Indian debt capital markets – take a deep breath

(The following article appeared on cnbctv18.com on September 24, 2018

https://www.cnbctv18.com/finance/indian-debt-capital-markets-no-need-to-panic-but-it-is-time-to-act-897431.htm )

We rarely find any market in a just-right Goldilocks frame of mind. Echoing greed and fear, market moods swing between exuberance and dismay.

The events of the last few days, starting with the IL&FS downgrade, could mark a turn in our debt capital market mood to the dark side.

We were wrong to be complacent earlier – there are real issues that we delayed resolving, which need to be addressed now.

We would equally be wrong to panic now – we need to confront all our monster-under-the-bed fears for what they are.

It isn’t as good as we thought it was, and it will not be as bad as some fear it could be. But we do need to act – now.  

The age of growth

In recent times, Indian debt capital markets have gone through a period of complacent, near-exuberant growth. Outstanding corporate bonds have more than doubled the past five years, from INR 13.6T in June 2013 to INR 28.4T in June 2018. Commercial paper outstanding tripled, from INR 1.7T in June 2013 to INR 5.1T in June 2018. In FY17, incremental lending through bonds surpassed bank lending for the first time.

Concomitantly, mutual fund assets under management (AUM) in schemes with a debt component – income, liquid and balanced funds – have more than doubled in the same period. Insurance, pension and provident fund AUMs rose similarly.

There were concerns were raised at various forums – including by regulators - around the lack of secondary market volumes and liquidity, and around reliability of credit ratings and valuation mechanisms. Market participants largely deflected these. After all, they pointed out, our debt capital markets have a long way to go, in comparison with other countries. Fund managers also reveled in contrasting the quality, tax efficient returns that they offered, to the many loan skeletons that were tumbling out of the banking closet.

The fears and the past few days

Even if it wasn’t visible to the world at large, debt market participants have been edgy for a while now.

For one, risk-free yields and credit spreads have moved up quite sharply since the middle of 2017, and debt funds have had a forgettable period.

Second, stressed banking and corporate balance sheets inevitably impact the larger debt market as well, and IL&FS is a stark example.

Third, our market is replete with cases where the issuer name is sometimes the only line of comfort – including, uncomfortably so, with some prized PSU issuers.

Fourth, fund managers have always known that the liquidity that they promise with daily fund Net Asset Values (NAVs) simply doesn’t exist.

With the IL&FS downgrade and default and subsequent spillover to other NBFC names, all the worst fears of the market could confront us. Let us try and separate the monsters-under-the-bed from the clear and present dangers.

The liquidity monster

The ultimate rumor that could do the rounds is that debt funds are in trouble, and that we should rush to redeem money from them.

The brutal truth about every financial system – including US banking – is that if every depositor wanted to withdraw at the same time, the system would simply collapse. This isn’t a grand revelation - this is a widely recognized basic truth.

But there is a way out, when the unthinkable happens. A central authority steps in to provide liquidity against the assets held by the participants. We saw this with banking in 2008, for example.  As long as most of the assets are good, there isn’t any issue really. Of course, the authorities will rightly kick a fuss and punish players for knocking on their doors. But the remedy itself works, and is the comfort against the ultimate finance monster-under-the-bed. Knowing the remedy exists itself can keep the malaise away.

There are two takeaway questions from this, for our own debt markets. Do we have such a lender-of-last-resort mechanism? Equally important, the success of the fallback is predicated on the huge caveat that the ultimate assets should be good – do our bonds fit the bill?  

Lender of last resort mechanism

Admittedly, our debt capital markets cannot be sanguine. For one, the first line of defense - secondary market and repo liquidity - is abysmally low. Against the INR 28.4T outstanding corporate bonds, average monthly market volumes (including primary issuances) are barely INR 1.5T. As SEBI points out, in FY18, only 5,226 of the 18,137 debt securities outstanding ever traded through the year.

