Corporate debt market

A Report On The corporate debt market in India June 2009 Introduction Despite India boasting of the third largest equity market in Asia with a market capitalization of nearly $600 billion, the debt market in India is still underdeveloped. The debt instruments traded are mostly issued by public sector entities or financial institutes. The issue and trading of corporate bonds has not yet picked up in India. Indian firms typically rely on equity or the banking sector to raise capital. The overt dependence on these two modes of raising capital is not without its disadvantages – with the global financial crisis, the Indian investor’s appetite for equity instruments has waned majorly. Banks also are reluctant to lend, fearing an increase of Non-performing Assets (NPAs). Over the past few years, the use of External Commercial Borrowings (ECBs) by Indian firms to raise capital has also been heavy. However, with the global liquidity crunch, this source of finance has also dried up. The development of a corporate bond market would serve as an alternate means of finance for Indian firms. This report analyzes the corporate bond market in India in comparison to other nations. It describes the advantages of an active corporate debt market and the reasons why the same has not yet been achieved in India. This report also analyzes Non-convertible debentures (NCDs), a corporate debt instrument. It lists down the regulatory aspects of public issuance of NCDs and includes a case study on the successful public issuance of NCDs by Tata Capital in Jan 2009. Recommendations on how the corporate debt market can be improved in India and how corporate can raise funds using corporate debt markets have been included in this report. 1 Overview The corporate debt market is anomalous among Indian financial markets in that it has not developed as rapidly, or to the same extent, as other parts of the Indian financial system, or comparable markets elsewhere. The graphs below presents a comparison of the exchange-traded corporate debt market and equity markets in India. (Source: www.nseindia.com) The corporate debt market (exchange-traded) is barely 2.6% of the equity market. This is contrast to markets in other developed countries like the US, where the debt market is around 3 times the size of the equity market. A functioning corporate debt market is generally recognised to be a necessary component of a modern economy. It is also observed that the debt market in other developed economies is significant and acts as an important source of funding for corporates. (Source: City of London report – Development of India’s corporate debt market Feb 2008) 2 Many international agencies strongly recommend the development of corporate bond markets as a key part of countries’ capital market development. In large part this recommendation was prompted by the events of the Asian financial crisis in 1997, during which many countries suffered as a result of an over-reliance on weak banking sectors for the finance of corporates. The likely benefits that would be derived from a vibrant corporate debt market are: Access to new sources of capital for existing, large firms. Many larger Indian firms already raise capital without undue difficulty through the Indian banking sector and international debt issues; however a corporate debt market would provide an additional source of finance. Access to capital markets for smaller firms, although these are likely to be low rated. The development of a competitor source of alternative funding to the (dominant) banking sector. In the absence of such a market, banks face limited competition, which reduces the pressure for innovation and the provision of new methods of finance for India’s growing corporate needs. The current market is not, in fact, a true market for corporate debt, in that: Relatively few real corporates make debt issues. Most issues are either by public-sector entities or by financial institutions raising money to lend onwards. Almost all issues are private placements to a small group of investors, often just a single bank – thus they are closer to syndicated loans than bond issues. There is very little secondary market liquidity – partly because of the fragmentation of issuance and the small investor base. 3 Reasons for underdevelopment of the Indian corporate debt market The Indian corporate debt market, and in particular, the retail debt market is underdeveloped because of the following reasons: Companies prefer private placement rather than public issuance of corporate bonds. o Public issues are bonds offered to a wide range of investors and which need to conform to the regulatory standards required of public issues of bonds. They require a prospectus approved by SEBI, and have to be open at a fixed price to allow investors—particularly retail investors—to subscribe. Private placements can be made to a maximum of 50 “Qualified Institutional Buyers” (professional investors). They require much less documentation. The small number of investors makes it relatively easy to renegotiate terms. Typically, for example, a change in interest rates will lead to a renegotiation of the coupon on a placement during the currency of the issue. This makes private placements very flexible. The public issuance process is slower, which, with high marketing and other costs, makes public issues more expensive. In contrast, documentation for private placements is minimal, although requirements have been increased in recent years. Placements can