Debt Markets In India

Debt Markets

Debt Markets involve issuance, trading and settlement of fixed income securities such as bonds of various tenors. Debt Market instruments can be issued by Central and State Governments, Public Sector Units, Statutory Corporations, Banks, Financial Institutions and Corporate Bodies.

 

Objectives Of Debt Markets In India

• • Efficient mobilization and allocation of resources in the economy.
  • Financing the development activities of the Government.
  • Transmitting signals for implementation of the monetary policy.
  • Facilitating liquidity management in tune with overall short-term and long-term objectives.
  • Reduction in the borrowing cost of the Government and enable mobilization of resources at a reasonable cost.
  • Provide greater funding avenues to public-sector and private sector projects and reduce the pressure on institutional financing.

 

Components Of Indian Debt Market

The debt market in most developed countries is many times larger than other financial markets – including the equity markets. In the post reforms era, since the liberalization of the Indian economy in 1991, following debt market segments have emerged:

• • Private Corporate Debt Market.
  • PSU Debt Market.
  • Government Securities Markets [ usually referred to as the G-Sec market ].

The G-Sec market commands over 90% of the volume of transactions in the debt market – it is the principal segment of the debt market in India.

 

Reforms In Indian Debt Market

Before 1990, in order to provide cheap capital for state enterprises, the government had established a well-knit structure of national and state level development financial institutions (DFIs), for meeting the requirements of medium- and long-term finance of all ranges of industrial units. In order to enable term-lending institutions to finance industry at concessional rates, the Government and the RBI gave them access to low cost funds. But it did not produce the expected result.

The situation changed significantly after financial sector deregulation in 1991. The DFIs no longer enjoyed their protective policy climate, and had no access to concessional sources of finance like government guaranteed bonds or budgetary support. DFI’s, thus, found it difficult to remain viable by raising funds from the market and competing with commercial banks. Moreover, banks started substantially increasing their term-lending with the help of the low-cost deposit funds. During the 1990s, therefore, the DFIs were increasingly withdrawing themselves; others, like ICICI and IDBI, merged with commercial banks and lost their original identity. On the other hand, the banking sector witnessed sweeping changes, including elimination of interest rate controls, reductions in reserve/liquidity requirements, and an overhaul in priority sector lending, and commercial banks gradually diversified into several new areas of business like, merchant banking, mutual funds, leasing, venture capital, and other financial services. In India, external capital borrowings are being permitted by the Government for providing an additional source of funds to Indian corporations. The Indian Government through the Ministry of Finance – monitors and regulates these borrowings through policy guidelines. The discouragement of external debt has restricted domestic entities’ ability to issue bonds on international markets and the entry of foreign investors to the domestic bond market. Moreover, the restrictions on purchases by foreigners in the corporate and government bond markets are much more strict. Hence, the market for private bonds remains underdeveloped. By contrast, the approach to equity inflows has been much more liberal. Restrictions on FDI inflows have been relaxed progressively.

Traditionally, the Indian debt market has been restricted to a few institutional players – mainly Banks, other participants include primary dealers, mutual funds. Banks have a statutory requirement [ under RBI regulations ] to main a specific percentage of their deposits in the form of Government Securities – also called the Statutory Liquidity Ratio [ or SLR ]. This is the reason for banks to actively trade in Government Securities.

Due to the administered interest rate regime, the volume in the debt market segment was extremely negligible until the early 1990’s. Also, the return from investing in Government Securities was lower as compared to other alternative investment avenues. Thus, RBI instituted reforms in the debt market. But in spite of these reforms, volumes are usually low in the corporate debt market and the PSU debt market segments.

An integral aspect of the financial liberalization initiated in the early 1990s was the process of reforming the debt market.

Two Of The Main Reasons For This Reform Are As Follows:

1. 1. Realization that the growing budget deficit would have to be funded through a  liquid, efficient government securities market.
   2. Recognition that sustained economic growth will require a significant improvement of the nation’s infrastructure, which itself will require a deep and liquid domestic debt market.

