By Rajeev Jhawar (email@example.com) [Updated as on September 18, 2018]
In a vibrant market, resides a healthy economy. On the budget day, India sought to expand its bond market beyond the traditional ambit of sovereign debt. In pursuant to this, Securities and Exchange Board of India has initiated to diversify borrowings of Indian corporates by mandating to raise at least a quarter of their incremental funds from the bond market. The regulator came out with a consultation paper in order to address the liquidity problem persisting in the bond market, with an intention to create a robust secondary market for the debt securities in India.
SEBI’s proposal and corresponding inferences
The regulator proposed that listed entities other than scheduled commercial banks, with outstanding long-term borrowings of Rs. 100 crores and a credit rating of “AA and above” and intends to finance itself with long-term borrowings** will have to compulsorily raise 25% of their debt from the bond market from the next financial year, as a part of corroborating the same. Lower rated corporates have been exempted from the framework for the time being due to the limited demand for such securities.
**Further, SEBI has clarified that the term “borrowing” shall mean the borrowings which have original maturity period of more than 1 year. However, such borrowings shall exclude external commercial borrowings (ECBs) and inter-corporate borrowings between a parent and subsidiary. This means that a company taking inter-corporate borrowings from any another company will be included in the definition of borrowing. However, ECBs shall be excluded from the definition of borrowing for every company.
It is believed that if the 25% norm is followed religiously, it would tantamount to increased bond floatation as more companies would be able to access the debt market. Ideally, the move should provide insurance companies, provident funds and pension funds an opportunity to invest in high yielding instruments and open up a new funding avenue for lower-rated companies. Besides, the government might limit corporates’ dependence on banks and the risk associated with it. However, there is a need for an expansion in the investor base for implementation of these rules.
There is no secondary market for corporate bonds in India to speak of. The sorry state of affair could be because of illiquid debt market, bad press in case of default, risk averse attitude as well as dearth of investor’s awareness.
On the bright aspect, bonds are ideal way to raise financing for a certain kind of long-gestation infrastructure project. Typically, infrastructure projects are capital-intensive and long-gestation. It takes years to roll out toll-roads, build flyovers and set up massive power generating plants. The project developer has no cash flow to service debt until the project is running and banks may not be considered a viable source as bank funding is short tenure, which would result in asset-liability mismatch.
A sound corporate bond market, would take a lot of pressure off banks, which are reeling under bad debts. Retail investors will also get a chance to invest in such projects via debt funds. In short, large exposure to risk would be substantiated with huge rewards.
The issuer-issuance conundrum
The chart above demonstrates the issuance by various entities. It is palpable that almost 60-70% of the total issues are done by financial sector entities and the private sector non-financial entities constitutes only around 20 % of the total issuances. One of the major reasons for this huge concentration among the financial institutions is the relaxation with respect to DRR enjoyed by them. In order to liberalize the regulatory framework for all types of issuers, the Working Group has proposed to scrap it off for all types of issuers.
Debenture Redemption Reserve (DRR)
As noted above that financial sector companies, including NBFCs, are currently exempted from the requirement of maintenance of DRR for debenture issuance on private placement basis, whereas all issuance by non-financial entities and entities doing public issue are required to set aside a part of their profits (equivalent to 25 % of the value of outstanding debentures) as DRR. Besides, such companies have to invest at least an amount equivalent to 15% of the debentures maturing during the year in bank deposits, government securities, etc. Such an earmarking of funds imposes an opportunity cost on the issuer.
In respect to DRR, the paper provides that DRR maintenance imposes a significant cost on public issue of bonds and on bonds issued on private placement basis by non-financial corporates, and given that issue of protection of bond investors, in cases of default, has been significantly addressed by the enactment and operationalization of Insolvency and Bankruptcy Code, it is felt that if the requirement of DRR is dispensed with, it will naturally facilitate more corporates to access the bond market for their financing needs.
The need to invest in bonds with lower ratings and deviating from ‘AA’ to ‘A’ grade ratings, would impact pension and provident funds more because they have largely invested in AAA-rated securities. As of today, even the provision to invest in up to AA-rated instruments is hardly explored by most of the larger investors. Corporate bonds rated ‘BBB’ or equivalent are investment grade. In India, most regulators permit bonds with the ‘AA’ rating only as eligible for investment. However, this case may not hold true post SEBI’s proposal.
As per SEBI, in 2016-17, 51 percent of total borrowings came from bonds compared to 37 percent in 2012-13, a good indication for deepening of bond market. However, borrowings are still heavily skewed towards high rated borrowers, with 90 percent of the issuance concentrated in the AA and AAA rated categories. In light of the extant depth structure of the bond markets, it is supposed that the proposed rules should not be onerous for corporates.
Impact on Financier’s Interest
The entry barrier for lower rated corporate bonds would be demolished because the proposal might escalate the pool of investment grade issuers. So far, the small borrowers resorted mostly to institutional finance and inter-corporate deposits. The bond avenue would serve as an alternative for them to raise finance at a reasonable price keeping in mind investor’s perpetual keenness to diversify their investments. It may be useful to classify BBB-rated corporate bonds as investment grade and thus allow pension funds and insurance companies to enter that space.
SEBI proposed a “comply or explain” framework for the new rules. This means that companies would need to disclose non-compliance as part of “continuous disclosure requirements,” to Stock Exchanges, the regulator said.
Further, from the third year of implementation i.e. FY 2021-22, the requirement of bond borrowings shall be tested for a contiguous block of two years i.e. FY 2021-22 and FY 2022-23,which will be treated as one block and the requirement of 25% borrowing through bond market shall need to be complied for the sum of incremental borrowings made across the period of the block and at the end of block if there is any deficiency in the requisite bond borrowing, a monetary penalty in the range of 0.2%** of the shortfall shall be levied.
Whether SEBI’s attempt would prove to be a boon or a bane, is likely to be seen as days unfold.
** Updated as per the SEBI press release dated September 18, 2018 (https://www.sebi.gov.in/web/?file=https://www.sebi.gov.in/sebi_data/attachdocs/sep-2018/1537273303454.pdf#page=1&zoom=auto,-23,842).
The changes introduced by this press release are as follows:
- Earlier, an entity was categorised as a large corporate in case there was an outstanding long-term borrowings of Rs. 100 crores and a credit rating of “AA and above”. Now, a third criteria has been introduced which requires that there must be an intention of the listed entity to finance itself with long term borrowings.
- The definition of borrowing have been inserted.
- Previously, it was proposed that the monetary penalty would range from 0.2% to 0.3%. Subsequent to this press release, the monetary penalty is fixed at 0.2%.