This means that even relatively minor redemption pressures can cascade into a full-fledged panic sell-off, including for otherwise good quality assets.

Given the size of the capital market, and the failure of the market to develop secondary market and repo volumes, we do need a formal lender of last resort mechanism. This can be done quite quickly. RBI had anyway proposed in 2016 that it would work towards accepting well-rated paper as collateral to provide liquidity via their liquidity adjustment facility (LAF). It isn’t ready to do so yet – this needs a change in current legislation.

But it can nudge banks to offer repo against corporate bonds to funds – say against AAA or PSU paper - and in turn offer to fund the banks against their holdings of government bonds.

As ever, SEBI and RBI can slap the market later for having approached them. But such a window would provide the backstop to preempt unnecessary systemic stress.

A related rumor that could do the rounds is that debt papers are not marked down appropriately by funds. After all, as we will discuss later, the valuation mechanism for illiquid paper is – euphemistically – inexact. This could spark a rush to the exit as well, since the investors that stay on could bear the brunt of optimistic valuations. To address this, RBI & SEBI must ensure that any fund that takes advantage of any liquidity window must mark down their portfolio conservatively, and protect the investors that remain. And any fund that tries to skirt around illiquidity with cute inter-scheme transfers should be resoundingly slapped.

Fund asset quality

Providing short-term liquidity against assets to tide over a crisis is all very well, but what about the quality of the underlying assets?

This is where the next set of insidious panic could do the rounds. After all, many NBFCs have grown their assets very rapidly – arguably too rapidly – and housing finance companies and NBFCs accounted for 41% of corporate bond issuances in FY18. Leading lights like Uday Kotak and Dr. Rajan have warned about the imminent stress in SME loans. Even blue-chip PSU names such as REC and PFC ultimately are part of the very stressed power sector mess. Credit rating agencies are the subject of jokes anyway – and ILFS, with its shock downgrades from AAA to AA+ to BB to D in a matter of days, exemplifies the farce. Should we just sell and run away from this monster?

At times like this, we should take a deep breath and reflect. As SEBI data shows, in FY18, 90% of the issuances were rated AA and above. In tricky names like IL&FS, to give credit where its due, professional fund managers have been bringing down their exposures for years now – they have always feared what the credit rating agencies have acknowledged only now. Lastly, any rumors around any PSU names are very, very extreme – it is unreasonable to expect that any government would ever allow a blue-chip PSU to falter, never mind what prim academics say.

In short, the core asset quality of funds is good – with some exceptions that we will cover below. If we see yields shoot up now, it is because secondary and repo markets simply don’t have the capacity to bear the weight of redemptions – not because the underlying asset is worthless.

Addressing a real issue – valuation

Having addressed the panic, this is the time to address the real issues.

The long-outstanding issue around market liquidity is worth a standalone debate by itself.

More immediately, the valuation mechanism of corporate bonds is flawed, particularly for select illiquid paper.

Credit rating agencies provide funds valuations of bonds, including illiquid bonds, often on the basis of inputs from the fund managers themselves. The valuation rates are not disclosed to the public. There is inherent conflict of interest all around. In fact, it would be interesting to learn where IL&FS paper was marked through the past month, and ask the question, did the ecosystem (including frontline fund managers) truly believe in them?

The system has to stick to its brief – valuation should reflect where the market could be reasonably expected to buy the paper. It cannot be a reflection of where the market “ought” to be, on emotional or philosophical grounds. Nor should they worry about implications to the market or country of their valuations (yes, I have heard that as a justification for suspect valuations) – the country will get by very well without their forbearance, thanks.

SEBI has put out a consultation paper on May 16 this year that seeks to address some of the issues around valuation. It is high time that the practitioner community smelt the coffee, and stopped perpetrating a near-fraud.

Yet, it’s important to maintain perspective. This issue is not life threatening. A majority of the paper on fund books are well rated and fairly marked. We were wrong to let this issue fester during good times. We would be wrong to only focus on this now, and make it out to be bigger than it is.