Corporate bond market development: Is

bank loans to bonds the game changer?

Author: Ashutosh Desai
Email: subhash.a@somaiya.edu
Phone: +91 8879736440

College: KJ Somaiya Institute of Management Studies & Research

(SIMSR), Mumbai
Course: MMS (Masters in Management Studies)
Batch 2015-17
First Year

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1) EXECUTIVE SUMMARY
India aspires to be a developed economy and a world super power, an important ingredient in
making this dream come true is a developed corporate sector. If corporate sector is to develop it
needs access to various sources of funding. In a developed economy like the US, bond market is
an important source of funding for corporations. Corporate Bond market plays a critical role in the
long term development of the country, unfortunately in India it has failed to keep pace with its
aspirations. In India major source of borrowing for corporations has been bank loans. Having a
developed bond market would give corporations an alternative source of borrowing which could
compete against banks loans, this would decrease their cost of borrowing and thus encourage
corporations to investment more. Today large portion of banks funds go to large corporations
crowding out SME's. A well-developed bond market would free up bank's resources to lend to
SME's.
One idea to get the corporate bond market to move forward is to convert the present loan portfolio
into bonds and encourage further lending by banks in the form of bonds. Converting the existing
loans into bonds may sound like a dramatic step, but such measures may be required if India wants
to see a vibrant bond market. This paper looks at various hurdles in converting corporate loans to
bonds and makes recommendations about how to overcome them. Overcoming these hurdles
would require some bold steps by the government, this paper charts out those steps in detail.

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TABLE OF CONTENTS

1) EXECUTIVE SUMMARY
2) INTRODUCTION
3) LOANS TO BONDS
4) FANNIE MAE
5) CREDIT DEFAULT SWAP MARKET
6) GOLD BOND SCHEME
7) BELOW INVESTMENT GRADE BONDS
8) INTEREST RATE FUTURES MARKET
9) CONCLUSION
10) REFERENCES

Executive Summary: - 252 words

Main Content :- 2324 words

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2) INTRODUCTION
Indian government has long been struggling to improve the corporate bond market with little
success. After various committee recommendations, various measures taken the corporate bond
market has failed to take off. The size of Indian corporate bond market much smaller compared to
other developing and developed countries.

Figure 1 Source: Asifma report, Indian Bond Market Roadmap

Even if only domestic currency debts were to be considered India lacks behind most Asian
countries

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Figure 2: Source of Data: Asian Bonds Online, Sep 2015

Large portion of long-term borrowing by Indian corporations has been in terms of bank loans.
Having a well-developed bond market gives corporations an alternative source to raise capital.

Figure 3: Source MPRA archive

3) LOANS TO BONDS
Historically banks have preferred to give direct loans to corporations than invest in corporate
bonds. An underdeveloped bond market gives banks kind of monopoly. Their profits would take
a turn for the worse if they had to invest in corporate bonds than direct loans. Therefore banks
would not voluntarily take to investing in bonds unless there is a mandate from the government or
RBI. Thus, the government would have to mandate that corporate loans can only be given by either
private placement of bonds or public issue of corporate bonds where banks could be bulk buyers.

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Without a mandate banks would go back to giving direct loans. In case of private placements,
banks corporate bond portfolio would have to be marked to market. This would encourage trading
in secondary market, if they are not marked to market banks may just hold bonds to maturity and
it would beat the purpose. Making such a dramatic shift would most probably jump start the
corporate bond market.
But there are issues that would need to be addressed before this can be done. Converting the present
corporate loans to bonds and making further lending by banks in the form of bonds would create
a number of problems. Below are a list of issues that would have to be resolved.
1) Banks would be subject to sudden losses if all their bad loans are suddenly marked to
market.
2) Illiquid secondary bond market where banks could adjust their exposure to particular
bonds.
3) Illiquid credit default swap market for banks to hedge their credit risk.
4) Illiquid interest rate futures market for banks to hedge their interest rate risk.

