are issued by a government enterprise to raise funds for a particular purpose. One example of these bonds is the municipal bonds. They offer a fixed interest rate and hence is a low-risk investment avenue. As the name suggests, its most attractive feature is its absolute tax exemption as per Section 10 of the Income Tax Act of India, 1961. Tax-free bonds generally have a long-term maturity of ten years or more. The government invests the money collected from these bonds in infrastructure and housing.
F. Perpetual Bonds:
A perpetual bond, also known as a “consol bond” or “prep,” is fixed income security with no maturity date. This type of bond is often considered a type of equity, rather than debt. One major drawback of these types of bonds is that they are not redeemable. However, the major benefit of them is that they pay a steady stream of interest payments forever.
G. Public Sector Undertaking Bonds (PSU Bonds):
Bonds, usually for medium or long term, issued by the Central Public Sector Undertakings are very common in India and are known as PSU Bonds. These bonds are supported by Govt. of India and therefore have a strong demand in the Indian market. PSU Bonds are mostly sold through Private Placements to the targeted investors at market-determined interest rates.
H. Junk Bonds:
Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations and governments. A bond is a debtor promises to pay investors interest payments and the return of invested principal in exchange for buying the bond. Junk bonds represent bonds issued by companies that are struggling financially and have a high risk of defaulting or not paying their interest payments or repaying the principal to investors.
I. Secured / Unsecured Bonds:
When a bond is backed by a specific asset, it is termed a secured bond. Typical assets include cash or physical property, such as plant equipment or machinery. A secured bond tells the investor that something of value will be available to bondholders in the event the issuer cannot pay the interest owed, or repay the principal balance.
An unsecured bond also referred to as a debenture, is not backed by an asset of any kind. If bankruptcy occurs, repayment is not guaranteed by a future revenue stream, equipment, or property. An unsecured bond is only backed by the full faith and credit of the issuing institution.
As far as the corporate bond market in India is concerned, there are several types of securities, including fixed-rate bonds, floating-rate notes, structures notes, and others.
III. KEY DEVELOPMENTS IN THE INDIAN CORPORATE BOND MARKET:
A. Reforms in Indian Corporate Bond Market:
Many committees such as The High-Level Expert Committee on Corporate Bonds and Securitisation in 2005 (Patil Committee), chaired by late Dr R. H. Patil; The Committee on Infrastructure Financing in 2007 (Deepak Parekh Committee) under the chairmanship of Shri Deepak Parekh; High Powered Expert Committee on Making Mumbai an International Financial Centre in 2007 (Percy Mistry Committee); A Hundred Small Steps- Report of the Committee on Financial Sector Reforms in 2009 (Raghuram Rajan Committee) have made several recommendations in respect of the development of the corporate bond market in India.
Based on these recommendations several reforms have been initiated by the Government of India (GoI), Reserve Bank India (RBI) and Securities and Exchange Board of India (SEBI) for the development of the corporate bond market in India. The reforms undertaken by the GoI and RBI and SEBI are outlined as follows:
- In 2006, for the development of corporate bond and securitization markets, the GoI accepted the Patil Committee recommendations and provided clarification on issues of regulatory jurisdiction of the RBI and SEBI. SEBI becomes responsible in the case of corporate bond transactions in the primary market both for public issues as well as private placements. Similarly, RBI is responsible for the transactions related to the repo, etc. But, if such trading takes place on exchanges, in that case, the procedure of trading and settlement would be decided by SEBI.
- As per RBI in 2007, State Development Loans (SDLs) became eligible securities under the liquidity adjustment facility repos
- In 2008, the GoI made the announcements on the launch of exchange-based interest rate futures, separation of equity option from convertible bonds, exemption of TDS for listed and demand instruments and market-based system for classifying instruments based on complexity.
- The RBI, in 2009, introduced non-competitive bidding for SDLs. Also, it reintroduced interest rate futures with modification.
- In 2011, GoI has announced infrastructure debt funds under the non-banking financial company (NBFC) and Asset Management Company (AMC) route.
- RBI has introduced Credit Default Swap (CDS) effective from December 1, 2011, to provide hedging opportunities for both residents and FIIs. In this year, RBI also permitted NBFSs to set up infrastructure debt funds.
- In order to facilitate direct participation by retail and mid-segment investors, a web-based system for access to Negotiated Dealing System (NDS) auction and Negotiated Dealing System-Order Matching (NDS-OM) was introduced by RBI in 2012. This system is an order-driven electronic system. Here the participants make their trades anonymously and place their orders in the system or accept the orders which have already been placed by other participants.
- In 2013, RBI permitted short-term debt securities for corporate repo and CDS for unlisted but rated corporate bonds even for issues other than infrastructure companies. Also, in this year, inflation-indexed bonds were introduced by the RBI.
