LITERATURE OVERVIEW

BOND MARKETS IN INDIA – A sign of mature financial

markets

11/15/2010
ITM BUSINESS SCHOOL
RITURAJ PRIYADARSHI DAS - 147
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Project Title
BOND MARKETS IN INDIA – A sign of mature financial
markets

Introduction

The Corporate Debt Market in India is in its infancy, both in terms of the market participation
and the structure required for efficient price discovery. Primary corporate debt market is
dominated by non-banking finance companies and relatively a very small amount of funds are
raised by manufacturing and other service industries through this market.

Indian firms are still seeking bank finance as the path to fulfill the funding requirements. While,
the secondary market activities in corporate bonds have not picked up till date. Efforts of
Securities Exchange Board of India (SEBI) and the stock exchanges to bring the trading to
electronic stock exchange platforms have not yielded desired results.

On the flip side, the government securities market has grown exponentially during last decade.
This is mainly down to the many structural changes introduced by the Government and Reserve
Bank of India to improve transparency in the market dealings, method of primary auctions,
deepening the market with new market participants like Primary Dealers, borrowings at market
determined rates, and creating technology platforms like NDS to recognize the institutional
characteristics of the market. The same kind of impetus has been lacking in the corporate bond
markets in India and as a result this major source of corporate funding is all but non-existent.

The US and other countries experience with corporate bonds clearly bears out that the Indian
private corporate sector is adopting a myopic approach by overlooking the advantages of
financial disintermediation achieved through accessing the bond markets directly rather than
going down the loan path. Sooner it gets out of the habit of depending excessively on the banks,
institutions, and the private placement market, the better it would be for it from a long-term point
of view.

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India lacks bond market when it is most needed

“India needs to invest $475 billion (Rs18.7 trillion) between now
and 2012 to ease shortages in roads, ports, power stations and
subway systems.”

US treasury secretary Henry Paulson happened to be in Mumbai on the day the Sensex rose
above 20,000 for the first time.Paulson’s attention on Tuesday, however, was focused on another
Indian market, one that’s nowhere near equities in breadth, depth or innovation.

That market—for corporate bonds—is going to play a critical role in sustaining the fast growing
Indian economy, and creating trade and investment opportunities for US businesses.

India needs to invest $475 billion (Rs18.7 trillion) between now and 2012 to ease shortages in
roads, ports, power stations and subway systems. At the existing levels of investment, the
country will miss the target by a staggering $162 billion.

So, where will the additional investments come from?

Although tax collections in India are buoyant, the government is frittering away the good times
by spending money on populist causes—such as a rural job guarantee—that do nothing to build
productive capacity in the economy.

Leaving infrastructure to the private sector is easier said than done. Sure enough, Blackstone
Group and other private equity funds have begun to play an increasingly important role in
bringing overseas risk capital into Indian infrastructure projects. There is, however, a limit on
how much foreign money India can absorb and how quickly.

Ultimately, domestic capital has to take the lead. And that’s where the absence of a functioning
corporate bond market in India is a handicap.

Stunted market

About one-third of the total annual savings of India’s households, companies and the
government routinely gets locked up in physical assets—such as gold jewellery—and isn’t
available to the financial industry. Of the remaining, only between 15% and 20% goes into
public works.

At least half of the country’s additional financial savings over the next five years must get
channelled into infrastructure projects, a government-appointed committee had said in May. This
will require a huge effort.

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The debt market, which could facilitate the flow of money from those who have tonnes of it—
such as insurers—to where it’s most needed, is practically non-existent.

“Infrastructure investment requires long-term financing,” Paulson said at a conclave of

executives in Mumbai on Tuesday.

“The development of corporate bond markets will provide opportunities for such long-term
investment by insurance companies and pension funds.”

Agenda for change

Speaking at the same conference, India’s finance minister P. Chidambaram agreed that the fast
growing economy had fallen behind in creating a functioning market for corporate borrowings.

Equity markets in India have come a long way in the past decade. Debt capital markets, by
comparison, have been given short shrift by policymakers and regulators.

Withholding taxes and high duties on bond ownership documents ought to be removed.
Corporate bonds aren’t eligible collateral in the interbank repurchase market. That needs to
change.

There ought to be more opportunities for investors to hedge their risks. While equity derivatives
in India are quite well developed, interest rate futures, introduced in 2003, are practically dead;
credit-default swaps are only now making a hesitant entry.

Bank loans are six times bigger than the outstanding stock of Indian corporate bonds. And that
isn’t at all surprising.

Mark-to-market norms push banks away from investing in corporate bonds and towards lending
money to companies and individuals; state-owned life insurance companies don’t hold their
mandated minimum of 15% of assets in infrastructure and social investments. They park their
money in government securities.

Currency risk

It’s because the domestic bond market hasn’t been allowed to prosper that corporate issuers have
practically abandoned it over the past few years, choosing instead to borrow overseas.