Banks would now be exposed to interest rate movements more than before because if the interest
rates are to rise it would quickly affect their assets. We would see banks credit exposure be more
visible. Which has the potential to cause panic among deposit holders if they think their deposits
are at risk, such panic could create a classic run on the bank. So banks need liquid derivatives
market to hedge these risks. And these markets would need to be developed very quickly for banks
to hold such a large portfolio of bonds.
Though there are number of recommendations already made on the policy front, here are four very
important measures the government or concerned departments would have to take
1) Allow speculation in the derivatives market. Currently CDS market can only be used for
hedging purposes, presence of speculators in the market would make it more liquid.
2) Allow foreign investors to take position in the derivatives market without any limits.
3) Increase the number of participants in the CDS market. Today only institutions approved
by RBI are allowed to sell protection. RBI needs to expand this list to make the CDS market
more active.
4) Allow banks to hold AAA and AA rated corporate bonds and securitized debt instruments
as its SLR securities.
Though these measures would have a large impact, the government still has the challenge of
creating a very active derivatives market almost overnight.

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4) FANNIE MAE

US government in the 1930s wanted to increase home ownership. Banks have a fundamental
mismatch between the duration of their asset and liabilities, since loans are on average of longer
duration than deposits. Banks thus could not take on large quantities of long term mortgages, since
they will have to fund these mortgages with short term deposits, thus exposing the banks to
liquidity risk. Franklin Roosevelt, then the president, decided to setup a federal government agency
called Federal National Mortgage Association (Fannie Mae). Fannie Mae initial mandate was to
create a secondary market for mortgage loans. Fannie Mae was to purchase, hold, and sell FHA
insured loans. By buying these loans from the private lenders and trading in them Fannie Mae
ended up creating a liquid market for these loans and thereby made it possible for banks and other
loan originators to issue more housing loans. Today Fannie Mae is an independent company which
finances mortgages by issuing Mortgage Backed Securities (MBS) and today these securities have
a hugely liquid market. Setting up Fannie Mae ended up overtime creating a market that did not
initially exist.
Today we see an illiquid market in India for credit default swaps and below investment grade
bonds. This paper suggests Indian government take similar measures by setting up special purpose
vehicles that would trade in these securities which would help jump start the derivatives and
corporate bond market in India.
Since the corporate bond market is in its infancy active participation of government in the market
could be the much needed impetus for this market. How could the government be an active
participant in the market? Government schemes could be launched such that it would make active
use of corporate bonds and various other derivatives instruments, thus increasing activity in these
markets. Here as an example we consider the case of how Sovereign Gold Bond scheme could
have been launched differently by the government.
Suggestions made in this paper:1) Special Purpose Vehicle for Credit default swap market
2) Special Purpose Vehicle for Securitization of corporate bonds.
3) Gold Bond Scheme

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5) CREDIT DEFAULT SWAP MARKET

CDS market in India is underdeveloped, as there are few entities willing to sell CDS. Indian
government could setup a SPV which would sell CDS to the banks. This entity would hedge its
risk by issuing security which would be sold to the public. This security would not cost anything,
but the investor buying this security would have to deposit certain amount with the SPV on which
they would earn interest. Incase certain corporate bonds default money would be withdrawn from
these deposits. Thus the investor is actually selling insurance, only on a smaller scale. Thus the
SPV would in effect buy CDS from a large number of investors and then sell CDS on each of the
bonds in the market. Securities sold to investors would be of different tranches each with a different
risk return profile. These tranches would be from A to E and they would be order of payments in
case of default, with the E tranche being the first to payout. In case of tranche A, B and C investors
need not open an account with the SPV they would simply have to pledge a fixed deposit they hold
with a bank. The buyer of a CDS tranche could be any individual investor or institute with a fixed
deposit (FD). The fixed deposit would act as collateral in case payments have to be made.
Individual investor could decide which tranche they would buy. Below the balance sheets show
how this would work. If an entity sells CDS it is shown as a liability on their balance sheet.
Similarly if it is a buyer of a CDS contract it is shown as an asset.

In case of fixed deposits the returns would be less compared to a margin account with the SPV
since the investor already earns interest on the FD.

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The tranches would be divided such that the lowest tranche would first make payments in case of
defaults. Each tranche would be issued on a nominal value of underlying bond of Rs 100. So an
investor would have to put up a fraction of the 100 rupees in the margin account. Amount they
have to put up and what returns they would earn would depend on the tranche they choose to buy.
The total amount of corporate bonds outstanding in India is Rs 1911225.74 Cr (source SEBI). The
total amount of deposits at banks is 7955721.22 Cr (source RBI). Thus if even a fraction of deposit
holders plan to own CDS tranches it would end up insuring a large portion of the corporate bond
market. Table below shows how returns could be structured for each tranche. The returns would
be market determined based on supply and demand for each of the tranches. In the example given
below the SPV would have to price its individual CDS it plans to sell such that they make an
average return of 2.26 % or greater.