- In 2014, GOI allowed Employees’ Provident Fund Organisation (EPFO) to invest up to 55 percent in debt securities issued by corporate bodies and also made an announcement on Real Estate and Infrastructure Investment Trust.
- RBI allowed credit enhancement reset in securitization transactions for both banks and NBFCs and also introduced a cash-settled interest rate future on 10-year G-Sec in 2014.
- With effect from April 2014 reporting of transactions related to corporate bonds in the secondary market has been discontinued at FIMMDA as per the RBI circular dated 24th February 2014.
- In 2015, GoI notified a new pattern of investment in equity and new instruments such as Real Estate Investment Trust (REITs) and Infrastructure Investment Trust (InvITs).
- In 2015, RBI introduced a draft framework on the issuance of rupee-linked bonds abroad and bonds issued by multilateral such as World Bank Group (IBRD, IFC), ADB and AfDB in India that made such bonds eligible underlying for the repo. This year, NBFCs get to undertake forward contracts as well as ready forward contracts in corporate debt securities.
- Budget 2020 declares to increase Foreign portfolio investors’ (FPI) limits in corporate bonds increased from 9 per cent of outstanding to 15 per cent outstanding – this would mean incremental, about Rs 2.11 trillion of Corporate Bond FPI limits. While the roadmap for this increase would come from the RBI, it is positive for corporate bonds from a medium-term basis.
B. Legal Framework:
India is considered to be more “regulators-friendly” than to be “business-friendly”. World Bank, in its Doing Business Report 2016, has placed India at 130 out of the 189 countries for ease of doing business. From a recovery perspective, the corporate bonds are deemed risky and the procedural requirement is too lengthy. In the case of resolving insolvency, the World Bank has placed India at 136 out of 189 countries.
Delay in resolving the dispute is a key hindrance for the financial entities looking to invest in the corporate bonds. There is a need for a strong and faster process of deciding insolvency, winding up and liquidation. The Sick Industrial Companies Act led to the establishment of the Board of Industrial and Financial Reconstruction for revival and rehabilitation of sick undertaking; however, the success was limited. The Corporate Debt Restructuring scheme introduced by RBI for the safety of money given by banks and financial institutions, this scheme had mixed success. The Recovery of Debts Due to Banks and Financial Institutions Act led to the establishment of Debt Recovery Tribunals were established to avoid delays with courts in the enforcement for debt but unfortunately, the success was very limited. In the year 2002, the SARFAESI Act was introduced for enforcement of security interest without court intervention and the success was high. However, the need for a uniform code led to the enactment of the Insolvency and Bankruptcy Code, 2016 – In case of Insolvency Resolution and Liquidation for Corporate Persons – National Company Law Tribunal shall be the adjudicating authority and for individuals and partnership firms – Debt Recovery Tribunal shall be the adjudicating authority. The success of both the authorities will be determined in the years to come.
IV. STRUCTURE OF INDIAN CORPORATE BONDS MARKET:
1. Issuers:
Corporate bonds in India are issued by Public Sector Undertakings (e.g. REC, KRCL, NTPC); State-level Undertakings (e.g. Power Transmission Corporations, Power Finance Corporation, Road Transport Corporation); Municipal Bodies; Public or Private Sector Banks; Non-banking Finance Companies (e.g. Tata Capital, Reliance Capital); All India Financial Institutions (e.g. IDFC, EXIM, NABARD); Private Sector Entities (e.g. Reliance Industries, Tata Motors, ACC); Housing Finance Companies (e.g. HDFC, NHB).
1.1 Bonds issued by Public Sector Undertakings (PSUs):
PSUs are the largest and most active corporate bond issuers in India. The largest issuers (in terms of bond outstanding) are Power Finance Corporation (PFC), Rural Electrification Corporation (REC), National Bank for Agriculture & Rural Development (NABARD), LIC Housing Finance and India Railway Finance Corporation (IRFC) and SAIL (Steel Authority of India Limited).
1.2 Bonds issued by Non-Banking Finance Companies (NBFCs):
The second category of the issuer of bonds comprises of Non-banking finance companies. The major private NBFC issuers are Housing Development Finance Corporation (HDFC), LIC HF, Infrastructure Development Finance Corporation (IDFC), etc. They issue senior as well as subordinated bonds.
2. Investors:
The main investors in the corporate bond market are banks, insurance companies, provident funds, and mutual funds. Mutual funds are primary investors in short-dated paper and their investment pattern is primarily guided by the growth of AUM’s. Life insurance players, on the other hand, are buyers of long tenure paper given their asset-liability structure and the constant stream of renewal money. Bank’s investment in the debt market is primarily in sovereign securities guided by mandatory SLR requirements.
