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How Regulation is Killing the Indian Bond Market

Submitted by Smart Singh on Fri, 01/14/2011 - 16:01

Fixed Deposits (FDs) are very popular in India. People feel very safe putting their hard-earned money in the bank deposit and they know how much it is going to earn in a year. A fixed deposits is also insured up to Rs. 1 lakh in case the bank goes bankrupt (yes, that can happen!).

First, let me try to explain how Fixed Deposits work:

How FDs Work

You deposit your money with a bank for 3 years and bank pays you 8% return on it. The bank collects this money from you and thousand other investors and lends it to a company for 3 years for 12% interest. Suppose the bank has lent money to 10 companies which want to expand or start a new project. Usually the bank does a strict scrutiny of the projects and there are RBI guidelines to be followed as well.

Now if one of these companies fails to be profitable and shuts down, the bank still gets 12% from others. That means that the bank is still getting 10.8% (12% X 9/10) interest every year. Thus they are still making a profit of 2.8% every year.

Suppose you had invested in these companies directly, but without a guaranteed return. Then it would have been you who would be earning 10.8% every year.

Company FDs

In an ideal scenario, the company would have issued a bond promising 12% return to investors and raised this money directly. In fact, we do have company FDs which borrow directly from the investor. However, liquidity is a big problem for these company FDs. If you have bought a company FD with a term of 5 years, you'll need to hold that FD till maturity and collect interest every year, and get your principal (original sum) back at the end of 5 years. What if you need this money after 2 years? Sorry, we don't have an exchange like a stock exchange where you can sell it.

This problem would have been solved if we had good debt funds and good bond markets. In India, debt funds hold a large percentage of government securities or bank certificate of deposits (CDs). This is stupid because debt funds should aim to earn that higher 12% by buying corporate bonds. But there are not enough bonds in the markets!

Now this is where it starts getting complicated. This lack of enough bonds and people who are ready to buy them is what we call illiquid or shallow markets. And this illiquidity feeds itself. Companies don't issue bonds because no one buys them. No one buys bonds because there are not enough bonds and not enough people who will buy these bonds from them, when they need to sell it. In financial language, the primary market (similar to IPO) is not strong, because the secondary market (similar to stock exchange) is weak. In common language, the resale value of bonds is very low.

So why don't debt funds and other financial institutions buy bonds in the first place?

Mark to Market

The answer to this question lies in a simple accounting rule (mark-to-market) imposed by Indian regulatory authorities. If a debt fund has bought a certificate of deposit worth Rs. 1 crore, it can include that Rs. 1 crore as its assets on the company balance sheet (an account of assets and liabilities of a company). But if it buys bonds worth Rs. 1 crore, it can only include the 'market value' of these bonds. Now if no one wants to buy your stuff, you have to sell it at a huge discount. So the 'market value' of these bonds would be Rs. 60 lakhs only.

Just because of an accounting rule, the fund company suddenly looks 40% poorer to its shareholders! So why the heck will the fund house or any other institution would buy corporate bonds? So at the end of the day, everyone plays super safe, and you end up getting 8% from your debt fund as well. And who would take the risk of a non-guaranteed return when you get the same from an FD?

Well, there still are tax and liquidity advantages of debt funds, but fund managers often rue about the fact that this product could have served the public much more.

UPDATE: After pondering on inputs provided by Amit below, I'll say that while Mark-to-Market and other regulatory requirements are the bottleneck CAUSES of illiquidity, but removing them is not really the SOLUTION. Mark-to-Market is a necessary evil. But we need to think of other solutions like tax-breaks and better regulation on fund management charges to promote Indian bond market.

Comments

Submitted by Ashwini Damani on Wed, 12/14/2011 - 12:48.

Nice Article

Nice Article Sirji...Have become an avid follower of your site now. Helps me a lot on my own financial planning.
- Ashwini Damani
Check my blog (goldensilt.blogspot.com) for interesting articles on career tips, good living and other management mythos

Submitted by Smart Singh on Mon, 12/19/2011 - 12:49.

Thanks a lot for your kind

Thanks a lot for your kind words Ashwini. You've got a nice blog too. Happy blogging!

Submitted by S P SHARMA on Sat, 12/10/2011 - 12:33.

