This Article is written by Ms. Pragati Singh, a Third year Law student at Calcutta University, West Bengal
Abstract:
Corporate Bonds: What Are They?
One kind of debt product that is marketed to investors by corporations is the corporate bond. In exchange for providing the company with the necessary capital, the investor receives a certain amount of interest payments at a set or variable interest rate. When a bond “reaches maturity,” or expires, the initial investment is refunded and the payments stop.
The ability of the business to repay the bond, which is based on its expectations for future sales and profitability, typically serves as its security. Physical assets of the corporation could be utilized as collateral under specific circumstances.
Introduction:
A safe and cautious investment is seen as being high-quality corporate bonds in the investing hierarchy. Bonds are frequently added to balanced portfolios by investors as a way to counterbalance risky assets like growth stocks. To protect their earned wealth over time, these investors typically make fewer riskier assets and more bond purchases. To create a steady income supplement, retirees frequently allocate a bigger percentage of their assets to bonds.
Corporate bonds are typically seen as carrying a higher level of risk than US government bonds. Because of this, even for businesses with excellent credit quality, interest rates on corporate bonds are virtually always higher. The credit spread is the amount that separates the yields on US Treasuries and highly-rated corporate bonds.
Issuance of Corporate Bond In India:
Corporate bonds are bonds issued by companies to borrow funds from the market. In India, the Companies Act of 1956 doesn’t distinguish between corporate bonds and debentures. Debentures are defined as securities of a company, including debenture stock and bonds, whether they create a charge on the company’s assets or not.
Corporate bonds can be issued through public offerings, where both retail investors and institutions can participate, or through private placements, which involve a limited number of investors. Unlike equity shares, corporate bonds don’t provide ownership in the company but offer regular income in the form of interest.
Corporate bonds have different characteristics based on maturity (short-term, medium-term, or long-term), coupon (fixed rate, floating rate, or zero coupon), option (call option or put option), and redemption (single redemption or amortizing bonds). They can have a maturity period of 1 to 20 years and can also be listed on exchanges.
Credit Rating of Corporate Bonds:
When companies want to raise funds, they can issue corporate bonds to investors. But before these bonds hit the market, they go through a thorough review process conducted by rating agencies like Standard & Poor’s, Moody’s, and Fitch. These agencies play a crucial role in determining the creditworthiness of the bonds.
Now, you might be wondering, what exactly does “creditworthiness” mean? Well, it’s all about assessing the likelihood that the issuer of the bond will be able to make regular interest payments and repay the principal amount when the bond matures. The rating agencies evaluate various factors such as the financial health of the company, its ability to generate cash flow, and its overall stability.
The ratings assigned by these agencies are represented by a letter-based scale. The highest-rated bonds are known as “Triple-A” or AAA bonds, indicating that they have the highest level of creditworthiness. On the other end of the spectrum, we have the lowest-rated bonds, which are often referred to as high-yield or “junk” bonds. These bonds carry a higher risk of default and therefore offer higher interest rates to compensate investors for taking on that risk.
Why are these ratings so important? Well, they provide valuable information to investors. When you’re considering investing in corporate bonds, the ratings can give you an idea of the bond’s quality and the level of risk associated with it. Higher-rated bonds are generally considered safer investments, as they have a lower chance of defaulting. On the flip side, lower-rated bonds come with higher risks but can potentially offer higher returns.
The ratings also have an impact on the interest rates offered by the bonds. Higher-rated bonds typically have lower interest rates because investors perceive them as safer investments. Lower-rated bonds, on the other hand, need to offer higher interest rates to attract investors who are willing to take on the additional risk.
Additionally, the ratings can affect the price of the bond in the secondary market. If a bond’s rating changes, it can lead to fluctuations in its price. For example, if a bond is downgraded, its price may decrease as investors become more cautious about its creditworthiness. Conversely, an upgrade in the rating can lead to an increase in the bond’s price.
When it comes to investing in corporate bonds, it’s important to note that they are typically sold in blocks of $1,000. This means that investors can purchase bonds in increments of $1,000.
