Four factors key to a thriving corporate bond arena

This is the second of a two-part series

The corporate bond market looks all right on the surface. The market has increased in size and depth over the last ten years and private sector share in the issuers market has tripled.

The market has seen beneficial changes of centralised clearing, repo facilities, compulsory reporting of trades and better valuation tools. So what ails the market?

The four issues facing the market are 1) lack of a spread curve; 2) non-mark to market investors; 3) low participation by banks; and 4) absence of  a deep secondary market. Let’s look at them one by one.

Lack of a spread curve: The market is skewed towards AAA or AA+ issuers or those with the highest safety ratings accounting for over 90% of the primary market. The lower rung corporate issuers of below AA+ have only a marginal presence. This hampers the development of a credit spread curve leading to a lack of price discovery for lower-rated issuers.

Investors are also to blame for the lack of a good spread curve as they stick to higher rated bonds for investments. The lack of depth in the below AAA/AA+ bond market adds on to liquidity risk and forces investors to restrict investments in the lower rated bonds.

This is a deadlock and can only be broken by investors raising exposure to lower rated bonds if spreads are attractive, while issuers access the market despite their lower ratings. This scenario was actually played out at the beginning of 2000, when many companies restructured businesses and their ratings still reflected a weakening economic cycle.

Top-rated companies such as ACC and Tata Steel were rated below AA and their credit spreads were at 400 basis points (bps) levels.

‘The market foresaw a good opportunity for rating upgrades and traders came in and bought into the spreads. The issuers, too, did not balk at such high spreads leading to a healthy corporate bond market.

Non-mark to market investors: The primary investors in the market are buy-and-hold investors such as insurance companies and provident funds. These entities do not mark to market their bonds or even if they do, they do not sell at a loss (at time when spreads or interest rates move up, they just freeze). The non-marking leads to investor mispricing because they do not take into consideration expected future spread/interest rate movements.
The current scenario is a good example of mispricing. In the beginning of 2010, when liquidity was abundant, highly rated corporate bonds were trading at levels of 7% in the three-year maturity segment. The rates are now 9%, which is a loss of 6% on the principal invested.

The buyers of the bonds from the segment of insurance companies and provident funds have held on at the purchase yield of 7% as they do not find it necessary to sell even yields pop. This discourages trading, leading to a freeze in secondary markets when yields rise.

Low bank participation: Banks are the largest investors in the market but they do not actively participate in government bonds. They prefer trading in government bonds but do not actively trade in corporate bonds.

Banks are also forced to club credit risk exposure on their loan book together with the trading book leading to lower limits available for the trading book.
Banks are still uncomfortable with the market and except for a very few a majority of the banks do not have a presence in the market.
Absence of a deep secondary market: The size of the primary market is around Rs200,000 crore.

The secondary market on an extremely good trading day may see a maximum volume of Rs4,000 crores. In poor markets, even trading volumes of Rs100 crores is good.

In comparison, government bond volumes cross Rs20,000 crores on extremely good days, while averaging around Rs4,000 crores on bad days. Trader interest goes down when volumes are down, bid-ask spreads widen leading to a self-fulfilling downward spiral in volumes. Traders are also hampered by the fact that they cannot hedge out the interest-rate risk from corporate bonds and carry only the credit risk. The trader carries interest rates risk, credit risk and liquidity risk in running corporate bond positions and unless spreads are very compelling, the trader is forced to stay away from the market.

Corporate bond market can improve in two ways. One, by natural factors such as spreads going up to very attractive levels bringing traders into the fray; or, two, by some of the factors mentioned above being addressed by interested parties. The latter is a much preferred option as it is long-term in nature.

Find the first part here.