BOND MARKET

Dear Smart,

First of all my compliments for this educative blog - to you and all the contributors of it.
While bond market in India may not be a very developed one, I think the industry people get the money through loans as and when they require it- from Banks and launching IPOs etc.I don't think the absence of a developed Bond Market is harming our industrial growth in any manner.The real economic growth happen with investments in actual production of goods, infrastructure and services, and not by creating more and more financial services. Financial services - a service whereby money makes more money- is nothing but unnecessary inflation. While the investment in means of production is good inflation of economy. In fact, the bond markets and other vehicles of 'funny money' as they exist in the West have done some harm there - all this euro problem and so on !! The only people who are complaining probably are the NBFCs because they all want to enter the debt business without the supervision of RBI.

I am not at all impressed by the financial services provided for by the mutual fund industry and the insurance companies who trade in ULIPs. These two entities have done the biggest dis-service to retail investors in India.

Submitted by Smart Singh on Mon, 12/19/2011 - 13:11.

Is finance a complete sham?

Dear Mr. S P Sharma,

What a wonderful insight. It takes a lot of financial knowledge to realize the harmful effects of the new age financial 'innovations'. I completely agree with your view that capital markets should be demand-based and not supply-based. If you have something worthwhile to produce, you will get the money. I sometimes argue that companies should have never gone public. I go as far as saying whether all this growth was really necessary? Aren't we consuming resources at a dangerous rate?

However, there is this other side of the story as well. Industrial revolution and digital revolution have shaped the planet in last two centuries, but not without the financial revolution supporting it. I highly recommend reading The Ascent of Money by Niall Ferguson. It kind of challenged the skeptic in me.

In short, there are two sides of the coin and I am not sure which is more correct.

Keep dropping in...

Submitted by SP SHARMA on Mon, 12/19/2011 - 14:05.

Dear Adheesh, Thanks for

Dear Adheesh,

Thanks for calling it a 'wonderful insight'- I wonder if it is - thanks for the encouragement anyway. I read your profile on the blog before replying this one. I feel humbled knowing that I was trying to match with the wisdom of someone who has achieved so much at such a young age.I am even more impressed with your humility- a virtue so rare these days. Please accept my compliments for that.

Your goal through this blog - "To educate the layman about basics of investing" - well as a layman keen to learn , I perfectly fit into that profile. I am a science graduate of the 1970s, and post graduate in Military Studies (of all things)- and from the profession of arms - all qualifications and work experience totally unrelated to finance. But somehow, had the urge to learn the subject - and did so the hard way - by losing through stock markets, though making up subsequently.And of course my reading habits helped improve my understandings.

I quite agree with you that the consumption patterns of the last century - in particular the last 40 years or so have created greatest damage to our planet.But then the digital technologies ( a quantum leap) has also happened in the last 40 years. Really difficult to say whether we would have been any better without these.

Thanks for suggesting the book - I have ordered it on flipcart right away. I have just finished reading two very interesting books by Satyajit Das - "Guns Traders and Money" - this educative as well as hilarious. The other one is " Extreme Money- The Masters of Universe". This was a little dense for me.

Thanks and Regards
S P Sharma

Submitted by Smart Singh on Wed, 12/21/2011 - 12:13.

Sir, Aggression is widespread

Sir,

Aggression is widespread and humility is underappreciated in business. In my professional experience, all I have heard and seen is people fighting, arguing and selling their opinion. I have great respect for people for who are mature and flexible about their opinions; people who can differentiate between opinions and facts. Your professional or investment experience is at least 6 times compared to mine and still you call yourself a learner. Hats off to you Sir!

I hope that you find the book accessible and interesting.

Happy investing!

Submitted by BALPREET1 on Sat, 09/03/2011 - 15:21.

A fixed deposits is also

A fixed deposits is also insured up to Rs. 1 lakh in case the bank goes bankrupt"

Is it true for nationalised banks as well??? or just private banks?

Submitted by Smart Singh on Sat, 09/03/2011 - 17:42.

FD insurance

Hi Balpreet,

All FDs up to Rs. 1 lakh are insured. Doesn't matter if the bank is private or not.

Submitted by BALPREET1 on Sat, 09/03/2011 - 19:38.

Thanks alot!!

Dear Adheesh!

Thanks alot !you articles realyy help me alot!!keep writing and imparting knowledge!!

Balpreet

Submitted by Smart Singh on Sat, 09/03/2011 - 19:43.

Thanks Balpreet. Your

Thanks Balpreet. Your comments help me a lot as well. I've been very busy in last few weeks. But hope to get back to blogging very soon.