Regulatory compliance of corporate bonds :
Earlier, SEBI (Disclosure and Investor Protection) Guidelines required debt issuers to obtain credit ratings from at least two credit rating agencies for public/rights issues. But now, they’ve decided that just one credit rating agency’s rating would be enough. This change aims to reduce the cost of issuing debt instruments.
Now, let’s talk about below investment grade debt instruments. Previously, SEBI guidelines stated that debt instruments issued through public/rights issues had to be at least investment grade. But now, SEBI believes that in a disclosure-based system, it should be up to the investor to decide whether they want to invest in a non-investment grade debt instrument. To foster the development of the debt instruments market, SEBI has decided to allow the issuance of bonds below investment grade to the public. This way, investors can choose based on their risk and return preferences.
SEBI has also decided to remove structural restrictions on debt instruments, like limitations on maturity and put/call options on conversion. This change gives issuers more flexibility in designing their instruments to suit their specific needs.
In October 2009, SEBI issued a circular that said trades in corporate bonds between certain entities like mutual funds, foreign institutional investors/sub-accounts, venture capital funds, foreign venture capital investors, portfolio managers, and RBI regulated entities must be cleared and settled through the National Securities Clearing Corporation Limited (NSCCL) or the Indian Clearing Corporation Limited (ICCL) starting from December 1, 2009.
Now we’ll understand about some measures taken by the Reserve Bank of India (RBI) to develop the corporate debt market. One of the things they did was to promote transparency by developing a reporting platform through FIMMDA. They made it mandatory for all RBI-regulated entities to report over-the-counter trades in corporate bonds on this platform. Other regulators have also imposed similar reporting requirements for their regulated entities. This has created a reliable database of all the trades in the corporate bond market, which provides useful information for regulators and market participants.
The RBI also allowed clearing houses of the exchanges to have a pooling fund account with them. This helps facilitate a settlement process called DvP-I, which is based on delivery versus payment, for trades in corporate bonds.
Another important step was permitting repo transactions in corporate bonds under a comprehensive regulatory framework. This allows banks to classify their investments in non-SLR bonds issued by companies engaged in infrastructure.
How is Corporate Bond different when compared to stock?
The difference between corporate bonds and stocks. When you buy a corporate bond, it’s like you’re lending money to the company. On the other hand, when you buy stocks, you’re actually buying ownership shares of the company.
Now, the value of stocks can go up and down, and as a stockholder, your stake in the company will rise or fall accordingly. You can make money by selling the stock at a higher price or by collecting dividends that the company pays out.
When you invest in bonds, you earn interest instead of profits. The main risk is if the company goes bankrupt, but even then, bondholders and other creditors are usually paid back before stockholders. So, bondholders have a higher priority when it comes to getting their investment back.
Sometimes, companies issue convertible bonds, which can be converted into shares of the company if certain conditions are met. It’s a way for investors to potentially benefit from the company’s success.
Having a balanced portfolio is a good idea, and including some bonds can help offset the risks of riskier investments. As you get closer to retirement, it’s common for investors to increase the percentage of bonds in their portfolio for added stability.
Suggested Reforms for development of Corporate Bonds Market in India:
1.Tax reforms can play a crucial role in boosting the development of the corporate debt market in India. Just like the favorable tax regulations for the equity market, implementing similar reforms for corporate bonds can have a positive impact. Here are a couple of reforms that could be helpful:
Expanding the scope of eligibility under section 80C of the income tax act to include corporate bonds of entities other than just infrastructure companies would be beneficial. Alternatively, creating a separate window, similar to the one for infrastructure bonds under section 80CCF, for corporate debt investments could be considered. Until direct retail participation in the corporate debt market becomes more feasible, investments could be made through debt mutual funds with a 3 to 5 year lock-in period, providing investors with a tax-efficient higher yield alternative to bank fixed deposits.
It’s important to incentivize foreign investors to invest in rupee-denominated corporate bonds. One way to do this could be to award exemption from withholding tax on interest payments to foreign investors. This would encourage greater participation from foreign investors and contribute to the growth of the corporate debt market.
