The rhinoceros in the bond market

Too often, Indian financial policymakers ignore the distinction between essential and desirable aspects of the “reform” measures they take. They focus on the desirable elements of policy, almost oblivious to the essentials that must be in place for the desirable elements to work.

In other words, how can the superstructure perform without the foundation being in place?

Recent developments with respect to the corporate bond market have sharply highlighted this proclivity of our policymakers — of focusing on the desirable to the exclusion of the essential.

It is an unending saga in corporate bonds. Recently, a deputy governor of the Reserve Bank of India lamented at a seminar on bond markets that he was addressing the same forum on the same issues for the second time in three years. He said he had done it many times in the past decade too!

What are the issues? In a nutshell, there is no secondary market in corporate bonds. Further, the primary market is dominated by issues (> 95 per cent) placed privately in the 2- or 5-year term bucket by a narrow set of large issuers. Another key concern — in the backdrop of the large infrastructure financing India needs — is that there is no long-term primary market at all.

Policymakers, regulators and investors have bemoaned the fact that in the absence of a vibrant corporate bond market, the entire financing risk in the economy has fallen on public sector banks.

But, despite that lamentation, the deputy governor went on to list the various steps the RBI has taken to “develop” the bond market, namely, reporting platform for post-trade transparency, repos, trade information dissemination, setting up a separate debt segment in the exchanges (in conjunction with SEBI).

Even a cursory glance at these measures would show that they are of the desirable variety and not the foundational type.

These paraphernalia have a somewhat different role — to fine-tune and increase efficiency levels in an already existing market. All those measures will surely help if there is a robust — both primary and secondary — market in the first place. In its absence, why harp so much on these measures?

Why is there no active market at all in the first place? That is because there are no divergent interest rate views. And why are there no divergent views? There are no divergent rate views because the RBI does not permit it.

Indeed, a very fundamental requirement for the formation of diverse interest rate views is that the central bank of the country permit it. But, with its vice-like grip over the government bonds market — which is the benchmark for the non-sovereign corporate market and from which the corporate market is priced for credit risk, term premium and most importantly inflation risk premium — the RBI emasculates the interest rates market.

Almost every market participant thinks and acts as if government bond yields will never be allowed to rise — and if at all they rise, they shall not beyond a certain level.

Even at the height of the currency crisis in 2013, for example, sovereign yields were above the 8 per cent levels for only a few months. Bond markets were confident that a solution to the large excess demand for dollars — which is what caused the rupee to sink — would not be found by raising interest rates sharply and curbing the demand for dollars.

Higher rates, across the board, is the classic policy solution for rolling back excess overall demand (and consequently foreign exchange demand) in any economy.

Markets sure were proved right when the Government and RBI, instead, contracted large dollar liabilities through the NRI deposits and bank borrowings route. That is, they increased dollar supply through increased debt but did not raise rates.

To be sure, the deposits were attracted to India only because of higher rates here, but Indian rates were higher more because overseas interest rates were much lower and were still falling.

That is, India’s favourable interest differentials had their origin in foreign rates falling and not Indian rates rising.

And, their belief and the actions based on those beliefs have never gone wrong.

Indeed, an analysis of the long-term trading history in the sovereign bond market would show that investors can close their eyes and buy government bonds if yields, at any time and accidentally, cross the 8 per cent levels.

This is because buying at those higher yields would assure investors guaranteed profits — as the RBI will emerge as a large buyer of bonds at lower yields when yields cross the 8 per cent level.

Therefore, one can buy at higher yields (lower prices) and sell to the RBI at lower yields (higher prices). (In bond markets, prices and yields move in opposite directions.)

Using the jargon, we can say that the RBI has sold a “put option” to market participants. A put option gives an investor the right to sell an asset at a particular price. Investors are confident that a put option is available from the RBI whenever yields cross 8 per cent.

And the RBI has never belied their hopes. Investors then exercise that right and sell bonds to the RBI after buying them at yields above 8 per cent.

It is because of strategically selling such put options over the last couple of decades — and also by directly purchasing government bonds in private placements from the Government — that the RBI’s portfolio of government bonds (of approximately ₹10,00,000 crore) is now as much as 25 per cent of the total outstanding stock of government bonds.

As far as government bonds are concerned, the RBI is the buyer of first resort and its put option is available on tap.

If Indian bonds — both government and corporate — have to develop, the RBI should not be able to sell this put option.

The RBI should deal in government bonds purely for implementing monetary policy. Divergent rate views would then take shape. And as players seek to implement those diverse views, active primary and secondary markets would develop. That is the most essential and fundamental reform.

The writer is a Chennai-based financial consultant