The corporate bond market in India is relatively underdeveloped compared to other emerging markets. While several supply-side problems have been resolved, the core issue of restrictive regulatory norms for investment in corporate bonds remains a significant constraint, particularly when it comes to exposure in lower rated bonds.
This is across all the major players in India’s corporate bond market — banks, insurance, mutual funds and pension funds (EPFO and NPS).
The volume of bond issuances in India falls significantly as we go down the rating scale. This is more a reflection of a regulatory regime which severely restricts investment in lower rated bonds than risk-aversion of investors.
Where regulations do not unduly restrict risk taking, institutional investors have developed assessment and risk management capabilities to handle riskier investments.
A prominent example of this is insurance companies which routinely take exposure to equity but shy away from looking at lower rated corporate bonds.
Out of the total investible pool of private sector life insurance companies in their traditional insurance products, only 1.3 per cent was deployed in bonds or debentures which had a rating of below AA. The investment in equity classified as approved category of investments was 8.5 per cent. The corresponding numbers for the private general insurers is 0.4 per cent in lower rated bonds and 2.9 per cent in equity. Thus, risk averseness does not explain low appetite for lower rated corporate bonds.
An examination of the regulatory guidelines bears out that the reason for non-participation in lower rated bonds is unduly restrictive limits for such investments. For insurance companies, investment in bonds rated below AA is classified as ‘Other than Approved Investments.’
Other investment products that form a part of this category include certain types of equity, securitisation, security receipts, real estate investment trusts (REITs), infrastructure investment trusts (InvITs), alternative investment funds (AIFs) and property investments.
The overall allocation to other than approved investments cannot exceed 15 per cent. Thus not only does the allocation for lower rated corporate bonds compete with several other investment products, but also the overall investment limit for other than approved investments is itself very restrictive, given the omnibus nature of this category.
Even if an insurance company wants to take indirect exposure to lower rated bonds by investing through a fund structure (like a debt-based AIF), existing guidelines severely restrict their ability to do so. Allocation to AIFs has a further sub-limit within the 15 per cent limit for other than approved investments of 3 per cent for life and 5 per cent for general insurance companies.
For the pension industry, the prospect of taking exposure to lower rated corporate bonds is bleaker. EPFO only recently took the decision to diversify out of AAA rated bonds by starting with a small 2 per cent allocation to AA+ rated bonds.
The National Pension Scheme (NPS) can only invest in corporate bond securities with a minimum rating of at least AA. Thus, the regulatory guideline for the pension industry prohibits any direct exposure to lower rated corporate bonds.Restricted route
The alternative route to take exposure in lower rated bonds through a debt-based AIF is also restricted. While EPFO cannot make investment in AIFs, PFRDA has permitted private sector NPS schemes to invest in AIFs but the operational guidelines for doing so are confusing.
PFRDA regulations stipulate that investment in AIFs is permissible only for funds which have a minimum AA rating from at least two credit rating agencies. This requirement cannot be currently complied with as no rating agency in India has a credit rating product for AIFs.
The current outstanding stock of corporate bonds in India is estimated at ₹25 trillion. Based on the historical trend in issuances, close to 85 per cent of the outstanding corporate bonds would have a rating of at least AA. Thus, lower rated bonds are estimated to have an outstanding of ₹3.75 trillion. By only marginally increasing the limit for lower rated bonds, we can add about ₹1.2 trillion to the demand for such bonds.
Changes in prudential guidelines permitting a higher allocation to lower rated corporate bonds will not only give a fillip to the overall bond market, but also reduce the disproportionate weight of high rated bonds. Greater flexibility in taking exposure to low rated bonds will also act as a signal to investors that the investment opportunity in the bond market warrants greater attention. This will lead to healthy growth of the bond market by catalysing efforts among investors to further develop credit risk management and underwriting capabilities and not only increase allocation to corporate bonds, but also investment across the rating spectrum.
The writer is Head – Investor Relations and Products at IFMR Investments