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Are the Issuers geared up for a Quarter Leveraging from Bonds

Synopsis
Time and again, Government of India ("Government") in consultation with the Regulators has taken several measures to strengthen the corporate bonds market. Now, since the concentration risk in the banking system looms large, the Union Budget 2018-19 aims to meet a quarter/ part/ one-fourth of financing needs of large corporates from the debt market.

With the increasing demand of borrowings from the corporates, there is a dire need in the industry to accelerate the development of local currency bond market[1]. As conventional banking is, brimming with bad loans, high costs and dreadful reputations, Government has made an attempt to enlarge the corporate bond market and to reduce substantial reliance on banks for financing large corporates.

The budget announcement is intended to strike a better deal for both borrowers and investors and is likely to facilitate even lower rated borrowers (borrowers rated between AA- and A) to raise funds from the Bond market.

Exigency for Bond financing
Bonds provide an alternative source of finance inter alia to real estate sector for its long-term investment needs. An active corporate bond market could also provide institutional investors, helping them in matching their assets and liabilities.

Existing Framework for Bond financing
Credit Rating of paper:
In terms of the extant regulations for institutional investors (including Insurance Regulatory and Development Authority of India (Investment) Regulations, 2016, National Pension Scheme, etc.) the regulators have stipulated "AA" rated debt instrument as eligible for investment. In other words, a security rated less than "AA-" category or equivalent are not eligible for investment by the institutional investors.

Therefore, institutional investors (such as insurance companies and provident and pension funds with quality long term financial assets), who are the largest investors in bond market, invest primarily in highly rated paper. Thus, there is high concentration in issuance of paper rated "AA and above".

Subsequent to the release of budget announcement, it is felt that there is a need to increase the confidence of the investors in low-rated papers.

Bankruptcy Code

The high risk of default is perceived to be the major roadblock for investment in low-rated corporate bonds.

With the coming into force of Bankruptcy Code, the default risk of bonds has been addressed to a large extent. Since, bond holders are recognised as financial creditors, they are entitled to initiate insolvency resolution process. Also, in the liquidation waterfall, the bond holders have been kept on higher priority than even Government dues.

DRR
Companies Act, 2013 provides that an issuer of Debt instrument shall create a debenture redemption reserve account ("DRR") out of the profits of the company available for payment of dividend and the amount credited to such account shall not be utilised by the company except for the redemption of debentures. All issuances by non-financial entities and entities doing public issue are required to set aside a part of their profits (equivalent to 25% of the value of outstanding debentures) as DRR. However, there are exceptions for creation of such reserves by financial entities.

RBI Policy framework[2]
With a view to address concentration risk in the banking system, Reserve Bank of India ("RBI") has laid down a policy framework on banks’ large exposures.

The framework involves mandating enhanced provisioning norms for banks’ exposure to large borrowers. These enhanced provisioning norms have come into effect from the FY 2018-19 and shall be applicable on incremental lending made to borrowers with Aggregate Sanctioned Credit Limit (ASCL) of INR 25,000 crores in FY 2017-18. Further, the ASCL limit for application of the extant norms will be gradually reduced and it will be INR 10,000 crores beginning FY 2019-20. These measures are expected to result in corporates further accessing the bond market but the impact of these measures is yet to be assessed.

SEBI paper to tap bonds
SEBI has floated a consultation paper on July 20, 2018 ("SEBI Framework") evolving the framework for operationalising the intent of budget announcement to meet fourth of fund needs by large corporates.

In the said framework, SEBI has deeply examined the need for such framework and current trends among the corporates for issuing listed corporate debt securities. It has been observed that corporate bond issuance is done primarily through private placement route. Also, it has been noted that 60-70% of total issues are done by financial sector entities and the private sector non-financial entities constitutes only around 20% of the total issuances.

In the view of the current trends and extant framework for Credit Rating, DRR, RBI Policy and Bankruptcy Code as detailed above, SEBI has taken a view that the mandatory requirement for funding via Bonds shall be for large corporates (except for scheduled commercial banks).

As per SEBI Framework, a large corporate shall be a corporate which as at the end of any financial year:
a)    has an outstanding long term borrowing of Rs 100 crores or above; and
b)    has a credit rating of "AA and above"; and
c)    intends to finance itself with long-term borrowings (i.e. borrowings above 1 year); and
d)    its securities (specified securities or debt securities or non-convertible redeemable preference share) listed in terms of Chapter IV, V or VI of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015.

For the above purposes, long term borrowing shall mean borrowings which have original maturity period of 1 year or above.  However, it shall exclude external commercial borrowings and inter-corporate borrowings between a parent and subsidiaries.

Thus, if a corporate fulfils the above criteria as at the end of any financial year, then it shall borrow at least 25% of its additional borrowings (in the next financial year) through the bond market. 

SEBI has also stated that this requirement is expected to be ‘light-touch’ in nature and shall not be onerous on the corporates. SEBI Framework is proposed to be implemented with effect from April 1, 2019.

In order to facilitate more corporate to access Bond market, following measures are proposed: (a) SEBI and other regulators will consider dispensing the DRR requirement for non-financial entities and entities coming up with public issues; and (b) the regulators may take steps to reduce the threshold of rating in the extant framework for issuing debt securities.

Other questions abound:
One major issue that remains unaddressed is whether the investors have the appetite for a comparatively vast Bond Market.

In order to attract/ boost the confidence of Investors into the Indian bond market, regulators must take steps inter alia to increase liquidity and awareness for secondary market of bonds along with an effective and robust implementation of Insolvency and Bankruptcy Code, 2016 ("IBC"/ "Bankruptcy Code").

Implementing this, however, will be a big challenge. 

End-Notes
[1] https://www.sebi.gov.in/reports/reports/aug-2016/report-of-the-working-group-on-development-of-corporate-bond-market-in-india_33004.html
[2] https://www.sebi.gov.in/reports/reports/jul-2018/consultation-paper-for-designing-a-framework-for-enhanced-market-borrowings-by-large-corporates_39641.html

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