Budget 2018 impact: Nervous times for debt market; bond yields hit new high

There could be a sudden issuance of massive amounts of corporate paper in a rising yield scenario

If the Budget follows through with the necessary policy changes, there could be interesting changes in the bond market. The Finance Minister said that he would ask the Securities and Exchange Board of India (Sebi) and the Reserve Bank of India (RBI) to mandate corporates to raise about one-fourth of their financing needs from the bond market. He also said that it would be useful to classify ‘BBB-rated’ corporate bonds as investment-grade and thus allow pension funds and insurance companies to enter that space. 

This means, in addition to the choices of tapping the equity market, making rights issues to existing investors, or borrowing directly from banks, corporates would be encouraged (‘nudged’ was the word used by Jaitley) to issue debentures. This has all sorts of implications. 

In most First-World nations, the bond market is often several multiples larger than the equity market. There is a high degree of secondary-market liquidity for debentures. By law, debentures are secured debt and in theory, a bondholder has strong legal recourse in case of default.

In less extreme circumstances, changes in interest rates or improvement/deterioration in corporate profile, can trigger bond investors into selling for capital gains or losses. So, the US bond markets have sharks trading junk bonds at high discounts. The ‘backbone investors’ are pension funds who only hold blue chips. There is also a thriving market in interest-rate derivatives. Speculative activity in such markets is entirely institutional but it's large-scale and it can be very lucrative. 

India has no secondary market for corporate bonds to speak of. It has the laws on the books to enforce debt servicing. But it has a tardy and spasmodic legal structure in practice.  So there are high risks in the Indian bond market. Those risks would increase if the amount of paper issued suddenly increases, without commensurate deepening of the secondary bond market and without serious improvement in the speed of legal redress for defaults. 

On the positive side, bonds are the ideal way to raise financing for a certain kind of long-gestation infrastructure project. Typically, infra projects are capital-intensive and long-gestation. It takes years to roll out toll-roads, build ports and attract traffic, dig mines or put steel plants into operation, or start generating power. The project developer has no cash flow to service debt until the project is running. There is also no point in seizing a half-built asset, as lenders have discovered.  

Banks suffer from asset-liability mismatches in funding such ventures as bank funding is short-tenure. But unlike a vanilla loan, a bond can be structured to pay up only after a project is up and running. Given a liquid secondary market, bond pricing will adjust accordingly and investors can trade these at will. If a bond has investment-grade rating, players with long-gestation funds at their disposal, such as insurers and pension funds can buy it for high long-term returns. 

If, and it’s a big if, India does develop a corporate bond market, it would take a lot of pressure off banks, which are reeling under bad debts. It would also make it possible to raise capital for private sector infra-projects, which are currently starved of funding. Retail investors will also get a chance to invest in such projects via debt funds. There would be big risks and commensurately huge rewards. The risk-reward equation would be similar to equity with chances for large capital gains or losses. 

The debt market will be distinctly nervous about the prospect of a sudden issuance of massive amounts of corporate paper. It reacted badly to the Budget with bond yields spiking to a 22-month highs because government borrowing is obviously going to rise in 2018-19. Higher government borrowing, plus higher corporate bond issuance, could mean much higher yields. There would be a point where the risks would be adequately priced into yields. 

But there may also be a behavioural issue for Indian investors. Most of them tend to avoid debt, no matter how attractively it is priced. On the other hand, Indian debt investors are risk-averse by nature. Far too many Indians invest in debt funds without even realising there is a risk of serious capital loss. Bonds have now been bearish for six months in a row. That could trigger losses for debt funds and it may indicate an impending bear market in equities.