Bringing corporate bonds and debentures on par with equity in terms of long-term capital gains tax would be a great move. Currently, long-term equity shares are exempt from tax if held for more than a year and if Securities Transaction Tax (STT) is paid. However, this provision has not been extended to corporate bonds. Extending this provision to listed corporate debt securities would encourage more participation from all investors.
While these measures may initially reduce the government’s revenues, in the long run, the benefits of increased turnover and a vibrant corporate bond market would outweigh the short-term impact.
2.Another important aspect is the participation of insurance companies and pension funds. Currently, insurance companies are required to allocate at least half of their exposure to government securities, 15% to infrastructure bonds, and the rest to equity markets, mutual funds, debt, and money market instruments. However, insurance companies face the challenge of managing their assets and liabilities, and it’s crucial for them to invest in instruments with varying maturities. Allowing insurance companies more flexibility to invest in corporate bonds would provide issuers with a diverse and significant investor base.
- To boost the infrastructure sector and make low-cost funds available, credit enhancement is a crucial tool. It helps improve the credit rating of asset-backed securities, making them more marketable.
One common method of credit enhancement is bank-issued letters of credit (LOC). These attach the bank’s strength and rating to the issue, resulting in lower borrowing costs for the borrower.
In the Indian context, credit enhancement schemes are particularly important because insurance companies and pension funds are currently not allowed to invest in corporate bonds below investment grade. By allowing companies with lower ratings to issue investment grade bonds through credit enhancement mechanisms, it would encourage the participation of institutional investors in the bond market.
4.Additionally, creating corporate bond indices would be beneficial. These indices would measure the performance of corporate bonds issued in the country. Bonds of similar maturity or rating could be grouped together, providing investors with a way to track the performance of bonds. Making these indices investible would further enhance transparency and accessibility for investors.
- To attract retail investors to the corporate bond market, we can implement some measures similar to those in the equity market:
- a) Allow higher quota for direct investment by retail investors in debt issues. This would give them more opportunities to invest directly in corporate bonds.
- b) Offer quotas to mutual funds in debt issues. Since retail investors often prefer investing through mutual funds, this would indirectly encourage their participation in the bond market.
- c) Make bonds of smaller lot sizes available to retail investors. This would make it easier for them to invest in smaller and more easily tradable bond securities.
- d) Encourage demat trading for listed bonds to increase ease of trading and reduce transaction costs.
- e) Provide a variety of tax benefits to retail investors in corporate bonds, similar to those provided for equity investments.
By implementing these measures, we can attract more retail investors to the corporate bond market and promote its growth.
These measures would contribute to the growth and development of the corporate bond market in India.
Conclusion:
Corporate bonds are indeed a great way for companies to raise long-term funds at lower borrowing costs compared to bank loans. The corporate bond market in India is still growing, but regulatory bodies are taking steps to boost its growth by making necessary amendments to the rules and regulations.
In addition to these measures, there is also a need to create awareness among retail investors about the benefits of investing in corporate bonds. By increasing investment in corporate bonds, we can further strengthen the market and provide more opportunities for companies to access funds.
References:
https://www.finra.org/investors/investing/investment-products/bonds
https://www.drishtiias.com/daily-updates/daily-news-analysis/regulatory-framework-for-online-bond-platform-providers
https://www.investopedia.com/terms/c/corporatebond.asp
https://www.sec.gov/files/ib_corporatebonds.pdf
https://www.sebi.gov.in/sebi_data/faqfiles/jan-2023/1674793029919.pdf
https://www.mondaq.com/india/debt-capital-markets/227488/corporate-bonds-in-india
https://www.mondaq.com/india/debt-capital-markets/227488/corporate-bonds-in-india
Circular No. SEBI/IMD/DOF-1/BOND/Cir-4/2009 dated 16th October, 2009
www.rbi.org.in – Corporate Debt Market: Developments, Issues & Challenges, dated 15th October, 2012
Reserve Bank of India Notification No. RBI/2012-13/366, IDMD.PCD.No.10 /14.03.04/2012-13 dated 7th January, 2013