Ever since July 2010, when the RBI disallowed banks to charge their borrowers interest rates which are lower than the respective bank’s base rate, there has been a marginal uptick in the otherwise moribund Indian bond markets. The current surge in bond market issuances is a continuation of this trend. The trend has been strengthened by the reluctance of Indian banks to reduce their base rates in tandem with the RBI’s reduction of repo rate.

Not structural growth Hopefuls who have been waiting for two decades for the growth of Indian bond markets may have good reasons to take the record issuance of fixed income securities by Indian corporates as a sign of sustained structural growth of this market. Global experience tends to suggest that disintermediation of the banking system is possibly the most critical driver of bond market volumes.

Commercial papers (CP), which are debt securities with maturity below 12 months, have seen their volume jump from ₹1,642 billion in January 2014 to ₹3,123 billion in June 2015. During the same 18-month period, the growth in industrial loans from the banking sector has grown by 8.7 per cent.

If the yields on Indian G-Secs increase or if Indian banks reduce the base rates meaningfully then the capital market debt issuance volume may shrink. Thus, one needs to wait before deciding whether the current revival in fixed income market is transient in nature or is a structural development. However, to ensure that early hopes of a bond market revival are not nipped in the bud, market participants need to remain careful about certain aspects which should be closely monitored and at any rate should not be allowed to go out of hand.

Falling grades

Between 2010 and 2013, the debt capital markets were more often tapped by corporates with high investment grade ratings, who issued CPs to finance their short-term funding needs and most issuances had full liquidity back-ups. While majority of the current issuances are not worrisome, in the current rush of CP issuances, investors need to be cautious of those corporates that are issuing CPs to effectively refinance their long-term debt. Such corporates may continue to roll over the CP by re-issuing fresh CPs. In effect, they are funding long-term assets with short-term liabilities. Ideally, they should have issued longer-term debt.

However, given the under-developed nature of the Indian bond market, the issuance volume of debt securities with longer maturities is not encouraging.

These corporates may feel temporary relief at the thought of reducing their interest outflow. However, they are exposing themselves to refinancing risk. Such corporates may fall into financial distress if their internal cash generation ability is out of sync with payment schedules and this coincides with market events, such as reduced funding liquidity or spike in interest rate.

One needs to be watchful of CPs issued by corporates in the mid-to-low investment grade rating category, particularly if they do not have liquidity back-up. In extreme cases, this may cause the company to actually default on its CP obligations.

Corporates with very high investment grade ratings or those supported by strong corporate parents are better placed to service the commercial paper obligations despite economic downturns or occurrence of market disruption events. However, investors should closely monitor CP issuance of corporates which do not belong to the above category. For these relatively weaker issuers, investors may do well to check whether such issuances are carved out of unutilised credit lines or are backed by other committed liquidity facilities. In the absence of such features, investors are exposing themselves to default risk on the CP.

There is also the argument that banks may be subscribing to CPs to bypass the base rate guidelines. However, what regulators should be more circumspect about is whether the CP issuance and subsequent subscription by the bank treasury is not a roundabout way of restructuring an existing loan so as to avoid keeping higher provisions for the same.

(The writer is Senior Director - Corporate, India Ratings & Research)