be issued quickly with book building and pricing usually completed within a day. Till recently, disclosure requirements for public issuance were excessive, with identical disclosure requirements for listed and unlisted companies. In June 2008, SEBI rationalized disclosure requirements for public issuance and specified different disclosure norms for listed and unlisted companies. Disclosure requirements for listed companies are now majorly simplified. o o o Exchange trading in corporate bonds was not allowed till recently. In Dec 2008, SEBI announced that it would allow exchange trading in corporate bonds in order to bring transparency in the corporate bond market and to attract investors to invest in long-term bonds. Till recently, SEBI permitted only companies with AAA or AA rating to issue corporate bonds to raise funds. These companies were, due to their high ratings, able to secure loans from banks at competitive rates and hence did not need to raise funds through issuing bonds. In December 2007, as per the new SEBI guidelines, the stipulation that debt instruments issued through public/ rights issues shall be of at least investment grade has been removed. This was done in order to facilitate issuance of below investment grade bonds to suit the risk/ return appetite of investors. Wholesale trading in the corporate bond market is entirely over-the-counter, with some major banks acting as unofficial market makers. The declining role of brokers in the 4 government bond market has led to their general withdrawal from the market. The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) offer order-driven, bond-trading platforms that are used for post-trade reporting but rarely for trading. The exchange-trading platforms are mainly used by a small number of retail participants. Delivery versus payment (DvP) clearing is available for the few trades transacted on the stock exchanges’ dealing platforms but not for OTC trades, which are the bulk of the market. However, corporate bond OTC transactions are settled bilaterally between the counterparties. There is no central counterparty to start the process and so reduce settlement risk. In 2002, SEBI introduced regulations requiring corporate bonds to be held in scripless form. However, cash is still settled inter-office—sellers instruct the CCIL to move bonds before they have the funds from the buyer, so the system is not truly DvP, and sellers are at risk during settlement. This potentially imposes a barrier to trading. But because the market is limited to a small number of major players in practice, the risk is considered manageable. Repurchase agreements were not permitted for corporate bonds. The RBI is the regulatory authority for this part of the market as corporate bond repos would be regarded as moneymarket instruments. The RBI has been considering allowing corporate bond repos for some time—and now may be moving toward permitting them. Tools such as derivatives, bond lending and borrowing, repurchase agreements (repos) and swaps, as well as OTC credit derivatives and credit insurance, are not available in the bond market. Developing derivatives and swap markets is a critical measure for broadening the investor base and for increasing liquidity in both government and corporate bond markets. These markets allow a wider dispersal of risk as derivatives and swaps help reduce costs, enhance returns, and allow investors to manage risks with greater certainty and precision. Derivative and swap markets also help address exchange and interest rate risks. The development of these markets needs to be underpinned by improving regulatory, legal, and infrastructure frameworks. The stamp duty is a significant barrier to the development of both the corporate bond and securitization markets. The rate of duty varies depending upon location (various states have set their own rates). Recently official comments have suggested that individual states have agreed to waive stamp duties but this has yet to be announced as official policy. Rates also vary with the nature of the issuer; and with the nature of the initial purchaser Interest payments are taxable as income and capital gains are taxable. Other factors that have a limiting impact on trade include (i) tax deducted at source—which complicates trades between tax-exempt and non-exempt entities; (ii) no single database of bonds; and (iii) no universal conventions for day count or interest calculation. 5 Non Convertible Debentures (NCD) NCD is a debt instrument that is issued by a corporate for fixed time period and in which no part of the debenture is convertible into equity. The face value of the debenture is redeemed in one installment (a bullet payment) or in tranches. Normally they can be bought from and sold to the issuer company. The ones that are not traded on the exchange come with a put or call option. In case of listed debentures, they can be traded like equity shares on the exchange. The market price of NCDs is determined by the existing interest rate on Govt. securities. If the interest rate on Govt. securities increases as compared to the coupon rate of the debenture, the NCD market price decreases whereas if the interest rate on Govt. securities decreases, the market price of the NCD increases. Thus NCDs offer limited scope for capital appreciation. Regulatory aspects for public issuance of NCDs SEBI (Issue and listing of debt securities) Regulations, 2008 deals with public issue of debt instruments. These regulations were aimed at simplifying issuance