REPORT ON

Government Bond Market in INDIA

By
Ajinkya Yadav
MBA – Executive Finance
PRN - 19020348002
 THE INDIAN DEBT MARKET
The Indian debt market, and the government securities market is at a turning point in India with
significant changes taking place in the domestic economic environment along with various
proposed legislative changes. The Indian debt market is a market meant for trading (i.e. buying
or selling) fixed income instruments.
A market where fixed income securities are issued and trade is called Debt market. The Debt
market is any market situation where trading debt instrument take place. The Indian debt
market while composed of bonds, both government and corporate, is dominated by the
government bonds.
Examples of debt instruments include mortgage, promissory notes, bonds, and certificate of
deposits. The central and state government need money to manage their short term and long
terms finance and fund budgetary deficits. Being the largest issuers in the Indian Debt Market,
they raise money by issuing bonds and T-bills of different maturities.

Debt market refers to the financial market where investors buy and sell debt securities, mostly
in the form of bonds.
These markets are important source of funds, especially in a developing country like India.
The Debt market in India is also considered a useful substitute to banking channels for finance.

Features of Debt Market in India

- It is competitive in nature, as number of participants is large.

- Strong and safe market, as gov. securities are traded.
- Substantially low transaction cost relative to equity & money market.
- Volume of transaction is huge, relative to equity market.
- Heterogeneous in nature, as a result of different types of participants.

Since the Government securities are issued to meet the short term and long terms financial
needs of the government, they are not only used as instruments for raising debt, but have
emerged as key instruments for internal debt management, monetary management and short
term liquidity management.

Link with Money Market

- For a strong debt the prerequisite is a strong money market.
- If debt is long term requirement, then money market serves as short –term
requirement.
- For liquidity purpose also money market is needed along with debt market.
Primary Market:
Primary market is that market where the debt instruments are issued for the first time which
can be issued as follows -
- Public prospectus: invites public to buy.
- Private placement: Invites few selected individuals, as the cost of public issuing is quite a
large.
- Rights issue: to the already exciting members, but they can refer to their beneficiaries in
case of unwillingness to buy.
However, the issuer has to inform the exchanges in case of issuing debts, to notify the
investors, about associated risk changes.

Secondary Market:
Secondary market is where the debt instruments can be traded, it can take place by the
following two ways based on the characteristics of the investors and the structure of the
market are:
- Wholesale debt market segment of NSE & Over the counter of BSE: Where the investors
are mostly Banks, Financial Institutions, RBI, Primary dealers, Insurance companies,
Provident Funds, MFs, Corporates and FIIs.
- Retail debt market involves participation by individual investors, small trusts and other
legal entities in addition to the wholesale investors classes.

Importance of Debt Market to the Economy

The debt market allows government to raise money to finance the development activities of
the government, Its plays an important role in efficient mobilization and allocation of resources
in the economy.
Since the Government securities are used to meet the short term and long-term financial needs
of the Government, they are not only used as instruments for raising debt, but have emerged as
key instruments for internal debt management, monetary management and short terms
liquidity management.
The debt market also provides greater funding avenues to public sector and private sector
projects and reduce the pressure on institutional financing. It also enhances mobilization of
resources by unlocking illiquid retail investment like gold.

The key role of the debt markets in the Indian Economy stems from the following reasons:
- Efficient mobilization and allocation of resources in the economy.
- Financing the development activities of the Government.
- Transmitting signals for implementation of the monetary policy.
- Facilitating liquidity management in tune with overall short term and long-term
objectives.
 Advantages of Debt Market
The biggest advantage of investing in Indian debt market is its assured returns. The returns that
the market offer is almost risk-free (though there is always certain amount of risks, however
the trend says that return is almost assured). Safer are the government securities. On the other
hand, there are certain amounts of risks in the corporate, FI and PSU debt instruments.
However, investors can take help from the credit rating agencies which rate those debt
instruments. Another advantage of investing in India debt market is its high liquidity. Banks
offer easy loans to the investors against government securities.

Disadvantages of Debt Market

As there are several advantages of investing in India debt market, there are certain
disadvantages as well. As the returns here are risk free, those are not as high as the equities
market at the same time. So, at one hand you are getting assured returns, but on the other
hand, you are getting less return at the same time. Retail participation is also very less here,
though increased recently. There are also some issues of liquidity and price discovery as the
retail debt market is not yet quite well developed.
 STATE OF INDIAN BOND MARKET
Globally, the bond markets are regarded as the largest and deepest source of capital for
companies. In India, the real sector consisting of non-banking non-financial companies (NBNCs)
has a very small dependence on bonds, thereby making it heavily reliant on bank and shadow-
bank credit. The policy direction of taking India to a $ 5 trillion economy by 2024-25 will need a
substantial part of corporate resources to come from the bond market. Penetration of bond
markets in India is about 15.45%, much lesser than that in several other countries (45.03% in
USA).
The extent of outstanding corporate bonds as a percentage of GDP is often referred to as
penetration. The penetration data is an indicator of the level of development of the bond
market in a country.
The three features that distinguish Indian market from the world are:
- predominance of the financial sector,
- predominance of the private placement market, and
- very significant share of mutual funds, and insurance companies as bond investors
(57%).

