Expressways can't be built without corporate bonds

Overdependence on bank funding of infrastructure will put unreasonable pressure on those financial institutions. As experts discussed at a recent conference on corporate debt markets, the bond market in India has not found enough takers in the past and the trend still continues—but could change as infrastructure provides low but steady returns. The development of a large and vibrant corporate debt market is crucial for meeting the infrastructure needs of the nation, says Chandrashekhar Modi.

Raju Yadav received a cool 100 per cent return from an XYZ stock over the past one year. Apart from insurance and fixed deposits, his only investment avenue is equity market. Indian investors love to ride the roller coaster of the equity market, where high risks may yield high returns. However, so far they have conveniently ignored the bond market, which gives low but safe and steady returns. Bond market in India had never found enough takers in the past and the trend still continues. In case of individuals who are willing to invest in the corporate bond market also act in a skeptical manner, given the abysmally low liquidity in bond trading when compared to equity trading.

“There is need to change our mindset to improve the market participation,” says DD Rathi, Director, Aditya Birla Group. The Indian debt market is composed of government bonds to the extent of 92 per cent of the volumes, suggesting that the corporate bond market is still in a very nascent stage.

Efficient development of a bond market is inherent to the infrastructure needs of any nation. Most of the infrastructure projects like large power projects; road, rail, airport and port projects need a longer term financing of the order of seven to 10 years. “Banks are normally reluctant to provide finance for such long gestation projects due to issues like asset-liability mismatch (ALM) and sector exposure limits,” Subir Gokarn, Deputy Governor, RBI, pointed out while addressing a conference on corporate debt markets organised by CARE recently in Mumbai. He said that until now, infrastructure has not had the momentum to put pressure on the financial system. That has changed certainly in the last year, it seems. “In all our conversations with banks the number one issue has been that although they are lending to infrastructure and it is the dominant source of their business, but it does not make sense, because that is not the kind of maturity profile that a bank should be getting into. Banks are the only source available so they are doing it.” Gokarn added that this compromise reflects the fact that there is a need for infrastructure finance in a new framework.

What that framework has to be is still open, although corporate bond markets have a long way to go and need a mindset change among Indian investors.

Need for long-term debt finance

The importance of long-term debt financing can hardly be overstated owing to the longer payback period of infrastructure projects and delays due to complexities in the design, safety and environmental aspects.

The characteristics of infrastructure finance (given above) suggest that the demand can be met efficiently only through debt markets and not through banks. The development of a mature and vibrant corporate debt market is eminently suited to match the investment requirements of long-term risk-averse investors seeking regular returns after a lock-in period. Greater deepening in the non-government debt market with sound financial, legal, and regulatory framework would enhance the benefit of price discovery and risk diversification. “The growth of the corporate debt market segment has not been satisfactory and there is need to revisit the subject. Clearly there are no simple answers here,” explained DR Dogra, MD and CEO, CARE Ratings. The PPP model was pioneered in Europe in the late 1960s has benefited immensely from the financial flexibility offered by the debt market by reducing over-reliance on the banking system.

The inadequate Rs 20,000 carrot

In an attempt to lure investors and provide them a tax-saving avenue, government had last year announced a deduction of upto Rs 20,000 on investments in long-term infrastructure bonds. The deduction is in addition to the Rs 1 lakh allowed under Section 80C of the Income Tax Act. Two important factors playing a vital role while choosing infrastructure bonds to invest in are inflation and interest rate movements. In the current inflationary scenario a deduction of Rs 20,000 means nothing if one considers the returns after accounting the reduction in purchasing power due to inflation. “The current tax exemption for infrastructure bonds seems to be too low and insufficient to attract a sizeable number of investors. In order to create a significant impact, the exemption limit should be raised to at least Rs 1 lakh. This will not only attract more investors, but will assist in improving the bond volumes,” explained Rohit Modi, Deputy Managing Director, Gammon India.

Initiatives for better depth

For improving the depth of Indian bond market, a number of steps have been taken for the primary as well as the secondary bond market. With the removal of TDS on bonds, it has become comfortable to trade in strips which will help meet the demand of risk averse investors. Simplification of disclosure norms will also help: While introducing a bond issue to the market, much expenditure is incurred because of the stringent disclosure norms and listing requirements, which at the same time are extremely time consuming. If the issue size is big, at least four per cent of the issue size goes as the issue expenditure and if it is a small issue, the figure can go up to even 10 per cent or 15 per cent of the issue size. So, saving a few lakhs of rupees by getting the issue rated with only one rating agency instead of two as per Sebi’s new guidelines will not tempt a company to opt for this route.

However, most of the corporate entities opt for private placement of debt because of the economy of cost and time associated with it compared to public issues.

The RH Patil Committee report has suggested that the rating rationale should be the basis for listing of bonds issued by unlisted entities. The corporate bond market is dominated by banks and institutions which invest mainly in higher-grade paper, the market for lower quality paper is almost non-existent.