However, it doesn’t make sense to finance infrastructure companies in India directly with dollar
debt when the revenue from such projects is almost entirely denominated in the local currency.
Such foreign capital is best raised by local banks for long maturities and then lent domestically.

“We ought to be doing whatever we can to improve the market for corporate debt and rupee-
denominated debt in order to be able to finance infrastructure,” said Montek Singh
Ahluwalia, deputy chairman of the Planning Commission, India’s top economic planning
agency.
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Good intentions alone won’t suffice. It’s time to implement them.

A Small Interview:
“India’s bond markets will take off in 3-5 yrs: Kaku Nakhate, Bank
of America Merrill Lynch’s India chief”

Kaku Nakhate has recently taken charge as MD, president and country head, India, at the
merged Bank of America. In an interview with ET, she speaks of how the integration has
gone through and the merged entity’s strategy for the future.

Is the integration process complete? What were the challenges?

The integration has been pretty fast. I thought it would take 3-4 years but majority has been
done and dusted. Having come back after 15 months, I can clearly say that I am surprised at the
swiftness with which the integration has been done, not just locally, but globally. In any firm,
when you go through integration, you will go through the ups and downs in the first few months.
Also, the processes differ from a bank and a securities firm. Most businesses are planned in
terms of who actually regulates these entities. When we combined, we moved the primary
dealership from the securities firm to the bank because it makes a lot more sense with statutory
liquidity ratio being part of the bank’s regulatory requirement. Merging the primary dealership
with banks was one of the earliest moves.

Was it because you were not bullish on bonds?

I personally feel that in the next 3-5 years, we will see real development of the debt markets in
India. In India, equity markets are well-penetrated while debt is not. But with all the measures
that regulators combined are taking, I really feel that bond markets will take off. If you look at
corporate balance sheets, there is enough room for leverage. People have raised equities well in
advance and now there could be very good opportunities for them to expand and they would not
want to miss out on those opportunities. We are seeing a lot of traction in the offshore bond
markets.

What will be the strategy for the merged entity?

Globally, it makes sense for Bank of America to take over Merrill as Merrill’s international
footprint is very strong. A lot more synergies have been also availed of. Our tier-I capital has
touched $160 billion —we have gone ahead of JP Morgan, which has tier-I capital of around
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$136 billion — because of the combined strength and ability to enhance tier-I with profits. There
has been renewed strengthening of new teams being hired in Asia, especially to fill in the
different product gaps. There is a conscious effort within BoA to concentrate on intra-Asia
because that also is something we cannot afford to ignore.

India used to always look up to the US and the UK, so did Korea and Taiwan, but there are a lot
more things in Asia one can take advantage of given that the two consuming markets are going
to be India and China. India is the second-biggest country in revenue contribution. It is important
from the overall strategy, which is one of the reasons I have decided to come back.

What would the merged entity’s revenue be like? Would it be largely fee-based or do you
see an increase in fund-based activity?

It will have a mix of both fee-based and fund-based activities. Both the bank platform and the
securities platform are very strong. Probably one of the things that we need to do more is to
increase our credit risk exposure in India and that is something clearly we would be doing as we
go forward. A fortnight ago, we had an offsite in Hong Kong addressed by our Asia chief and
there was total clarity that we are going to enhance the corporate banking capabilities across
Asia. Besides increasing our risk exposure, we would also increase the number of products as we
do not have too many products compared to our competition in banking.

Conclusion
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“Testing times continue for bond markets …”

“After surging in the month of September, government bonds changed course and fell sharply
in the month of October.”

Government bonds have been witnessing a rough patch for a while now; and there is more than
one reason for this. The first, and unarguably the most important one is the rising interest rate
scenario in the country. For quite some time now, the Reserve Bank of India (RBI) has been
consistently hiking interest rates in order to contain inflationary pressure. Besides, ongoing
concern over the longevity of the benchmark status of the 10-Yr benchmark bond, liquidity
crunch in the system, and unfavourable economic data, have been impacting bond prices
negatively at different points in time. The month of October witnessed a combined impact of all
of the above mentioned reasons. Apart from few intermittent jumps in prices, the 10-Yr
benchmark bond experienced almost a secular downtrend during the month. This is in contrast to
the previous month when bond prices surged, after falling sharply in the months of July and
August.