Corporate Bonds Turnover:

- The corporate bond market rate in India of 59.86% which is much better than several of
its global peers like South Korea (42.38%), Malaysia (15.04%), China (11.52%), but
however is behind USA (68.56%).
- However, non-standard market practices, continues to haunt the investors in the
secondary corporate bonds market

Issuances and outstanding in India

- The corporate bond issuances in India during the FY 2019 stood at USD 92.43 billion as
against USD 86.30 billion in FY 2018, therefore, reporting a growth of 7.1%.
- The FY 2020 has already witnessed issuances worth USD 49.93 billion till October 2019.
- The outstanding volume in the Indian market at end of 2018 stood at USD 421.17 billion

Growth rate: Over the decade from FY 2009 to FY 2019, the bond market issuances grew at a
compounded annual growth rate of 13.98%.
However, the growth rate between FY 2018 and FY 2019 stood at 7.1%, which is much lower
than the long-term standard.

Rating wise distribution: The issuance by AA and above bond issuers in India accounts for
nearly 80% of the total issuance, of which 60% is represented by issuances by AAA rated issuers
Mode of Issuance: In India, bonds are issued mainly on private placement basis (95%) and only
a fraction of the total issuances are through public offer.
Dominated by financial sector: The bonds issued by financial sector entities represent 76% of
the total issuances.
 Impact of Liquidity crisis on Indian Corporate Bond Market

The Indian NBFC sector has witnessed some major defaults in 2018 and 2019 Specific to the
bond market, DHFL has been admitted into insolvency As the mutual funds have faced a
substantial write down in the fair value of their investments, investors in the units of debt
mutual funds have turned jittery, resulting into significant decline in flow of funds into debt
mutual funds.

Spread of top-rated bonds over G-Sec before and after

the DHFL saga
2.50% The Period of turbulence

post the liquidity crisis

2.00%

1.50%

1.00%

0.50%

0.00%
May-19
Mar-19
Nov-18
Aug-18

Dec-18

Feb-19
Sep-18

Apr-19
Oct-18

Jun-19
Jan-19
Jul-18

G-Sec and AAA G-Sec and AA+ G-Sec and AA

The turbulence resulted into increase in bond yields, raising the average weighted yield for the
entire year. The overall weighted average yield of the corporate bond sector was 8.96% in FY 19
as against 8.09% in FY 18, an increase of 87 bps. The financial services sector was obviously the
worst-hit. The spread between G-Secs and AAA rated securities also fluctuated to a great extent
 Investor Classes in the Indian Corporate Bond Market

Currently, the Indian market has a dearth of investors.

- Most significant classes of investors are the insurance companies and mutual funds,
representing approximately 42% of the total investments.
- Banks are the next best class of investors, in terms of share, with approximately 17%.
- Besides them, the approximate share of national pension savings schemes and
employee provident funds is 15%.
- FPIs and other categories of investors sum up the remaining part of the pie with 26%

