Saving the debt markets

Indian investors love fixed returns and the Indian government is a prodigious borrower. Why, then, is the Indian bond market in the doldrums? This is the question analysed threadbare in a recent speech by the RBI Deputy Governor, Mr Harun R Khan, at a recent conference of money and bond market participants ( > http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=680 ).

The speech neatly breaks down the problems plaguing the domestic debt market into 7 ‘I's — investors, issuers, instruments, infrastructure, intermediaries, incentives and innovations. It offers solutions to each.

Too few investors

The Indian bond market, despite expanding manifold in the last two decades, remains small even in the Asian context. Lack of liquidity is a big constraint, with daily trading volumes at less than one per cent of the outstanding bonds.

The reasons, the RBI says, are many. With retail investors largely staying away and foreign participation curbed by law, banks and insurance companies are the big investors, holding nearly 70 per cent of the outstanding stock of gilts.

Insurance companies don't actively trade gilts because they are essentially long-term holders. Banks, having shifted a sizeable portion of their gilt holdings to the held-to-maturity category (HTM), have no need to trade either. Holding gilts as HTM shields the banks' books from mark-to-market losses.

In the corporate bond market, market depth is hampered by the fact that investors like to play it very safe, with appetite restricted to top rated companies.

The clear solution, argues the RBI, is to review the dispensation that allows banks to hold securities in the HTM category. Direct retail participation in gilt auctions should also be encouraged.

Government dominates issues

On the supply side again, the problem is one of concentration. With the government resorting to more market borrowings to fund its fiscal deficit, the market is constantly flooded with gilts with various maturities. This literally ‘crowds out' private borrowings.

Companies too prefer to rely on the banking system or foreign loans to meet their credit needs. What is left of the corporate bond ‘market' therefore is dominated by public sector companies and banks. Even here, 98 per cent of the deals happen through private placements, as public issue of bonds is costly and entails stamp duty.

The remedies are: To incentivise companies to tap the debt markets by changing tax laws, simplify procedures for public issues and reduce stamp duty.

Plain vanilla instruments

For a bond market to cater to a wide range of investors, it needs to offer a large menu. But despite efforts to introduce new instruments such as zero coupon bonds and floating rate bonds, it is the plain vanilla bonds with a fixed interest rate that dominate the market. Nor have investors warmed up to hedging instruments such as interest rate futures or swaps.

Now, that seems to be a ‘chicken and egg' situation. Investors don't want to trade in instruments where there is little liquidity and liquidity is, in turn, a function of investors wanting to trade!

These also seem to be the reasons why the many technological improvements in market infrastructure have not materially improved market depth or liquidity.

Intermediaries and innovations

Primary dealers have hitherto been the key facilitators for gilts, primarily underwriting the debt issues of the government. Mutual funds, though significant, invest mainly in short-term securities. The RBI suggests roping in primary dealers with the ability to bring in retail/mid segment investors.

Go retail!

Government bonds, available for such a wide range of terms and at attractive coupon rates, are really an ideal fit for the Indian retail investor.

The large sums that retail investors pour into low, but steady, return-earning products like bank and Sundaram Finance deposits and traditional insurance policies clearly show that Indian households value safety over everything else. This suggests that it must be lack of awareness and easy access that is preventing retail interest investors from buying up gilts or quality corporate bonds. Addressing these may be all that is needed to open the doors to retail money.

This apart, investors can also be encouraged to buy debt mutual funds, to allow diversification of risk. If retail investors have not taken to debt mutual funds in a big way (the segment is now dominated by corporate treasuries) so far, that is mainly due to the high churn in these funds and their unpredictable market-linked returns. Closed end, long-term debt funds that can indicate returns may attract good response from retail investors.

But what may really help the cause of bond issuers is better tax treatment of interest earned from debt instruments.

For years, Indian policymakers have used a low capital gains tax regime to prise households away from ‘safe' debt investments to take on risky equities. Maybe, in the interest of the bond markets, it is time to do the opposite.

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