Can bonds piggyback on equities?

If regulatory exertions were all that was required, India should by now have had a vibrant and very deep secondary market in corporate bonds. And there has been no shortage of regulatory intentions. The working group under the chairmanship of the former deputy governor of the Reserve Bank of India, Harun Khan, is just the latest in the series of such efforts that goes all the way back to 2005 when a committee headed by RH Patil submitted its report. The secondary market in corporate bonds wears an anaemic look.

But then these committees haven’t also helped their cause by focusing on side issues. Take, for instance, the recommendation that when a corporate comes up with more than one issue in a quarter all of them should be clubbed under a common security serial number (ISIN). The idea being that subsequent issues would create the illusion of a secondary market trading, as the ISIN remains the same.

Clearly there is a need for some out-of-the-box thinking on how to drum up extra support for secondary market trading in corporate debt instruments. Fortunately, the activity in the equity market which has grown both in the depth of trading and the breadth of companies whose shares are listed over the last 25 years is a pointer to the fact that it can be done. A vibrant secondary market trading equities suggests that there is no dearth of players in the market with divergent views about earnings prospects of individual companies and they are bringing these views to bear on the underlying value of equities.

Now technically, bond markets too are capable of such behaviour. The only difference being that unlike equity prices which are driven by investor expectations about future movement in corporate earnings, bond valuations reflect investor expectations about future movements in the interest rates. But unfortunately, the market structure for secondary market trading in corporate bonds hasn’t evolved adequately enough to accommodate a large number of players with diverse views about the future movement in interest rates in the economy. Various regulatory measures proposed over the last ten years or so haven’t addressed the issue of diversity of views on interest rate movements. It may still happen. But rather than wait patiently for such an outcome, a smarter option could be to bring the diversity of opinion about future corporate earnings to somehow reflect on bond prices. Now, how is this to be brought about?

Imagine that a company is issuing 100 non-convertible unsecured debentures each having a face value of ₹100. One of the conditions of issue could be that on the redemption date, the holders would get a redemption bonus which is linked to any appreciation in the share price over the ‘fair market value’ (SEBI formula for preferential issue of shares) on the issue date. What the debenture holder would be entitled to is not some bonus shares per se but only the post-issue appreciation in equity value.

Again, the quantum of redemption bonus need not be set at a 1:1 ratio but a fraction thereof. Thus, for example, if ₹10,000 worth of debentures is issued, then the pool of equity shares whose appreciation in value would be passed on the debenture holders on the redemption date could be set at ₹1,000 (a ratio of 1:10). If the ‘fair market value’ on the issue date is ₹50 per share, then the pool need carry only the value equivalent to 20 equity shares.

On the redemption date, whatever appreciation these 20 shares register, can be distributed on a pro-rata basis to the debenture holders. There is no cost to the company as the market itself would pay for the additional reward that accrues to the debenture holders.

The company would create a debenture redemption reserve with ₹1000 (20 shares multiplied by the ‘fair value’ of ₹50 per share). This would be matched by an equivalent value of treasury stock on the assets side. If the share appreciates in value to ₹100, say at the end of the first year, the company could sell one such share (‘treasury stock’) in the market and use the proceeds to buy one debenture in the secondary market.

Not only does the company become a market-maker in the debenture instrument, it does so at no cost to itself! In no time investors too begin to take positions both on both the ‘buy’ and the ‘sell’ sides of the secondary market for these debentures as their values start mimicking in some small way, the fluctuations in the equity price of the company that has issued these debentures. Will it work?

The burgeoning in investor interest in differential voting right shares (DVRs) suggests that it just might. An equity share with DVR can be likened to a combination of conventional equity and an unsecured debt instrument. For instance, every Tata Motors DVR share which is currently listed and actively traded in the market carries one-tenth voting right. If you hold 10 DVRs, then that is, for all practical purposes, tantamount to carrying one regular equity share and another nine unsecured debt instruments.

Of course the only difference is that these nine DVRs carry a higher payout (call it a coupon rate) that is set at a premium to the dividend paid out on the ordinary equity shares.

The mechanism of reward is different but the character of the instrument itself does not differ significantly from a debt instrument. But the fact that investors don’t enjoy any voting rights hasn’t dampened their interest in these instruments.

So if a debt instrument too can somehow be made to reflect changes in equity value even partially, then the problem of investor apathy in debt instruments can be overcome once and for all.