 

Increasing Issuance Of Government Debt

The central government is the largest issuer of debt. The growing national budget deficit has required the increased issuance of government securities. The annual primary [ gross ] issuance of central government debt increased 18 times during the 15 years since the reform process began, from Rs. 8,989 crores in FY 1991 to Rs. 160,018 crores in FY 2006. In FY 2008, this figure touched an all time high of Rs. 188,205 crores and was at Rs; 175,780 crores in FY 2009.

In addition, the growing needs of the state governments have led to their growing issuance [ gross basis ] in the debt market. The annual issuance of state government debt has increased as much as 20 times, from Rs. 2,569 crores in FY 1991 to Rs, 50,521 crores in FY 2004. In FY 2008, this figure touched an all time high of Rs. 67,779 crores and was Rs. 59,062 crores in FY 2009.

Although the Indian private corporate sector raises a large part of their financial requirements through bank loans, there has been increasing reliance on both the debt and equity markets. Within the debt market, especially the corporate bond market, issuances by state-owned public sector undertakings have persistently outstripped those by private companies. Further, there has been a strong preference for the private placement route for corporate bond issues rather than public issues owing to lesser regulatory requirements in private placements. Also, the high cost associated with public issuance deters corporate entities from accessing funds through this route.

 

Government Securities [G-Sec]

These are sovereign [ credit risk-free ] coupon bearing instruments which are issued by the Reserve Bank of India on behalf of Government of India, in lieu of the Central Government’s market borrowing program. These securities have a fixed coupon i.e., paid on specific dates on half-yearly basis. These securities are available in wide range of maturity dates even up to 30 years.

 

Corporate Debt Market

In the last decade, a number of innovations have taken place in the corporate bond market, such as securitized products, corporate bond strips and a variety of floating rate instruments with floors and caps and bonds with embedded put and call options. However, the secondary market has not yet developed in the debt segment of the Indian capital market. Furthermore, the corporate debt market in India remains underdeveloped as large domestic institutional investors, such as pension funds and the insurance sector, are restricted from allocating large portions of their investment funds in the corporate bond segment.

A number of policy initiatives were taken during the 1990s to activate the corporate debt market in India. The interest rate ceiling on corporate debentures was abolished in 1991, paving the way for market-based pricing of corporate debt issues. In order to improve the quality of debt issues, ratings were made mandatory for all publicly issued debt instruments, irrespective of their maturity. The role of trustees in bond and debenture issues has strengthened over the years. All privately placed debt issues are required to be listed on the stock exchanges and follow the disclosure requirements. However, despite the policy initiatives, corporate debt still constitutes a small segment of the debt market in India. Whereas the primary market for debt securities is dominated by the private placement market, the secondary market for corporate debt is characterized by poor liquidity – although this has relatively improved over the years. Corporations in India continue to prefer private placement of debt issues rather than floating public issues. The dominance of private placement has been attributed to several factors, such as ease of issuance, cost efficiency, primarily institutional demand, and so forth. About 90% of outstanding corporate debt is usually privately placed.

 

Debentures

Debentures are a type of financial claims issued by a company. The buyers of debentures are the creditors of the company, who have invested capital in the company. In return for the invested capital, the debenture holders would obtain a fixed rate of interest usually payable annually or half yearly on specific dates. The principal amount is paid back by the company to the debenture holders on particular future date – this is the redemption date of the debentures.

The terms of reference of the debenture or bond may be customized in such a way that the principal may be payable [ back to debenture holder ] at regular pre-specified intervals. In some instances, convertible debentures are also issued, whereby the debentures can be exchanged for equity shares at a later date.

 

Features of Debentures

• • At the time of issue of debentures, a trustee is appointed through an indenture / trust deed. It is a legal agreement between the issuing company and the trustee, who is usually a financial institution/bank/insurance company/or a firm of attorneys. The trust deed provides the specific terms of agreement, such as description of debentures, rights of debenture holders, rights of issuing company and responsibilities of the trustee. The trustee is responsible for ensuring that the borrower of funds [ the company issuing the financial claims – debentures ] fulfills all its contractual obligations.

• • Unlike an equity shareholder, whose dividend income is subject to the risk of company’s performance, debenture holders are assured of receiving the fixed interest payable to them. This is a legally binding and enforceable contract. Debenture / bond holders have the first right to residual claims on assets, at the time of liquidation of the company. The issuing company can choose the fixed rate of interest payable for the debenture issued, based on the credit rating of the company. The interest rate is usually a fixed rate, but may also be a floating interest rate.

