Chaos on bond street

Sebi's move freeing FII investment in corporate debt one day and putting a cap on it some days later dents India's credibility.

On Monday, November 29, capital markets regulator Securities and Exchange Board of India (Sebi) allowed foreign institutional investors (FIIs) to invest in corporate bond assets outside the $1.75 billion FII ceiling on equity investment.

So far, this has been an umbrella ceiling for both government and corporate debt. Sebi did not make an oral announcement, but it put the new norms up on its website.

By Tuesday noon, deals worth $1.2 billion were struck for commercial paper and debentures of maturities of one year and above.

Among them, National Housing Bank was quick to close a Rs 300-crore zero coupon non-convertible debenture with a three-year tenure; Housing Development Finance Corporation closed a Rs 200-crore floating rate bond; and Nabard closed a Rs 925-crore three year non-convertible debenture with a yield of 5.85 per cent at lightning speed.

But everyone was not so lucky. Before the money changed hands came another Sebi announcement on Thursday, December 2, clarifying that the FII investments in corporate debt would be capped at $500 million, over and above the $1.75 billion ceiling.

Naturally, the debt market went into a tizzy and lost 20 to 25 basis points on the shorter end of the corporate bond curve as investor enthusiasm vanished into the blue.

In the three days between November 29 and December 1, the day before the clarification came, the spread between the yield on government and corporate paper of comparable maturity shrank dramatically.

Some of them, like Power Finance Corporation's 2020 zero-coupon bond and Reliance Ltd's 2012 paper, even traded in the secondary market with a negative spread "" that is, below the yield on a comparable government paper.

What does this hasty retreat mean for the corporate bond market? First, take a look at the market. It has been in existence for over three decades.

The value of dematerialised outstanding corporate bonds, including those floated by public sector undertakings and guaranteed by state governments, is over Rs 4,00,000 crore. In contrast, outstanding government securities could be worth over Rs 9,00,000 crore.

At present, the monthly average secondary market volume for the corporate bond market is about Rs 3,000 crore against the government securities' monthly average volume of over Rs 60,000 crore. So it is clear that the secondary corporate bond market lacks liquidity. Incidentally, some Indian papers in overseas market are more frequently traded.

Against this background, the market is divided over whether FIIs should be allowed to invest in corporate debt assets without a limit. A senior fund manager with a private mutual fund says the FIIs should not be allowed to hijack the Indian market and road-blocks must be created. Jayesh Mehta, head of debt markets in DSP Merrill Lynch, feels that $500 million is too little. He also favours introducing structured products in the debt market to add to the depth and segregate interest risk from credit risk.

Vipul Ambani, chairman and managing director of Tower Capital & Securities, a leading bond house, says there should be a $1 billion cap for FII investment in paper of one-year maturity while their exposure to longer term papers should be limitless.

Nobody can deny that developing the primary and secondary market for corporate bonds is vital to satisfy India Inc's appetite for long-term funds.

Academically speaking, the corporate bond markets supply long-term investment products to long-term investors and diffuse stress on the banking sector by diversifying credit risks across the economy.

An active and deep corporate bond market can intermediate between investment needs and capital for private and public sector activities.

The other avenue for corporations to source funds is through external commercial borrowings. However, local borrowing could be a better option since it does not carry any currency risk. In fact, it's the FII investing in the local market that is exposed to the currency risk and not the issuer of the bond.

In a situation where the cost of the forward premium cover is higher than the current level, borrowing in foreign denominated currency, on a fully-hedged basis, could work out more expensive for an Indian corporation than raising money from the domestic market.

However, those firms that have a natural hedge in the form of export earnings do not need to take forward cover. At present, a triple-A rated corporate borrower can domestically place a one-year bond at 5.8 per cent and a three-year bond at 6.5 per cent.

The entry of FIIs in the corporate debt market would have done the market a world of good since the existing players "" mutual funds, banks and primary dealers "" are all exposed to the risk of rising rates and are cutting down their positions.

Commercial banks now prefer to offer corporations plain vanilla loans instead of subscribing to the debentures since debt investments are required to be marked to market quarterly while loan exposure does not face this stipulation.

Mutual funds have seen redemption pressure that, in return, has lowered their appetite for these assets. The total assets under income funds have dropped from a high of Rs 21,000 crore to Rs 9,000 crore.

The FIIs, on the other hand, would have lapped up corporate paper. This is because they see a huge arbitrage opportunity between the overseas market and the Indian market.

For instance, an FII will make more money investing in ICICI Bank paper in India than what it has been making in the Singapore market. So it will buy more ICICI Bank paper in India and pare its exposure to the same paper in the Singapore market.

Now, take a look at the Sebi regulations on FII investment in India. In October 1996, any FII or sub-account already registered with Sebi was allowed to put in 30 per cent of its total investment in debt instruments.

In addition, any registered FII willing to make 100 per cent investments in debt securities was permitted to do so, subject to specific approval from Sebi.

The norm has consistently been that FII investment in debt through the 100 per cent debt route is subject to the overall debt cap of $ 1 billion to $ 1.5 billion for investment by all FIIs in debt (government securities as well as corporate bonds).

Sebi also has the power to impose ceilings on individual funds or sub-accounts. This ceiling is based on the FIIs' track record and its experience in managing debt funds in emerging markets. Investments by FIIs through the 100 per cent debt route is permitted only in debt securities of listed companies.

Subsequently, the overall limit was raised to $1.75 billion and over and above this, the $500 million pocket was created for the corporate debt. In other words, foreign funds can invest up to $2.25 billion (approximately Rs 9,900 crore) in Indian debt, including government securities, treasury bills and corporate debt.

Caught between the relaxation of norms on November 29 and its reversal on December 2, a string of FIIs are left holding corporate bonds way above the prescribed ceiling. They will indeed be given time to run down their exposure to corporate paper but these players are yet to get over the shock of the regulator's hasty retreat on bond street.

The fiasco may be the result of a spat between the finance ministry and the Reserve Bank of India over the issue of liquidity management.

It is suggested that Sebi reproduced a finance ministry decision that could have been taken without consulting the banking regulator. The change in stance might have been prompted by the RBI's discomfort at the opening up of the corporate debt market.

The episode points to a lack of co-ordination between regulators and the finance ministry. The FII exposure to the bond market must be raised. The $1 billion cap was created when the country's foreign exchange reserves were $13 billion. Now, with reserves of $130 billion, it must be raised manifold, if not freed.

If the RBI is concerned about issues of hot money and volatility in the foreign exchange market, it can free the limit on FII investment in longer maturity, say, three-year and above corporate debt paper, and restrict their short term entry.

At any cost, the drama of taking one step forward and two steps back on opening up the financial sector should be avoided; it dents India's credibility severely.