The Corporate debt market is primarily regulated by three institutions namely the Reserve Bank of India, the Securities and Exchange Board of India and the IRDA. It is important for us to understand the context associated with each of these regulatory institutions.
“The RBI is the monetary authority in India and is therefore primarily interested in ensuring an adequate flow of credit in the economy, maintaining foreign currency market, and managing the twin objectives of economic development and price stability.
On the other hand, the SEBI’s outlook is more narrow- promotion, development, and regulation of securities markets in India keeping the investors’ interests protected. The backbone of SEBI’s action plan has been the SEBI (Issue and Listing of Debt Securities) Regulations, 2008 in an attempt to reduce costs and improve transparency in the corporate debt market.
Since insurance companies are one of the largest components in the demand side of the corporate debt market, it is essential to note that the governing body, IRDA has kept pace with the supply side reforms initiated by the RBI and SEBI. IRDA ensures the participation of insurance companies in the corporate debt setup.”
V. RISKS ASSOCIATED WITH THE CORPORATE BONDS MARKET:
1. Credit and Default Risk:
Credit or default risk is the risk that a company will fail to timely make interest or principal payments and thus default on its bonds. Credit ratings try to estimate the relative credit risk of a bond based on the company’s ability to pay. Credit rating agencies periodically review their bond ratings and may revise them if conditions or expectations change.
The corporate bond contract (called an indenture) often includes terms called covenants designed to limit credit risk. For instance, the terms may limit the amount of debt the company can take on or may require it to maintain certain financial ratios. violating the terms of a bond may constitute a default. the bond trustee monitors the company’s compliance with the terms of its indenture. the trustee acts on behalf of the bondholders and pursues remedies if the bond covenants are violated.
2. Interest Rate Risk:
As discussed above, the price of a bond will fall if market interest rates rise. this presents investors with interest rate risk, which is common to all bonds, even US treasury bonds. A bond’s maturity and coupon rate generally affect its sensitivity to changes in market interest rates. the longer the bond’s maturity, the more time there is for rates to change and, as a result, affect the price of the bond. therefore, bonds with longer maturities generally present greater interest rate risk than bonds of similar credit quality that have shorter maturities. to compensate investors for this interest rate risk, long-term bonds generally offer higher interest rates than short-term bonds of the same credit quality. For example, imagine one bond that has a coupon rate of 2% while another bond has a coupon rate of 4%. All other features of the two bonds—when they mature, their level of credit risk, and so on—are the same. If market interest rates rise, then the price of the bond with the 2% coupon rate will fall by a greater percentage than that of the bond with the 4% coupon rate. This makes it particularly important for investors to consider interest rate risk when they purchase bonds in a low-interest-rate environment.
3. Inflation Risk:
“Inflation is a general rise in the prices of goods and services, which causes a decline in purchasing power. With inflation over time, the amount of money received on the bond’s interest and principal payments will purchase fewer goods and services than before.”
4. Liquidity Risk:
Liquidity is the ability to sell an asset, such as a bond, for cash when the owner chooses. Bonds that are traded frequently and at high volumes may have stronger liquidity than bonds that trade less frequently. liquidity risk is the risk that investors seeking to sell their bonds may not receive a price that reflects the true value of the bonds (based on the bond’s interest rate and creditworthiness of the company). If you own a bond that is not traded on an exchange, you may have to go to a broker when you want to sell it. In addition, the bond market does not have the same pricing transparency as the equity market, as the dissemination of pricing information is more limited for corporate bonds in comparison to equity securities such as common stock.
5. Call Risk:
The terms of some bonds give the company the right to buy back the bond before the maturity date. this is known as calling the bond, and it represents “call risk” to bondholders. For example, a bond with a maturity of 10 years may have terms allowing the company to call the bond any time after the first five years. If it calls the bond, the company will pay back the principal (and possibly an additional premium depending on when the call occurs).
VI. CONCLUSION:
The Criticality of the Corporate Bond Market in the Economy as it allocates resources efficiently and enables long-term resource raising to sectors, such as infrastructure. A vibrant corporate bond market provides a suitable alternative to conventional bank finances and also mitigates the vulnerability of foreign currency sources of funds. In India, the regulators have taken proactive steps and provided the market with tools for risk management. As we discussed above, From the perspective of financial stability, there is a need to strengthen the Corporate Bond Market. there are various laws that came into force for strengthing the Indian Corporate Bond Market like IBC, SARFAESI Act, RDDBFI Act, etc. and continuous issuance of circulars or rules by all the regulatory authorities of the Indian Corporate Bond Market.
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