• • A Debenture Redemption Reserve (DRR) is created for the redemption of all debentures with maturity period exceeding 18 months. The amount in this DDR [ which is a sinking fund ] should be equivalent to at least 50% of the total amount of issue / redemption, before commencement of the redemption.

• • Debentures may also have features of a “call option” – whereby, the company may have the right to redeem all the issued debentures – with settlement based on specific price. On the other hand, if the debenture holder is given a right to seek redemption of the debenture held by the investor, this is called a “put option“. The call or put option may be exercised at predetermined prices, keeping an allowance for the option premium – which is the extra amount related to the right but not the obligation, provided by the option.

• • Debentures are normally secured/charged against the asset of the company in favor of the debenture holder. This is usually on the present and future immovable assets of the company by way of an equitable mortgage.

• • Non-Convertible debentures can only be redeemed by the issuing company. On the other hand, Convertible Debentures, which may be either Fully Convertible Debentures (FCD) or Partly Convertible Debentures (PCD) are eligible for conversion of either a full or part of the holdings into equity shares.

• • All debenture issuers are rated by credit-rating agencies namely, ICRA, CRISIL, Fitch or CARE.

• • Zero Interest Debentures are issued at a discount to the face value [ i.e., the face value amount redeemable on maturity date is discounted ].

• • Secured Premium Notes (SPN) is a secured debenture, redeemable at a premium over the purchase price. Usually, there is a lock-in price for the SPN, during which no interest is paid. The redemption is made in instalments after the lock-in period. SPN is usually a tradable instrument.

 

Advantages Of Debentures

• • Lower cost due to lower risk.
  • Tax deductibility of interest payment.
  • Debentures do not carry voting rights – hence there is no dilution of control over the company if debentures are issued.
  • Debentures, unlike equity offer stable returns for the investors.
  • Debentures have a fixed maturity.
  • Debentures are also protected long term capital investments. The Debenture Redemption Reserve and the trust protect the interests of the debenture holders.
  • Debenture holders also have preferential claim over the assets of the company at the time of liquidation.

 

Disadvantages Of Debentures

• • The company issuing debentures have the disadvantage of the limitations of the covenants in the trust deed that contains legally enforceable contractual obligations with reference to periodic interest payment and principal repayment at time of redemption.

• • Debentures result in a steady cash outflow for the company – by way of interest payment – even if the company makes losses. In the case of equity shares, this is not a problem, since dividends are the prerogative of the company management.

 

Warrants

Warrants issued by a company entitle investors to subscribe to equity capital of the company on a specified future date, at a specific pre-determined price. The holder only has the right to buy, but no obligation – this is similar to selling call options. Warrants may be issued independently on a stand-alone basis or in combination with debentures or secured premium notes.

In a Convertible Debenture (CD), the debenture portion that earns a fixed rate of interest and the right to convert the debenture into equity shares cannot be separated. This is in contrast to a Warrant, which can be issued independently also. Warrants are exercisable directly for cash – i.e., exercising a warrant would result in purchase of equity shares for a consideration paid for in cash.

 

Bonds

Bonds refer to negotiable certificates evidencing indebtedness. It is normally unsecured. A debt security is generally issued by a company, municipality or government agency. A bond investor lends money to the issuer and in exchange, the issuer promises to repay the loan amount on a specified maturity date. The issuer usually pays the bond holder periodic interest payments over the life of the loan. The various types of Bonds are as follows:

Zero Coupon Bond: Bond issued at a discount and repaid at a face value. No periodic interest is paid. The difference between the issue price and redemption price represents the return to the holder. The buyer of these bonds receives only one payment, at the maturity of the bond.

Convertible Bond: A bond giving the investor the option to convert the bond into equity at a fixed conversion price.

Callable Bonds: This provides flexibility to the company to redeem the issued outstanding bonds on a specific future date.

Puttable Bonds: This provides flexibility to the investor to seek redemption of the bonds that he/she has purchased, on specific future date.

Debenture is a type of bond. But the debenture is secured by way of a trust deed.

 

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