and listing of non-convertible debt securities (excluding bonds issued by Governments) issued by any company, public sector undertaking or statutory corporations. The Regulations will not apply to issue and listing of, securitized debt instruments and security receipts for which separate regulatory regime is in place. The Regulations provide for rationalized disclosure requirements for public issues and flexibility to issuers to structure their instruments and decide on the mode of offering, without diluting the areas of regulatory concern. In case of public issues, while the disclosures specified under Schedule II of the Companies Act, 1956 shall be made, the Regulations require additional disclosures about the issuer and the instrument such as nature of instruments, rating rationale, face value, issue size, etc. While the requirement of filing of draft offer documents with SEBI for observations has been done away with, emphasis has been placed on due diligence, adequate disclosures, and credit rating as the cornerstones of transparency. Regulations prescribe certifications to be filed by merchant bankers in this regard. The Regulations emphasize on the role and obligations of the debenture trustees, execution of trust deed, creation of security and creation of debenture redemption reserve in terms of the Companies Act. The Regulations enable electronic disclosures. The draft offer document needs to be filed with the designated stock exchange through a SEBI registered merchant banker who shall be responsible for due diligence exercise in the issue process and the draft offer document shall be placed on the websites of the stock exchanges for a period of seven working days inviting comments. The documents shall be downloadable in PDF or HTML formats. The requirements for advertisements have also been simplified. 6 While listing of securities issued to the public is mandatory, the issuers may also list their debt securities issued on private placement basis subject to compliance of simplified regulatory requirements as provided in the Regulations. The Regulations provide an enabling framework for listing of debt securities issued on a private placement basis, even in cases where the equity of the issuer is not listed. Case Study: Public issue of Tata Capital NCD Recently, Tata Capital has come up with a public issue of secured, non-convertible debenture: Terms of the Instrument: 7 Objectives of the issue: The funds raised will be used for various financing activities including lending and investments, to repay existing loans and business operations including for capital expenditure and working capital requirements. Income tax implication for Debenture Holders: Interest on NCD received by Debenture Holders would be subject to tax at the normal rates of tax in accordance with and subject to the provisions of the I.T. Act. No income tax is deductible at source. Where debentures are held for a period of not more than 12 months, the transfer of listed debenture would be considered as short term capital gain. Thus the interest earned would be treated as any other interest (say, from a bank FD). It would be a part of investor’s “Income from other sources”, and would be taxable. However, there would be no TDS (Tax Deducted at Source). Note: A debenture is a capital asset. If investors sell the debenture on the stock exchange before holding it for a year, it would be a short term capital gain (STCG) – it would be included in your income and would be taxed as per prevailing IT slabs. If investors sell it on an exchange after holding it for a year or more, the gain would be long term capital gain. This LTCG should be calculated without indexation, and would be taxed at 10% of the gain. Let’s understand the features of the Tata Capital NCD issue: Secured: The debentures are “secure”, meaning that the amount Tata Capital accepts from investor is tied to (or backed by) some assets of the company. This makes them better than company FDs (and even bank FDs) in terms of their risk profile. Non-Convertible: The Tata Capital debentures are non-convertible. This means that the debentures are more like traditional fixed deposits. Investors can not convert them into shares of Tata Capital at a later date – Investors get back the principal amount at the time of maturity. Credit Rating: This issue has been rated “LAA+” by ICRA, which means “high credit quality and low credit risk”. It has been rated “AA+” by CARE, meaning “high safety for timely servicing of debt obligations”. These indicate that the issue is quite safe. Tenure / Redemption: The tenor of the debentures is 5 years – the debentures would be redeemed 5 years after the date of allotment – if the put or call option is not exercised. 