Of late, debt markets have been largely driven by expectations of where interest rates are headed.
The scenario in the month of October was no different. Government bonds, especially the 10-Yr
benchmark bond, came under pressure at start of the month itself as fears of an aggressive rate
hike came back to haunt the markets. This was mainly due to the hike in monthly inflation
numbers released then. But major blow came from the comments made by RBI’s Executive
Director Deepak Mohanty, expressing concerns over "unacceptable high inflation". He stressed
on the need for appropriate policy measures to check the rise in inflation. This prompted market
participants to sell, thus pushing down the bond prices. The 10-Yr benchmark bond was further
impacted by the lingering fear that it may soon lose its benchmark status. The 10-Yr benchmark
7.80%, 2020 paper had witnessed issuances worth Rs 480 billion then. Conventionally,
government stops issuing a dated securities once it’s outstanding reaches around Rs 600 billion.
Hence most market participants remained wary of buying the 10-Yr benchmark bond. As the
month progressed, market sentiments improved a bit following the sharp decline in industrial
output for August. India's industrial production (IIP) clocked a growth of only 5.6% in August as
against the revised IIP number of 15.2% in July. This led the market participants to believe that
the RBI may not resort to a big rate hike in its monetary policy review on November 2, 2010.
However, this turned out to be a temporary relief as unexpected rise in monthly inflation data
resulted in a sharp fall in the bond prices. Moreover, this came as an unpleasant reminder of
likely rate hikes by the RBI in the weeks ahead. India's headline inflation rate based on the
wholesale price index rose unexpectedly to 8.62% in September from 8.51% in the prior month.

While that was the first half of the month, the second half was no different either. The fear of a
rate hike and the uncertainty over the longevity of the 10-Yr benchmark bond continued to haunt
the markets. What contributed to that was remarks from RBI’s Deputy Governor Subir Gokarn
that the rise in food prices is structural and, therefore, may have a complex implication on the
monetary policy. This heightened fears of interest rate hikes by the central bank at its monetary
policy review. But, sentiments improved and scenario turned in favour of government bonds
towards the fag end of the month on the back of some positive cues. The 10-Yr benchmark bond
rose sharply on hope that the government may not be compelled to float a new 10-Yr benchmark
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bond soon. This was because a senior finance ministry official said that the informal issuance
limit of Rs 600 bn was not sacrosanct. Bond prices also got a fillip from the fall in weekly food
inflation number. Food articles' inflation for the week to October 16 stood at 13.75% from
15.53% in the prior week. Further, the sentiments got a boost on the back of ad hoc measures
announced by the RBI to improve liquidity. This spurred hope that the central bank may
continue to protect the banking system from undue pressure on liquidity.

Though all these helped bond prices to move up, it was not enough to make-up for the fall it
witnessed over most part of the month. Finally, the deemed 10-Yr benchmark 7.80%, 2020 bond
settled at Rs 97.95 or 8.11% yield as against previous month’s close of Rs 99.67 or 7.85% yield.

Debt Category Performance

In order to merit funds’ long-term performance, they have been ranked based on their one-year
Morningstar risk-adjusted return for this review.

Liquid
The Morningstar India Liquid fund category registered 4.5% return for one-year period ended
October 2010. This category consists of funds with average maturities upto 91 days. Out of 32
funds considered for analysis, 17 funds outperformed their peers. In terms of one-year risk-
adjusted return, IDFC Savings Advantage Fund registered highest return. On an absolute basis,
the fund posted 5.1% return.

Ultra Short Bond

The ultra short bond category with funds consisting of average maturities over 91 days but less
than one year, posted 4.9% return. Out of 29 funds selected, 12 funds beat the category average.
Religare Credit Opportunities Fund had the best risk-adjusted performance. The fund delivered
5.3% return on an absolute basis.

Short-Term Bond
During the one-year period, the short-term bond category with residual maturities between one-
to three-years, posted 5.3% return. Out of 23 funds considered, 9 funds outperformed their peers.
IDFC SS Income Medium Term A Fund continued to remain an outperformer and fared the best
in terms of risk-adjusted return. The fund returned 7.7% for one-year period through October.

Intermediate Bond
This category includes funds with maturities between three- to seven-years and registered 4.6%
return, during the one-year period ended October 2010. Out of 23 funds shortlisted, 11 funds
beat the category average. HDFC High Interest Fund delivered the largest risk-adjusted return.
On an absolute basis, the fund registered 5.8% return.

Short Government
Short government funds invest in government securities with one- to three-year maturities. For
one-year period, the category delivered marginal 3.8% return. In terms of risk-adjusted
performance, HDFC Gilt short term Plan posted the highest return. On an absolute basis, the
fund registered 5% return.

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Intermediate Government
The intermediate government bond category includes funds with residual maturities between
three- to seven-years and generated 3.3% returns. Out of 11 funds shortlisted for analysis, four
funds beat their category peers. The best performer in this category was Birla Sun Life Gov Sec
L/T in terms of risk-adjusted performance. The fund posted exceptional performance and
generated 9.3% return for one-year period through October 2010.

Long Government
Long government funds invest in government securities with average maturities of more than
seven years. This category generated 3.5% return during the one-year period. Out of 10 funds
selected for analysis, six funds outperformed their peers. HDFC Gilt Long Term Fund fared the
best in terms of risk-adjusted performance. On an absolute basis, the fund delivered 5.2% return.

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