Submitted by Amit on Sat, 02/05/2011 - 18:24.

want to raise some points

Hi Smart,
Excellent blog, and I liked most of the posts. But I want to raise a few points with this post:

0. Let us consider the consequences of doing away with MTM. Investors pool in their money, the NAV increases at a predictable rate. Whoever exits first, gets the NAV, which means his profits don't have to take into account the 10% company failures. There will be no money left for the last 10% of investors. Is this the future of mutual funds you envision? The "irresponsible" early exiters profit at the expense of "responsible" long timers?

1. Read the following post by Dhirendra Kumar about MTM : http://www.valueresearchonline.com/story/h2_storyView.asp?str=12970 . In a different context, but indicates the inevitability of MTM, in any system, especially mutual funds.

2. Mutual fund, by definition, cannot take on the default risk upon itself. It is just a group of investors pooling in their money, and renting the expertise of a fund manager. UTI tried to do away with this definition around the turn of this century, with disastrous results. Though, the advantage of this event was that mutual funds in India became a transparent and well regulated vehicle for investment, in some respects better than many developed market mutual fund industry.

3. In return for 4% interest rate spread the banks enjoy, they take on the risk of default upon themselves. They also have to submit themselves to RBI snooping around with their capital adequacy ratios and such.

4a. I don't see any bond listed at 40% discount. A 5% discount is not unheard of, but most of the times the discount merely accounts for transaction costs.
4b. Even so, this is a mutual fund we are talking about. As you yourself said, there are "liquidity" benefits to it. Which means that the investor can sell this fund unit any time. Which means getting 60% for the bond, exactly equal to the NAV (minus taxes and loads, of course).

If we have learnt any lessons from the UTI disaster, it is that false pretence of profits is not only useless, but dangerous.

Submitted by Smart Singh on Mon, 02/07/2011 - 14:27.

Great Points!

Hi Amit,

Wonderful points. After your comment, I read my post again. It seems that the article has come across as arguing against having mark-to-market accounting. My original intention was to criticize the special privilege that banks enjoy, but looks like I got carried away.

0. I'm sorry I didn't get this one.

1. Mark-to-market is good and protects the investors, but it has to be applied consistently, so it doesn't strangle the growth of a particular market section.

2. Institutions as well as many retail investors would like to earn a couple of percent more, and they are ready to take the marginal risk associated. Mutual funds should never be sold as risk-free products anyway. I'm simply against the forced super-safe state of Indian debt market. At least, institutions like corporate treasuries should not be afraid of buying corporate bonds.

3. In spite of all the scrutiny, the borrowers that banks choose, are risky as well. So why those loans are free from any mark-to-market requirement and carried at full value. As the loans get old, the valuation still remains the same. But for bonds, the complete lack of liquidity often asks for huge discounts when doing MTM. Obviously, no one sells these bonds at such discounted prices. Most of the bonds in Indian markets are never resold, but held to maturity.

4. Please excuse the numbers. The numbers I used are just to emphasize (sometimes exaggerate) the differences, as the layman doesn't often appreciate the difference in basis points. :)

Again, many thanks for your input.

Submitted by Amit on Mon, 02/07/2011 - 19:54.

As it seemed to me, arguing

As it seemed to me, arguing against MTM appeared to be the mainstay of your post. If not, I will hold that part of my arguments until you suggest a solution to the problem. Currently, you point to a problem but provide no solution. The kind of solution that Bank of America suggested in the US, is terrifying. From your other comment, I assumed you sympathise with them.

0. I see that this point was not very clear in my last comment. NAV is the concept by which MFs allow investors to monitor the progress of their investments. Please provide a formula for calculation of NAV, without MTM, such that it is fair to all investors. Big / savvy investors should not be able to game the system to the detriment of small / less savvy investors. MTM satisfies this criteria, your solution is yet unknown.

1. How is it to be applied consistently? No solution provided.

2. Here, MTM is not about making MFs super-safe. It is to make them super-fair. That is why it is called "mutual". I am not arguing about MFs having no risk. I am arguing that the fund-house should not shoulder any risk. If Reliance short term bond fund makes losses, it should neither affect Reliance growth fund, nor ADAG's Rel Cap. (For brevity, I would skip the reason for this, but please let me know if you want me to elaborate on this.)

If one product of a bank goes into losses, bank compensates from another product. Do you want the same for MFs?

3. As far as risk is considered, I have replied in my earlier point 3, that RBI ensures solvency of banks by interfering, and monitoring their capital adequacy ratios. Do you want RBI to do fund management for MFs?

