Corporate Bonds Market in India vis--vis South Korea

A report Submitted to Prof. Amit Parakh In partial fulfillment of the requirements of the course Fixed Income Securities
On 06/9/2012

By

Abinas Mishra(B11002) Anubhuti Anup (B11008) Prashant Madhogaria(B11032)

Corporate Bonds Market in India vis--vis South Korea

Corporate bond: A debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company's physical assets may be used as collateral for bonds. A developed corporate bond market helps in easy access to funds by the corporate which can be utilized for productive investments. These investments will help in increasing the output of a country thereby driving growth of an economy. India already has a well developed equity market which provides corporate a medium to raise capital but its corporate bond market is still underdeveloped. This limits the scope of an corporate entity to raise capital primarily to equity markets and loans from bank (secure loan). The scope of this write-up is to find out the bottlenecks that are preventing development of the corporate bond market in India, it also tries to understand how economies like South Korea were able to create a thriving corporate bond market. As we can see in Exhibit 1(a&b) the total outstanding corporate bonds issued (in 2012) in India is $21bn compared to $407.9bn in South Korea. This when compared to other major economies in terms of percentage of GDP is also quite abysmal standing at 1.25 % (India) compared to 36.54%(South Korea ).The major reason that can be attributed to this skewed-ness is the size of banking system in the country. Banks and bond markets compete in providing external finance and thus a well developed banking system may act as a deterrent to the development of corporate bond market. Exhibit 2 helps us in giving an idea of the major source of funds for corporate in India. As we can see, companies in India use mostly secured loans from bank than using corporate bonds to do the financing activities. Another reason that can be attributed especially to most unlisted companies is that, that they are not open to disclosures of their financial statements. This is because most of them are family owned and lacks transparency. Besides the above, factors like development stage of the economy which implies that development of corporate bond market in a country would be positively correlated with the overall development of the economy. This is because development brings with it a less volatile investment environment, less government involvement in commercial activity and strong creditor rights, transparency and good corporate governance.

Other aspects like benchmarking yields, the availability of reliable trading platforms, and the development of hedging instruments are fundamental for improving the breadth and depth of corporate debt markets The Korean experience The corporate bond market in Korea can be divided into two phases: Pre Asian currency Crisis Post Asian currency Crisis The corporate bonds markets in Korea had sprung up from early 1970.After the war, the Korean government followed a developmental model where it allowed few industrial houses to grow into conglomerates manufacturing everything and creating a export oriented business, These conglomerates are called chaebols.The model followed was basically monopolistic/oligopolistic in nature. The chaebols were allowed to raise debts by issuing corporate bonds which were guaranteed by the local banks and hence carried a lower interest rate. After the Asian financial crisis the banks went into massive restructuring and stopped guaranteeing the bonds issued by corporates, they were also reluctant to extend loans to the corporate as they had to meet the Basel capital adequacy requirement. This led to the government raising the ceiling on an individual firms corporate bond issuance from double to four times its equity capital. The corporates started issuing non guaranteed bonds with a higher interest rate. The initial impact was not significant but with the downturn in interest rate there was a huge surge in fund inflows to these instruments and it grew from 65 trillion won at the end of 1997 to 181 trillion won at end of June 1999.This led to an increase in the proportion of funds raised from corporate bonds from 16.7% in 1997 to 21% in 2001.(Exhibit 3) . This surge can be attributed to two main reasons: Individuals perceived bonds issued by chaebol-affiliated firms to be safe investments Banks could not compete with the higher interest rate offered by corporate bonds(A three year bank deposit rate was 17% whereas a three year corporate bond (AA rated) yield was 24%) This surge led the government to put a cap on amount of bonds that chaebol affiliated firm could issue as they were accumulating huge debts. The concerns were justified when Daewoo then the third biggest chaebol declared bankruptcy. It had accumulated debt to the tune of 500%. Immediately after this the amount of corporate bonds issued was negligible as investors became sensitive to corporate credit risk (Exhibit 4). The bond market showed signs of returning to normalcy after the Korean asset management company(KAMCO) took over the assets of Daewoo and the investors were able to salvage ninety percent of the investment .Subsequently, the debt percentage came down to 150%, due to investor risk averseness . Though no strong

relationship was found out why people were investing so heavily on the bonds issued by chaebols one reason could be that they perceived it to be highly secure as they were too big to fail. Another reason could be that they associated the bonds issued by one chaebol Group Company to be backed by another. In, the aftermath of the bankruptcy of Daewoo and a another chaebol SK corporation, the investors started pouring funds to a large extent in BBB rated and above corporate bonds (Exhibit 5). The BBB rated bonds are the lowest investment grade bonds and also provided higher returns, hence it could be understood that investors tried to balance risk and returns and hence these bonds were the most in demand which lead to narrowing the gap in spread between a BBB rated and a AA rated bond. (Exhibit 6)