Market share of various class of investors

Others (Corporates, HNIs etc.)
10% Mutual Funds 20%

Banks
17%

FPIs Insurance
10% Companies 22%

Pension Scheme
2%
EPFO
Exempted trusts 13%
6%
 From the IL&FS default to the Pandemic
The banking sector is the most important financial intermediary in India's debt market. Over the
last few years, the bond market has emerged as an alternative to the banking sector especially
for the top rated firms. This trend has been pronounced ever since the banking sector started
reporting high levels of non-performing assets. Figure 1 below shows the flow of commercial
credit in India from various sources and highlights the growing relative importance of bond
issuance especially from 2015 onwards.
The bond market has faced two big shocks in recent years: (i) the default by IL&FS
(Infrastructure Leasing and Financial Services Limited) in September 2018, followed by other
relatively low-impact shocks due to problems in companies such as DHFL (Dewan Housing and
Finance Limited) and IndiaBulls Housing Finance as well as Yes Bank, and (ii) the outbreak of the
Covid-19 pandemic in India since March 2020. As a result of these shocks the risk perceptions in
the bond market have gone up. In this article, we take a look at changes in the risk perceptions
in the corporate bond market especially in the ongoing context of the pandemic and ensuing
economic slowdown. We also highlight the asymmetry in the risk perceptions of the markets
towards private sector corporate bonds vis-a-vis public sector unit (PSU) bonds and discuss the
likely implications of changes in the risk perceptions, for the future funding model of non-
banking finance companies (NBFCs).
Measuring risk perception
The most important metric for assessing risk perception in the bond market is the credit spread
which is the difference between the yield of a corporate bond and of a government security of
comparable maturity. Highly rated bonds (with ratings of AAA and AA) are traded relatively
actively and their yields reflect changing perceptions of investors regarding the riskiness of
these bonds. Movement over time of credit spreads on corporate bonds is therefore a good
indicator of the bond market's perception of risk.
We look at the credit spreads of AAA rated bonds of 3 years and 5 years maturity from April
2018 to June 2020. The data is sourced from Bloomberg. The bonds in our data are separated
into 3 categories - NBFCs (non-banking finance companies) and HFCs (housing finance
companies), private corporations and public sector undertakings (PSUs), which may include
public sector NBFCs such as Power Finance Corporation (PFC) and Rural Electrification
Corporation (REC). The figures 2 and 3 below show the evolution of credit spreads for these
three categories of bonds for the two specific maturities.

As we see from figure 2 above, prior to September 2018, the credit spreads on the NBFC,
private corporate and PSU bonds were stable, between 50 and 100 basis points for the 3-year
paper and between 40 and 60 basis points for the 5-year paper. In the rest of our discussion we
focus on the credit spreads on the 5-year paper. The pattern is the same for the 3-year paper,
only the absolute levels of credit spreads are different.
Above figure shows that credit spreads on NBFC AAA paper of 5-year maturity nearly doubled
between September 2018 and November 2018 and reached 160 basis points by February 2019.
This shows that the IL&FS episode that unfolded in the 3rd week of September significantly
enhanced the risk perception of the bond market regarding all top rated NBFCs.
After a small dip, the spreads went back to around 140-150 basis points by July 2019 and stayed
at this high level, with some fluctuations, till November 2019. During this period, crisis in other
NBFCs (such as the Dewan Housing and Finance Limited (DHFL)) as well as in Yes bank, added to
the overall risk perception of the bond market. This is reflected in the credit spreads remaining
high one year after the IL&FS default.
Private corporate and PSU bonds' credit spreads also widened in the aftermath of the IL&FS
default, but not by the same magnitude as the NBFCs. The IL&FS default triggered a liquidity
crunch primarily for the NBFC sector. The corporate sector experienced spillover effects owing
to a rise in risk aversion in the bond market.
While in the pre-IL&FS default period the spreads of all three categories of bonds were closely
bunched together, the difference between them began increasing from October 2018 onwards.
The difference was particularly acute between the NBFC and private corporate bond spreads on
one hand and the PSU bond spreads on the other hand especially in the second half of 2019.
This is despite the fact that these bonds were all rated AAA. This reflects the implicit
government guarantee enjoyed by the PSU bonds.
The government and the RBI took several actions to deal with the ensuing crisis in the NBFC
sector. Government appointed a new Board for IL&FS. RBI took several steps including open
market operations to inject liquidity into the system, reducing the risk weights on bank lending
to NBFCs, instructing banks to disburse sanctioned but undisbursed credit to NBFCs etc.
These eventually resulted in enhanced credit flow to the NBFCs which reduced the credit
spreads in the later part of 2019. For both NBFCs and private corporate sector, the spreads
declined by about 50 basis points to settle at about 100 and 50 basis points respectively. These
spreads, especially for the NBFCs, were still higher than pre-IL&FS episode but much lower than
their peak. We see a similar dynamic with the 3-year maturity bonds as well as shown in below
figure, except the absolute levels of the spreads were different.