As for the resale value of bonds, banks have long term customers and retains the right to levy big exit charges to existing depositors, or disallowing withdrawal completely before maturity. MFs always provide cheap exit - either by listing MF units on stock-exchange, or by redeeming underlying assets and paying out as per NAV. You yourself said that MFs provides liquidity benefits. They don't do it by magic.

4. Exaggeration is fine. That is why I included point 4b. Even if there is a 40% discount, what is the solution? How to report NAV to investors without MTM ?

I guess we Indians have a habit of criticizing regulators. It is unfortunate that even when Indian regulators do their work honestly and intelligently, they are being criticized.

Submitted by Smart Singh on Tue, 02/08/2011 - 19:47.

mark-to-market

Amit, the question of MTM for funds and corporates is quite inter-related. Illiquidity feeds itself. If corporates have MTM restrictions, they can't freely buy bonds, which results in illiquid bond markets, which results in funds shying away from bonds.

But you are so right that there is no alternative to MTM. How would one decide the fair value of an illiquid loan? Now that you have asked me for a solution, I'm able to appreciate that mark-to-market is a necessary evil. Even though the Indian bond market is dead, relaxing MTM constraints would only provide loopholes and opportunities to corporate wizards. While MTM is the bottleneck one would conclude while analyzing the CAUSES of illiquidity, removing it is NOT A SOLUTION.

Retarded bond market is more of a legacy problem in India. The onus of raising debt money from public should have passed to investment banks from banks. But several restrictions and regulatory requirements discourage corporates to issue bonds. Also cheap money is available to large corporations. But the risk distribution is really screwed up. Cost of money is evaluated at the firm credibility level and not at a project level. A big firm with pathetic project would get cheap loan, while a small firm with a solid project has no access to funds.

Certainly this situation needs to be addressed. Right now, there is no activism from small companies and retail investors to address this problem. I think that two things need to be done to address it. First, there should be a major tax relief on buying corporate bonds, for individuals and corporate both; degree of tax relief should differ of course. Second, the fund management charges for long term debt funds are excruciatingly high at around 1.75% per annum. Especially, when they don’t really trade the bonds, but hold them to maturity. We need to find a way to curtail these charges, so the investors can really utilize the nifty little instruments called corporate bonds.

Thanks a lot for your thought-provoking input. I’ll add updates to the main post accordingly.

Submitted by Amit on Tue, 02/08/2011 - 22:25.

company finances

I get a feeling that you still think MTM is evil, and unnecessarily so for company finances. My question is the same - even in company finances, what should MTM be replaced with? Requirements from the answer are similar - promoters and large investors should not be able to game the system at the expense of small investors.

You say there are other problems in corporate bonds, but you don't mention any problem except MTM.

Submitted by Smart Singh on Wed, 02/09/2011 - 01:03.

MTM is restrictive for people

MTM is restrictive for people with good intentions. But of course we have to make regulations keeping in mind the possible bad intentions. There is no realistic replacement for MTM, whether in MFs or treasuries.

As I mentioned, the real problem with bond markets is the cozy relationship large firms and banks are enjoying. Bond markets need to be developed to ensure that small businesses have access to debt and investors can get more bang for the buck.

Submitted by Amit on Wed, 02/09/2011 - 11:28.

If MTM were optional, what

If MTM were optional, what would a person with good intentions replace MTM with?

Submitted by Abhishek Gupta on Sun, 01/23/2011 - 15:11.

MTM...

MTM leads to variations in quartely pnl statements which is mandatory disclosure for companies. No company would prefer such variations as it does not gel well with investors. Moreover same exposure can be taken by banks by giving loans rather than buying bonds.

Submitted by Amit on Mon, 02/07/2011 - 20:14.

mutual funds

You seem to be talking about something else (company finances, I think). But since this post of Smart Singh is about mutual funds vs. banks, I will reply in that context. You too don't provide any solution. If MTM is bad, what would replace it? How would NAV be reported to MF investors?

For company finances, read http://www.valueresearchonline.com/story/h2_storyView.asp?str=12970.

Submitted by Smart Singh on Mon, 01/24/2011 - 11:53.

I happened to attend the

I happened to attend the Fixed Income panel discussion in the CFA conference on 7th Jan 2011. It was a bunch of angry industry leaders like Nilesh Shah from ICICI Pru, Naresh Takkar from ICRA, Jayesh Mehta from Bank of America. They all bashed this regulation and how it provides unfair advantage to banks who deal in loans and not bonds. They lamented the state of Indian bond markets and requirements like mark-to-market and minimum AA rating for bonds held by insurance companies, etc.

Thanks a lot Abhishek for providing this post idea.

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