Budget 2018 and Corporate Bonds: Sebi plans mandatory bond market borrowing

Mumbai: Large companies may have to compulsorily borrow a fourth of their financing requirements from the bond market and long-term investors may be encouraged to buy A-rated bonds, as part of continuing efforts by the government and regulators to limit the exposure of banks to companies and develop the corporate bond market.

Stock market regulator Securities and Exchange Board of India (Sebi) will consider mandatory bond market borrowing, finance minister Arun Jaitley said in his Union Budget 2018 speech on Thursday.

Debt market experts said the move is in line with a similar move by the Reserve Bank of India (RBI), which has issued guidelines in this regard.

“Most of the large borrowers are already coming to the bond market, especially since the RBI has put in place certain limits on bank exposure. We will have to wait for the final guidelines to understand the market impact. But there is room to implement this in phases so as to ensure that the market is not disrupted,” said Ajay Manglunia, executive vice-president and head of fixed income at Edelweiss Financial Services.

Under RBI rules, in case the banking system’s exposure to a borrower crosses the normally permitted lending limit (NPLL), banks must set aside an additional 3% provision. (NPLL is defined as 50% of the incremental funds raised by the borrower over and above the aggregate sanctioned credit limit or ASCL—currently Rs25,000 crore.) ASCL will come down to Rs15,000 crore and Rs10,000 crore, respectively in the next two financial years. Banks can buy bonds of these companies over and above their NPLL starting April 2018, but the entire holding must be divested, in phases, by March 2021.

Separately, the central bank has also linked banks’ exposure to companies with their capital adequacy. Starting 1 April 2019, banks’ exposure to a group of connected companies will be capped at 25% of the lenders’ core or Tier 1 capital. In the case of an individual company, this limit would be at 20% of Tier 1 capital.

According to bond market participants, an expanding investor base and predictability on the government’s fiscal position are prerequisites for the implementation of these rules by Sebi.

The government has also committed to increase the investor base.

In his speech, Jaitley also said that, most regulators in India permit bonds with the ‘AA’ rating only as eligible for investment. “It is now time to move from ‘AA’ to ‘A’ grade ratings. The government and concerned regulators will take necessary action,” he said.

Corporate bond market in India is largely dominated by top-rated (AAA and AA+) companies, majority of these are non-banking financial companies. The pool of highly rated large corporates who are regular in the bond market is limited, bond dealers said.

One of the reasons for this is lack of takers for lower rated and longer papers. For this to change, there is need for regulators such as Pension Fund Regulatory and Development Authority, and Insurance Regulatory and Development Authority to liberalize investment norms for the entities they regulate, who have appetite for lower rated bonds. Alternatively, credit enhancement mechanism is seen as a way of helping lower rated companies, especially from the infrastructure sector having higher funding requirement.

Under this mechanism, an external agency, a dedicated fund or banks, can give partial repayment guarantee in case of default. This helps the project to get a rating bump-up.

Jayesh Mehta, country treasurer at Bank of America Merrill Lynch said that enhancement mechanism works when players with good credit such as banks are constrained by funds and therefore earns fee income by giving credit enhancement to lower-rated bonds.

“Right now, the market in India is narrow. Those considered good credit to give guarantee has no funding constraints. So therefore, they would rather earn entire spread by giving loans or buying bonds (of a particular company), rather than just enhancing the credit partially. Hence, there is need to allow more foreign players in the bond market as they have the expertise of understanding various credit papers,” he said.

Bond market participants also said that given market borrowings are subject to volatility, there is a need for the government to stick to its scheduled borrowings. Deviation from the fiscal consolidation roadmap leads to higher sovereign borrowing, and eventually crowds out private sector players.