Takeaways A striking balance between investor protection and financial disclosures must be arrived as an investor would not like to put his/her money in a place where he has limited information. Strong bankruptcy law will also help in attracting more foreign institution investors. A lack of quality corporate bonds in the secondary market is hampering twoway price discovery and hence creates low liquidity as investor who hold quality corporate bonds often stay invested till the maturity. Electronic trading of corporate bonds may help in alleviating this problem as a move to this may lead to price discovery as more bonds would be traded through exchange than through OTC.(Steps, are being taken and ICAP Inc. is into talks to create an exchange for corporate bonds in India)

Most corporate bonds issued in India are mostly in the AAA & AA rated category. This limits the no. of firms which can issue such bonds since a three year AA rated corporate bond is currently issued at somewhere between 11%-11.5% , hence a low rated bond has to pay a higher spread which increases the cost of borrowing and comes into direct competition to what is being offered by banks. This could be addressed if bonds of such issuers come with third party guarantees for a fixed time frame which will make these bonds attractive for both. The investor will able to increase its risk appetite after it sees the performance of such bonds and will be willing to invest in low rated bonds thereby lowering the spread. Finally, a strong regulatory oversight and favourable government policy will help in development of corporate bonds.

EXHIBITS
Exhibit 1.a
1,957.10 2000 1500 1000 500 0 Germany United States China India South Korea 342.1 21 2010 659.7 407.9 2011 2012

Exhibit 1.b
36.54%

40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00%

2010 9.56% 12.97% 9.04% 1.25% Germany United States China India South Korea 2011 2012

Exhibit 2 19811985 1642 34.2 1.9 8.7 23.5 65.8 2.8 2 0.8 37.5 9.2 19861990 1983 32 2.3 5.8 23.9 68 8.3 3.2 5.1 37.2 9.9 19911995 1795 29.9 1.3 13.5 15 70.1 20 4.4 15.6 32.4 6.7 19962000 1696 41.4 0.8 11.3 29.3 58.6 12.1 4.2 7.9 31 6.8 20012005 2301 56.4 0.7 12.2 43.4 43.6 10.2 3.8 6.4 13.6 -2.5 20062010 3168 38 0.51 24.3 13.2 62 16 1.5 14.5 27.6 2.5

SOURCES OF FUNDS Number of companies INTERNAL SOURCES Paid-up capital Reserves and Surplus Provisions EXTERNAL SOURCES Paid-up capital Net issues Premium on shares Borrowings Debentures

Loans and advances From banks From other financial institutions From others Trade dues & other current liabilities

22.4 12.2 7.8 8.3 25.3

25.3 13 9.4 5 22.3

24.8 9.6 10.8 5.4 17.6

23.1 9.5 10.5 4.1 15.2

16.1 22 -5.6 -0.4 19.3

24.4 16.1 0.1 7 17.8

Exhibit 3 1997 311.4 (42.9) 150.2 (20.7) 121.3 (16.7) 68.8 (9.5) 224.5 (30.9) 726 1998 290.8 (41.1) 147.6 (20.8) 157.7 (22.3) 55.6 (7.9) 204 (28.8) 708.1 1999 289.4 (41.1) 162.4 (23.0) 148.2 (21.0) 40.3 (5.7) 226.7 (32.2) 704.6 2000 307.2 (41.7) 177.1 (24.1) 123.7 (16.8) 33.9 (4.6) 271.4 (36.9) 736.2 2001 335.6 (40.6) 191.9 (23.2) 179.9 (21.7) 44.1 (5.3) 268 (32.4) 827.6

Total loans Of which: loans from banks Corporate bonds Commercial papers Others Total

Exhibit 4

Exhibit 5

Exhibit 6

References

http://www.imf.org/ www.bis.org www.wikipedia.org http://www.ipedr.com/vol32/010-ICEFR2012-Q10013.pdf http://www.cmie.com/ http://www.investopedia.com/