It is now agreed that we need to have a vibrant corporate bond market to meet funding requirements. We also know that this market has not evolved the way it was visualised for a variety of reasons, the chief one being that we have limited players, who ‘buy and hold’ only highly rated instruments. The RBI is working on moving large exposures of banks to the bond market since the system has its own challenges. The conundrum that emerges is that if this starts from 2018, will there be any buyers for such paper? One way out is to create a junk bond market.
These bonds typically have high yields and low rating and would not be touched by insurance companies and pension funds. If AAA-rated borrower can get funds from banks at, say 9%, which is the base rate, the same may come at 50 bps lower in the debt market. But a junk bond can go at say 10-12%, which will be lower than the rate charged by banks. In the west, such bonds were issued for leveraged buyouts and were serviced by the profit made through such actions. But the risk of a collapse cannot be ruled out.
It is for this reason that we also need to have some covers provided on these bonds. Banks lend to all kinds of clients excluded from the bond market as they are backed by collateral. As these clients are bankable, we need to mimic such structures to develop this market. Once this takes off, the positive ripple effects can be seen in the corporate bond market. First, a credit default swap should be made mandatory for any bond with a rating of say less than AA, which has become the unofficial norm in this market. This will simultaneously lead to growth of the CDS market, too, as the class of CDS-writers emerges.
Secondly, banks should be allowed to provide credit enhancements on these bonds. Currently, it is permitted on infra bonds. The same can be extended to junk bonds and will reside as a contingent liability, which puts less pressure on capital allocation. Consequently an A-rated bond can move to AA with this enhancement. Thirdly, there can be a mandatory escrow of the income flows with a first charge on interest payments and then the debt repayment, which is addressed by the trustee. Lastly, the enactment of the bankruptcy bill will help this cause. The rules of the game would be that any default for say six months would automatically mean impounding of the assets and subsequent sale. This will address the issue of moral hazard. It is quite timely that the issue of bankruptcy has been taken on in earnest by Parliament and will go a long way in addressing this challenge.
The evolution of a junk bond market will automatically add depth and width to the corporate bond market. There will be more players on both the buy and sell side. Retail interest will be elevated because of the returns as a conventional bank deposit earns 7-8%, while such bonds could give doubledigit yields.
Mutual funds and other institutional investors could be willing to apportion a part of their portfolio to these bonds. The concept of credit enhancement would make some of these bonds investment worthy for insurance companies, pension and provident funds.
The sequencing of the creation of this market is important. Firstly, it should be permitted in non-infra industries where there is a capital asset created that can be sold in the worst case scenario. Secondly, we should begin with A-rated bonds and then move down the pecking order to BBB and then BB. Thirdly, it must be made applicable for existing companies rather than new ones as this will enable prospective investors to evaluate the balance sheet more effectively.
Any form of disintermediation is a winwin option for both the parties. The investor gets more and the borrower pays less as the intermediation costs come down. As long as the rate for the borrower is lower than what is paid to the bank, it would be attractive. More investors would also make the instruments tradeable and the platforms on NSE and BSE would provide exit routes.
There are several imponderables admittedly in such a model, but the regulator can work around them to move towards a workable solution.
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