8 Put and Call Options: The Tata Capital debentures have both put and call options so investors have an option to surrender the debenture before its maturity (after the pre-specified period) if investors want to. Similarly, the company can ask investor to surrender the debenture before its maturity (after the pre-specified period). That means both investor and the company have flexibility! Listing on stock exchange: Tata Capital debentures would be listed on the National Stock Exchange (NSE). Options and Minimum Investment Amount: There are four options available to investors, the major difference being the interest payment frequency. Investor can choose to receive the interest monthly, quarterly, annually, or the interest can be cumulative. Depending on the option investor choose, the minimum application amount varies (it is either Rs. 10,000 or Rs. 1, 00,000). Also, the time when the put and call options can be exercised also depends on the option investor choose (it can be either after 36 months or after 42 months). Rate of return: The interest rate offered (or the coupon rate) varies from 11% per year to 12% per year, and again depends on the option investor choose. The effective yield (considering the interest payment frequency) ranges from 11.57% to 12% per annum. Debenture Redemption Reserve (DDR): According to MCA (Ministry of Corporate Affairs) regulation, the company shall create DRR of 50% of the issue size in terms of this Draft Prospectus for the redemption of the NCDs. The Company shall credit adequate amounts to DRR, from its profits every year until such NCDs are redeemed. The amounts credited to DRR shall not be utilized by the company except for the redemption of the NCDs. Loan against NCD’s: The Company at its discretion may consider granting a loan facility to investors against the security of these NCD’s. Lien on Pledge of NCDs: Company, at its discretion, may note a lien on pledge of NCDs if such pledge of NCD is accepted by any bank/institution for any loan provided to the NCD holder against pledge of such NCDs as part of the funding. Buy Back of NCDs: The Company may from time to time, consider subject to all statutory approvals, buyback of NCDs on terms and conditions to be decided by the Company. 9 Holding the debentures: The debentures would be issued only in dematerialized (demat) form. Thus, if investor does not have a demat account, he would not be able to apply for these. Who can apply? Tata Capital NCD issue – Success Factors: Alternate Investment Option: It provided an alternate investment option to investors in an otherwise depressed/volatile equity market. During the Tata NCD public issue, given the continuing downturn in the global economy, equity markets across the world continued to exhibit bearish trends. The slowdown had also raised concerns about the safety of capital. In that scenario fixed income products were hence becoming popular. Also the NCD instrument which was rated “LAA+” by ICRA and AA+ by CARE offered an effective rate of return between 11% to 12% p.a. (depending upon the option chosen). Attractively Priced IPO: It offered a cumulative return of 12% which was much higher than that of prevailing bank Fixed Deposit rate (9%) for corresponding period. 10 Brand name/ Strong Promoters: Tata Capital Ltd’s strong parentage (the Company is owned 100% by ‘Tata Sons Limited’, rated at LAAA and A1+ for its long term and short term debt programs, respectively, by ICRA) would provide support to the Company to grow its financing volumes by leveraging the strength of the “Tata” brand. Tata Capital provides services, directly or through their subsidiaries to retail, corporate and institutional clients in the areas of retail finance, corporate finance, investment banking, retail broking and distribution, wealth management and private equity. Tata Capital has three subsidiaries in Singapore and is in the process of obtaining approvals for setting up a subsidiary in London. First Mover Advantage in terms of Liquidity & Security: It was a first public issue of any debt instrument in Indian market. Considering the bearish equity market at that time Tata capital offered higher rates than FDs, PPFs, NSC which could attract retail investors easily. No TDS (Tax Deductible at Source) for investors: Since the instrument is listed on NSE there was no TDS on investors which was an added benefit for them. Incentive for brokers to promote this product: Brokers assigned by the lead managers have been offered higher brokerage than the usual market rate. This step was taken just to promote and push the demand of this product by creating awareness & return opportunities associated about the debt instrument. Credible Lead Managers/brokers: Citi group global markets, ICICI Securites & DSP Merrill Lynch were the lead managers along with credible brokers like JM financial, Edelweiss etc. Note: JM Financials were the largest mobilizers—nearly 15 per cent of the retail and the high networth portion of the Tata Capital NCD issue NCD ranked pari - passu: To make it more secure, NCD was ranked pari – passu. Note: Pari – Passu means “Two securities or obligations having equal rights to payment”. For example, a secondary issue of shares that carry equal rights with existing shares are said to "rank pari passu." Debenture Redemption Reserve (DRR): Tata Capital also proposed to create DDR towards maturity to protect investors against the possibility of default by the company that made this issue more secure. Coupon re-investment possibility: Instrument is shielded from re-investment risk. Under cumulative option, investor can reinvest the interest proceeds at high coupon rates of 12%. 