The FII investment limit in the government securities and corporate bonds has been raised to $5 billion. This is a welcome step by the government and greater participation of foreign institutional investors will help in creating liquidity.

Bond prices are linked to bond yields which depend upon the existing and future trends in interest rates. A vibrant interest rate futures market will provide players to get a clear view on the yield curve. “Interest rate futures market should be given a boost in order to uplift the bond market in its real sense. Clear visibility of interest rates is very important for a bond trader to view future opportunities,” asserted Gokarn.

According to Assocham, measures should be taken to reform the debt market, including uniform stamp duty, screen based trading, clearing house settlement, increase in secondary market activity, and so on, measures that would lead to transparent price discovery and avenues for early exits for investors. Besides, there should be a gradual relaxation of investment restrictions and forced rule based buying on long-term investors such as insurance companies, pension funds and banks. Regulatory reforms are required in this space keeping in mind the learning from the international space. The current withholding tax of 20 per cent should be removed to encourage investors to invest in debt securities.

The infra debt fund

Recently, Planning Commission Chairman Montek Singh Ahluwalia announced to set up $10 billion infrastructure debt funds for financing long-term projects across the country. Infrastructure development would require over $1 trillion in the 12th Five Year plan that begins next year. These funds are expected to be two layered—domestic and offshore—just like venture capital funds. The offshore entity will raise funds from overseas investors, including pension and insurance funds, and then direct them to the entity in India for downstream investment. This structure would require changes in the rules governing external commercial borrowings (ECBs) as the current regime does not allow such borrowings by funds. Foreign funds can register as venture funds and provide equity to the infrastructure sector, but there is no such mechanism for intermediating debt funds.

The Securities and Exchange Board of India (SEBI) will have to create a framework for registering these funds on the lines of venture capital funds and the RBI will have to spell out a capital adequacy framework for them. Insurance and pension fund regulators will also need to tweak their rules to ensure flow of funds from such domestic entities to these debt funds. “Fixed deposit (FD) rates need to be linked to MIBOR to develop the markets and give it an international presence,” says Jayesh Mehta, MD and Country Treasurer, Bank of America ML.

Tapping the international market

Globally, the modest scale of bond financing of infrastructure is on account of limited access to international bond markets. The pricing of private corporate securities issued in the international bond markets depends partly on corporate financial characteristics and partly on the country characteristics. The efficiency of bond pricing can be enhanced by issuing and actively trading the sovereign debt in the market. This increases country visibility, and the appetite for corporate securities. It further provides a benchmark against which corporate debt can be efficiently priced. Issuing sovereign debt, however, implies that countries must be willing to accept continuous scrutiny of macroeconomic performance and economic policies by international credit rating agencies.

Platforms across the globe

In the current context, price discovery is not very efficient, which is essential for a vibrant market. There are successful trading platforms such as EUROMTS and EUREX-BOND, which match orders of banks and institutions without going through brokers. These alternative trading systems (ATS) have become highly successful in many countries. As the Indian market is structured similar to global markets, setting up a system like the EUREX-BOND would help immensely. An efficient corporate debt market requires a proper order-matching and guaranteed settlement systems. Restricting trading to a single exchange may be counter-productive in the long run. In the interest of the market development, the choice of setting up the trading platform should be open to all interested parties and the regulator should not play the decider’s role. Rather, the regulator’s role should be to specify norms for setting up an efficient order-matching system.

The road ahead

There has been a slew of bond issuances in the second half of the year 2010 and few more are in the pipeline. Recently Industrial Finance Corporation of India (IFCI) had completed a private placement of unsecured redeemable, non-convertible long-term infrastructure bonds and garnered Rs 100 crore.

IDFC raised Rs 3,400 crore through infra bonds, which were open to retail and institutional investors. L&T Infrastructure finance recently issued long term infra bonds worth Rs 700 crore.

The activity on the bond street suggests that the street has woken up to meet the infrastructure needs of India. However, India still has a long way to go. Bond market has to grow manifold from its current level. “The main success for this market is to introduce simple products that can be understood by all. Liquidity and standardisation are viewed as building blocks
for the market,” said PH Ravikumar, Managing Director, Invent.

Characteristics of Infrastructure Finance:

• Longer maturity between 5-40 years


• Large investments


• Higher risks arising from demand uncertainty, environmental transformations, technological obsolescence, political, policy and “ground-realities” elated uncertainties


• Fixed and low (but positive) real returns

Measures that need Consideration

• Exemption from withholding tax for FIIs


• Rationalisation of stamp duties across states


• Tax treatment of Pass Through Certificates


• Reconciling definitional differences–Bonds vs Debentures


• Enhancing scope of investment by insurance companies and Provident/Pension/Gratuity Funds


• Permitting FIIs to invest in to-be-listed bonds


• Repo lending by insurance companies and mutual funds


• Single unified database to ensure reporting by all entities


• Partial credit enhancement by banks