Junk Bonds in India

Sharp movements in the Indian equity market may be par for the course. But when it comes to the market for corporate bonds, it’s constantly stagnant. The reason is, we don’t have a corporate bond market. But this is overwhelmingly dominated by government securities (about 80% of the total). Of the remaining, close to 80% again comprises privately placed debt of public financial institutions. An efficient bond market helps corporate reduce their financing costs. It enables companies to borrow directly from investors, bypassing the major intermediary role of a commercial bank. One of the important instruments in corporate market is Junk Bonds which could be great source of financing for countries like India where markets are not much regulated.

A speculative bond rated BB or below, “Junk bonds” are generally issued by corporations of questionable financial strength or without proven track records. They tend to be more volatile and higher yielding than bonds with superior quality ratings.”Junk bond funds” emphasize diversified investments in these low-rated, high-yielding debt issues. Thus, these are high-yielding, high-risk securities issued by companies with less robust finances.

Need for Junk Bonds in India

The major issue amongst Indian bond markets has been how companies with poorer ratings can raise funds. At times the banks and FIIs are reluctant to invest in even the ‘AAA-rated’ companies. In fact for progress of a developing nation like India, this would give a wonderful opportunity for the smaller companies to get funds and implement their ideas. However, a proper regulatory mechanism also needs to be set-up to avoid high risk of default in the case of junk bonds.

Currently, there are only two instruments that FIIs can invest in India, i.e., equity and debt. The cap on FII debt investment varies from time to time between $1.5 billion and $2 billion. The Asset Reconstruction Company of India Ltd. (ARCIL), India’s first asset reconstruction company, has vied for permitting FIIs to invest in a new instrument in India — distressed assets. ARCIL has recommended SEBI, RBI and the Finance Ministry to allow FII investment in a new category, which is neither equity nor debt but a separate lucrative instrument — security receipts with underlying distressed assets.

Proposed Junk Bond Market in India — Scenario (Optimistic & Realistic)

An optimistic scenario would be having junk bonds in the market ideally for funding by FIIs and Institutions for financing the small Indian companies. However, considering the risk associated with these bonds it might not be possible in near future because economy is still in its nascent phase and on a fast development track. So any move which is risky and can affect future inflows of foreign funds and investor confidence would not be ideal.

The only way an investor should invest in junk bonds is by diversifying. A selection of at least half a dozen issues will afford the investor some protection. High risk is inherent in high yield bonds. Nevertheless, your portfolio may well have a place for some of these securities if you are not risk-averse. By having junk bond markets, it would in fact signify deepening and maturing of Indian debt markets. In India, companies are hamstrung by the fact that investment relaxations may come in only when the debt markets get deeper, so that insurance companies can increase their portfolio yield without exposing themselves to risk for long tenures by investing in junk bonds.

Impact of Junk Bonds on Indian Economy

A well-functioning corporate bond market allows firms to tailor their assets and liability profiles. If companies fear they will not be able to raise long-term resources, they are likely to stay away from long-term investments or entrepreneurial ventures that have a long-term payoff. In the long run, this can affect economic growth. The corporate bond and the junk bond market could fill this vacuum. In the absence of a corporate bond market, a large part of debt funding comes from banks. In the process, banks assume a significant amount of risk due to maturity mismatch between short-term deposits that can be readily withdrawn and relatively long-term illiquid loan assets resulting in high NPAs.

An active and efficient bond market gives companies an alternative means of raising debt capital in the event of a credit crunch. It also leads to better pricing of credit risk (since expectations of all market participants are incorporated into bond prices).

FIIs are major players in the equities market. However, thanks to the ceiling on their investment in the debt market (currently, there is a cumulative sub-ceiling of $0.5 bn on investment in corporate debt), they are present only in a limited way in the bond market.

Pension funds and the insurance sector could be another constituency, but the absence of pension funds and low insurance penetration has meant limited demand for long-term loans.

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