11 Comparison with various instruments: As evident from the above table, the Tata Capital NCDs issue was an instrument that had a potential to provide high returns with comparatively low risk, as compared to other similar sets of instruments. As a result, eventually the issue was oversubscribed 6 times the base value! Subscription Details: Number of forms received QIB: 253 Retail & HNI: 140000 Rs. 3282 crores (6.56x of the Base Issue) (2.19x of the Base+Green Shoe option) Rs. 2650 crores (5.30x of the Base Issue) (1.77x of the Base+Green Shoe option) Rs. 232 crores (Only 7% of the total subscription) Overall Subscription Retail + HNI Subscription QIB Subscription 12 Observations An interview was conducted with brokers from JM Financial and SBI Life Insurance to understand the retail investor’s appetite for this product. The following were the primary observations from these interviews: The Indian investor prefers equity instruments over debt instruments as debt instruments offer limited scope for capital appreciation. If debt instruments from renowned corporates are issued in the market with coupon rates higher than that of prevailing bank FD interest rates, retail investors will be attracted towards the product. This was clear from the huge oversubscription of Tata Capital’s NCD. There exists a class of investors who invest in traditional debt products like PPF, NSC and bank FDs. This market can be tapped into to promote corporate debt instruments like NCDs. Unlike the above mentioned products, no Sec 80C exemption can be claimed for corporate NCDs. However, this can be compensated for by the higher coupon rate offered by these instruments. Retail investors are likely to purchase debt instruments and hold them till maturity. i.e. they primarily look at these instruments as sources of fixed periodic income, rather than tools for capital appreciation. Hence there is unlikely to be significant trading in debt instruments by retail investors. Since limited funds can be raised from institutional investors and to raise large amounts, it would be necessary to tap individual savings, the best option to do so would be to allot a certain percentage of these instruments for mutual funds in private placements. These mutual funds in turn, would raise money from retail investors for investing in such products. 13 Recommendations Recommendations to SEBI To promote the development of the bond market in India, SEBI should put in a clearing and settlement system (similar to CCIL) in place for the debt markets. SEBI should also introduce clearing mechanisms like Delivery versus Payment (DvP) in the debt markets. SEBI should also encourage market makers to participate in the debt market. This would bring about the much needed liquidity in such markets. Recommendations for issuers Instead of offering fixed coupon rate Non-convertible debentures for public issue, issuers can consider offering floating-rate non-convertible debentures. The coupon rate can be linked to a benchmark rate such as the MIBOR (Mumbai Interbank Offer Rate) or G-Sec interest rates for that duration. This would avoid issuers having to pay more interest than necessary. At the same time, investors would be sure to receive higher interest payments as compared to bank fixed deposits and hence would be interested in such products. Issuers should create a charge against their assets and issue secure debentures rather than unsecure debentures. This would help them get higher credit ratings and in turn, issue the debentures at lower coupon rates. Issuers should issue their instruments in dematerialized form and list their issue on a recognized stock exchange. As per Clause (ix), Section 193 of the amended Income Tax Act, tax deduction at source (TDS) is not required for any interest payable on any security issued by a company, where such security is in dematerialised form and is listed on a recognised stock exchange in India in accordance with the Securities Contracts (Regulation) Act, 1956. To promote debt products among retail investors, issuers should incentivize brokers. E.g. Tata Capital had incentivized brokers by an extra Re 0.50 for applications to its NCD issue. 14 Recommendations for other participants Lead managers should identify active centres where there is likely to be significant retail appetite for instruments like NCDs. Road-shows and other promotional activities should be carried out at such centres to inform and attract investors. Lead managers should also allow retail investors who have accounts with Self-certified Syndicate banks to apply through ASBA (Applications Supported by Blocked Amount) process. ASBA is already being followed for IPO of equity instruments in the Indian market. Brokerage firms should educate retail investors about corporate debt instruments and elucidate their advantages as compared to traditional instruments such as NSC, PPF and bank fixed deposits. 15 References Wells S. and Schou-Zibell L. (Dec 2008). India’s Bond Market – Development and Challenges Ahead. Retrieved from http://econpapers.repec.org/paper/risadbrei/0022.htm The Development of India’s corporate debt market. (Feb 2008). London: City of London. Securities and Exchange Board of India – Issue and Listing of Debt Securities Regulations 2008. (June 2008). Retrieved from http://www.sebi.gov.in Securities and Exchange Board of India – Disclosure and Investor Protection Guidelines 2000. (Feb 2009). Retrieved from http://www.sebi.gov.in Tata Capital Limited – Prospectus for public issue of Non-Convertible debentures. (Jan 2009). Retrieved from http://www.nseindia.com http://www.ftkmc.com/markets-debt.html http://www.docstoc.com/docs/6251945/NSE-Security-type-codes http://www.moneycontrol.com/india/news/economy/experts-see-revivaldebt-mkts-posttata-caps-ncd-issue/388665/0 http://www.tata.com/media/reports/inside.aspx?artid=I+vK7T3RwhM= http://www.business-standard.com/india/news/tata-motors-raises-rs-4200-cr-viancds/358757/ [If you liked this document and found it useful, please spare a minute and visit the sponsored links appearing on this page – you would get further information on this topic and it would also help me greatly- Thanks] 16