Table 1: Source: Author

Historically in a developed bond market default rates on aggregate have not been very high even
in an economic crisis. Consider default rates in the middle of financial crisis for speculative grade
bonds.

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Figure 4: Source: Moody Global Credit Policy Report 2009

This shows tranches A, B and C would have low probability of paying out.

6) GOLD BOND SCHEME

Government of India will be launching a Gold Bond Scheme where the price of the bonds would
be linked to physical gold. Under this scheme the investor would buy gold bonds instead of buying
physical gold. The bond would have different denominations of gold. So a 10 gram gold bond
price would be equal to the price of physical gold of 10 grams. So the investor would buy bonds
based on spot price of gold and on maturity would receive amount based on the price of gold at
maturity. In addition to this the investor would receive interest on the bond. This scheme holds
enormous benefits for the investor as it reduces holding cost of gold plus the investor receives
interest. Government on the other hand is exposed to the price of gold. If the gold prices rise during
the tenure of the bond the price of the bond would rise with it. Government would have to pay
back higher amount than it received from the investor. Thus putting tax payers money at risk.
But for our case how could this scheme have been launched such that not only would it encourage
trading in corporate bond market and derivatives market, but also reduce government risk
exposure. This could have been done by launching the scheme through banks. Banks would issue
these gold bonds instead of the government. The money received from selling these bonds would
be used to purchase investment grade corporate bonds. Below is the list of risk exposures the bank
faces and how they would hedge these exposures

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1) Gold price risk would be hedged by entering into gold futures contract. Banks would buy
gold futures and close their position on maturity of the bonds.
2) Corporate bonds credit risk buy credit default swaps to hedge credit risk
3) Interest rate risk enter into interest rate futures (IRF) contract.
Consider if gold bond paid an annual coupon of 4%. These could be funded from the coupons paid
out on corporate bonds. Consider an annual coupon of 8% on the corporate bond. Since these
bonds are investment grade bonds, assuming a CDS spread of 200 basis points, bank would earn
an interest margin of 200 basis points, ignoring transaction costs.

7) BELOW INVESTMENT GRADE BONDS

Though these bonds would be risky to own by individual investors or banks, they would be much
safer if the individual investor / banks could diversity in them. Government could setup an SPV
through which banks could invest in these bonds, this would bring down the credit risk. Balance
sheets below show how this could be done.

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Also the SPV could issue much safer securities (securities with higher ratings) by hedging credit
risk.

8) INTEREST RATE FUTURES MARKET

Once the loan portfolio of banks are changed to corporate bonds there would be large number of
corporate bonds in the market. Interest rate futures market would naturally see more activity if
banks are to hold such large portfolio of corporate bonds. Also, we could expect many other market
participants to playing a more active role in this market. The largest risk that banks face would be
interest rate risk since now the value of their assets could change quickly due to changes in interest
rate. Thus, banks would have to hedge their interest rate risk. It seems reasonable to expect interest
rate futures market to take off without much government interference.

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Figure 5: Source NSE IRF Brochure

9) CONCLUSION
This paper suggests a lot of aggressive steps the government would have to take to develop the
bond market. But such bold steps may be necessary since many measures till date have failed to
generate activity in the bond market. There would certainly be some risks in implementing
suggestions made in this paper but the benefits outweigh the risks. India cannot risk having an
underdeveloped corporate bond market. If government were to implement measures suggested in
this paper it would overtime create a deep and vibrant bond market.

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10) REFERENCES
1) India Bond Market Roadmap Asifma report - October 2013
2) Rajeswari Sengupta and Vaibhav Anand (February 2014), Corporate Debt Market in
India: Issues and Challenges
3) Kanad Chaudari, Meenal Raje, Charan Singh (2014), Corporate Bond Markets in India
4) V. Sridhar, Securitization in India
5) NSE Interest Rate Futures Boucher
6) Stephen Wells, Lotte Zibell (2008), Indias Bond Market Developments and Challenges
7) Rajeswari Sengupta, Vaibhav Anand (2014), Corporate Bond Market in India : Lessons
from South African Experience
8) Anupam Mitra, Why Corporate bond market in India is in Nelson's low level equilibrium
trap for so long?
9) The development of corporate bond markets in emerging market countries (May 2002),
The Emerging Markets Committee of the International Organization of Securities
Commissions Report

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