Monday, April 5, 2010

For lack of anything better to do...

Finally, our revered Prime Minister has woken up to the fact that our debt markets need some attention. About 19 year too late (well, he was Finance Minister then) and 4 years after the report he wants to act on was submitted.

While it may turn out to be good news for the debt market, it would have been definitely better if this was an initiative taken because they thought it was a priority. On the contrary, if one is to believe this, it's obviously something that has been taken up for lack of anything better to do...

That is not to say that it isn't needed. In fact, much more is. The corporate bond market is a small section of the debt market in India. So small that it draws attention to itself and cries for reform. But truth is that reforms are needed more in the government securities market than any other segment.

In any country, government securities are considered to have the best credit quality. This is simply because the government is the only entity in a country that can create money and in the event that it finds themselves constrained to a point that it can't pay either interest or principal, it can create the required amount of money and pay. No other entity has that kind of power. And thank God for that.

Because of the above, one can assume that the government can borrow limitless amounts without a problem. In reality, that isn't the case since reckless creation of money can lead to extemely high inflation and no government would take that risk with it's population.

Thus, the government securities market which trades government debt for maturities ranging from 14 days to 30 years defines the structure of interest rates for investments with zero credit risk. Based on this term structure, rates for corporate lending can be decided based on the credit quality of the issuer. This becomes, in essence, the corporate bond market.

But for the corporate bond market to be efficient, it is essential that the government securities market is. Without that, any reform of the corporate bond market will be futile. If foundations are weak, structures built on them can never be stable.

So what is wrong with the government securities market, one might ask? It is, after all, the most liquid of all debt market segments. It not only has the highest outstanding amount, it also has high transaction volumes on a daily basis.

But just these facts don't signify perfection. Or anything close to it as well. Volumes and liquidity are restricted to 5-7 securities out of the close to 100 available. And these change every year. While there is a certain amount of predictability as to which security will become liquid every year, it doesn't make the situation necessarily better.

What makes the situation worse, on the other hand, is the fact that yields on the more illiquid securities are substantially higher than than those on the liquid ones. This, in effect, pushes up the barrier for corporate lending and sometimes can have an impact on the cost incurred by the government as well.

While there are various reasons for this illiquidity, the most common of these are,

1) Low floating stock: This is when the issued amount of the security is small. Much like a small cap stock, there are very few holders and hence low level of interest in trading them.

2) Large premium or discount: This is when the security has been issued with a coupon rate, or interest rate, which is very different from that prevailing at the time of trading. If the coupon rate is higher, the security will trade at a premium. If lower, it'll trade at a discount. There are certain circumstances in which these do trade well, but these aren't either frequent or consistent.

3) "On the Run" securities: These include securities that have a maturity which is close to a benchmark maturity, have a reasonable outstanding quantum, have a coupon rate which is close to the prevailing yield and have either been issued recently or are expected to be issued in the near future.

Because of these liquidity characteristics, the yield curve is not smooth. The kinks in the yield curve not only make it difficult to price corporate bonds but also to derive a zero coupon yield curve. Without a zero coupon curve, the debt market is effectively reduced to a spot market, which results in lower liquidity and inefficient price discovery. In the absence of a robust swap market, participants cannot hedge their positions if they believe interest rates will rise. The only option left in these circumstances is to sell their holdings of government securities within applicable regulatory constraints. This can result in a rush to sell causing extreme volatility and the possibility of market liquidity drying up.

For any reform to be effective, it has to focus on the development of a robust zero coupon yield curve. This will result in more efficient price discovery and pricing. It will also support the development of a derivatives market which will throw up hedging options. Also, a simple to understand yield curve will support retail participation in the government securities market. This wider participation will also have a beneficial impact on pricing.

RBI's attempt to resucitate their initiative of Seperate Trading of Registered Interest and Principal Securities or STRIPS is not enough to achieve this. Despite the supportive statements, most participants remain lukewarm to the initiative primarily because it will be traded outside the institutional Negotiated Dealing System (NDS). While the RBI has announced steps to ease the conversion from regular bonds to STRIPS, participants are not likely to undertake this in a significant manner. Also, if the institutional market trades regular bonds, the likelihood of a robust retail market trading STRIPs remains remote as the connect between the two shall remain tenuous. The retail market will not be able to drive pricing in the institutional segment due to low volumes. And since the two markets will trade different yield systems, the retail market may not be able to determine the connection between the two. This will result in mispricing of the retail instruments and possibly profiteering. If retail volumes remain low, it is unlikely that this profiteering will be traded out as the level of interest will remain low as well.

For trading of strips to be effective, it is essential that both the institutional market and the retail market trade them. And for this to happen the solution will have to be far more creative than the voluntary stripping of a few securities.

The involvement of the Ministry of Finance in its capacity as issuer will be essential and it is due to that reason alone that the time to undertake more meaningful reform is now. It is unlikely that once the government gets back to legislating, it will have the required attention span to undertake this. Even if this is done because there is nothing better to do, it will most certainly be a giant leap forward.

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