Needed: A debt alternative - II

In the previous article on this theme published on August 18, I had argued the significance and broad contours of developing a debt market in India.

The responsibility of building the debt market falls on the government of India (GoI), the Reserve Bank of India (RBI), and the Securities and Exchange Board of India (Sebi).

As some jurisdictional concerns have been voiced, the Centre has to initiate, lead, and coordinate the process by taking a few initiatives.

Currently, a large amount of securitised paper""asset-backed securities (ABSs), mortgage-backed securities (MBSs), collateral loan obligations (CLOs) floated via pass-through certificated (PTCs) by special purpose vehicles (SPVs) (trusts, in particular)""are not recognised as securities under the Securities Contract (Regulations) Act (SCRA).

Hence they cannot be listed. Similarly, a range of debt securities of private companies, cooperative banks, and unlisted companies cannot be listed and traded. Securitising home loan portfolios, another enormous opportunity, if listed and traded, will provide size and liquidity, and obviate maturity mismatches.

Further, under the current dispensation, banks cannot invest in unlisted securities. Thus, a very substantial segment""both demand and supply""is kept out of the secondary debt market.

Compulsorily rating such debt paper, before permitting listing, would ensure quality, and help investors in understanding risk-return profiles before they take an investment call, and protect their interests.

There is a bit of dichotomy in levying stamp duty. Whereas bonds issued in the nature of promissory notes to investors like the RBI, IDBI, IFCI, and commercial and cooperative banks attract stamp duty at 0.10 per cent of the amount, it is raised to 0.50 per cent if issued to others, which increases the cost for a whole lot of issuers, and retail and other investors.

Further, even though secured debt paper is exempted from stamp duty, creating a charge essential to ensure the benefit of the security attracts a state-level stamp duty. Such inconsistencies have to be eliminated and the issuers, investors, and market makers have to be given the incentive to promote the development of a debt market.

Various tax incentives are provided to Qualifying Debt Securities in Singapore, Hong Kong and Malaysia. For example in Hong Kong, income from "eligible securities" is subject to 50 per cent of the applicable profit tax and to qualify as an eligible security, an instrument should enjoy a BBB rating or higher, and bear an original maturity tenor of not less then five years and a minimum denomination of 50,000 Hong Kong dollars.

The role of primary dealers and non-banking finance companies has to be redefined. Primary dealers ought to be treated on a par with banks for purposes of investment in ABSs and MBSs and allowed to tap the inter-bank call money market to fund their portfolios.

The current limit of 5 per cent of the total capital allowed to be invested in tier II bank bonds should be enhanced to at least 10 per cent, which will enable them to hold adequate bank bonds for market making and will incidentally add to the liquidity.

NBFCs' governance framework has to be refurbished and thereafter access to liquidity should be enhanced for bringing about their greater participation in the debt market. To help banks play a greater role in the debt market, guidelines on held-to-maturity (HTM) and available for trading (AT) have to be revised.

More specifically, corporate bonds should be reckoned for computing the C-D ratio. To ensure equal treatment for corporate bonds and loans, banks should assign risk weighting on the basis of rating as outlined in the Basel II norms and pursue a uniform approach for marking to market.

Banks should be permitted, rather encouraged, to invest in corporate bonds at least to the extent of unutilised credit limits for the corporate sector.

The repo market enhances efficiency and portfolio profitability. The advantages to dealers/brokers flow in the form of financing long positions, matched-book and cash trading, reduced funding cost, and enhanced trading efficiency.

Investors benefit from completely flexible terms, another avenue for parking short-term liquidity in a fully collateralised vehicle, and competitively yielding money market instruments. The RBI and Sebi should coordinately focus attention on this area.

The corporate bonds' lending and borrowing mechanism (CBLBM) builds a strong platform of liquidity, which reduces the cost of trading, minimises the cost of capital, and brings about tighter dealer prices. Sebi should work with market participants on this.

The corporate bond index, covering the entire spectrum of investment grade paper, serves as a barometer for the corporate bond market and works as an underlying for index futures. Whereas the construction of the index is organised by a credit rating agency (or several of them), Sebi has to encourage and assist the progress.

Pricing corporate bonds should be de-linked from that of sovereign securities, and allowed to find their own levels. There is an urgent need to build a yield curve specifically tailored for the corporate bond market.

Even though a majority of the deals are currently taking place in the over the counter (OTC) market, blurring price discovery, Sebi should mandate reporting all deals to the exchanges so that the price discovery process becomes visible and the yield curve takes shape.

Some characteristics of the junk bond market are low rating, high coupon rates, and greater risks of default in raising resources for infrastructure and other greenfield projects, and companies with little or no triumphant record needs no under scoring.

The restructured loan market, estimated to be around Rs 25,000 crore, is surreptitiously getting transformed into a junk bond market without adequate safeguards.

Globally, junk bonds are preferred as investment instruments by the investors with high risk-and-reward appetite. Some mutual funds in the US float junk bond funds to meet the demand of retail investors.

A substantial amount of spadework in disclosure, listing, trading and settlement has already been done. Those need to be refined and put in place.

Once the proposed initiatives materialise, the market-issuers, investors and intermediaries can lend vibrancy to the corporate bond market.