The COVID19 Outbreak

The Indian corporate bond market has some special characteristics. Even after several
regulatory initiatives, the depth of the market has remained thin. As per an RBI research report,
corporate bond comprises less than 20 per cent of GDP, as compared to over 120 per cent in
the case of the US. It is dominated primarily by two types of firms — financial and
infrastructure. They are in general large in size. As per CMIE Prowess data, the leverage (as
measured by simple measure like debt as a percentage to total assets) of first the decile class of
Indian corporates is 10 times higher than the second decile class.
Therefore, the Indian corporate bond market is essentially a shallow market with participation
from large, concentrated and leveraged firms.
The Covid-19 shock to the economy is unprecedented. Almost the entire output of an economic
cycle is lost due to a public health issue, and we still do know how long this slump will last.
Amongst various sectors, the effect of Covid-19 on the corporate sector would probably be the
worst. With cash flows suddenly drying up, corporates need liquidity support, particularly in the
short run. As the potential risk of bankruptcy increases, there could be additional stress
emanating from both trade credit and existing credit lines. Longer the crisis, larger would be the
liquidity needs.
The Covid-19 crisis has posed significant challenges to Indian firms. The CD market is already
facing stress and the CP market has dried up. Credit offtake is the biggest challenge. All through
these years, banks have increased their resources for an easy target — consumer credit —
instead of corporate credit. Things are different now — Covid-19 has effectively killed consumer
demand, at least for a couple of quarters. Banks may face significant challenges as they have
limited machinery to expedite corporate credit. The RBI has its own policy dilemma, banks are
on a different plane, and consumers are somewhere else. With everything, the economy is in
the third quadrant, gasping for both breath and liquidity — quite a challenging time ahead.
Financial downfall
The demonetization of over 85 per cent of currency notes in November 2016 led to a huge
influx of liquidity in the banking system. As a consequence, corporate bond yields plummeted
to a historic low at around 7 per cent (Chart 1). This was also reflected in the yields of G-sec
market. Both abundant liquidity and a benign inflation outlook retained the corporate bond
yields at around the same level for some time. However, after a year, around October 2017, the
bond market witnessed a sharp upturn. This happened even though the RBI had kept its policy
rate unchanged.
Mainly three things contributed to this: first, the growth prospects of the Indian economy
turned unfavorable. Second, headline CPI inflation crossed the RBI’s comfort zone of 4 per cent,
and its outlook remained pessimistic. Finally, and most importantly, the government stepped
up its borrowing programmed and there was possibility of a fiscal slippage against the
background of poor implementation of the GST.
This episode was also marked by a sudden escalation of corporate bond spread over G-Sec
yields. While the spread increase was visible across maturity buckets, this was more
pronounced for the shorter maturity corporate bonds (Graph above). The signs of
macroeconomic weakness and corporate default risk were clearly building up. The features of
higher yield and excess spread continued and reached their tipping point in September 2018,
when Indian bond market came under severe stress due to the default of IL&FS (an AAA-rated
company). The failure of IL&FS triggered a massive liquidity crisis and subsequently increased
the borrowing costs of Indian corporates. This led to a series of defaults and rating downgrades.
This effect spilled over to the mutual funds which had large exposure to IL&FS and wiped out
large amount of investors’ wealth.
The matter deteriorated further when DHFL, a large NBFC, defaulted on its financial obligations
towards bonds issuance and commercial paper. The cascading effect snowballed into banks
which had exposure to DHFL. At the same time, CP and CD rates also started showing wider
volatility and issuance dropped (Graph Below). The stress on corporate bond market continued
– the yield spread across different rated bonds became highly volatile and hardened
throughout the period.
The shadow banking crisis has had a long, lasting impact on the banking sector. An overhang of
large NPAs, coupled with large frauds and muted macroeconomic performance during 2018-19,
forced commercial banks to become excessively risk averse. Banks were simply not lending and
liquidity support to the private sector in the market was fast drying up. Delayed and inadequate
recapitalization and other churning in the banking sector created a void in the liquidity
availability for Indian firms. The subsequent YES Bank moratorium also played an important
role.
For both NBFC and corporate bonds, the spreads rose by about 30-40 basis points between
February 2020 and April 2020. For both categories of bonds, the credit spreads reached their
peak in the first half of May, close to 180 basis points for NBFCs and 170 basis points for the
corporate bonds. The peak of the credit spreads during the pandemic has so far been higher
than the peak reached in the aftermath of the IL&FS default episode.
Spreads on PSU paper also went up, but by a smaller amount. The average spread on these
bonds in March and April was only 30-35 basis points. The difference between the credit
spreads on NBFC and corporate bonds on one hand and PSU bonds on the other widened
significantly to about 100 basis points. The large gap in spreads for bonds of the same ratings is
worth noting. Similar to the post-IL&FS period, this too is a reflection of the market's perception
of implicit government guarantee to the public sector units.
The impact of policy actions on credit spreads
The sharp rise in credit spreads of NBFC and corporate bonds in April 2020 could be attributed
to the announcement by the RBI to grant moratorium on loan repayments for all borrowers in
order to alleviate the financial stress triggered by the pandemic and the lockdown. Following
this announcement, NBFCs had to offer moratorium to their borrowers but at the time it was
not clear whether they themselves would also receive a moratorium from banks on their
repayment obligations.
In the second half of May, the government announced a package to boost the economy. This
included Rs 20 lakh crore of 'benefits' and effectively entailed an outlay of around Rs 3 lakh
crore for 2020-21. RBI also adopted several policy initiatives such as cutting the policy interest
rates aggressively and establishing new long-term targeted repo operations (T-LTRO) that
would provide 3 year funding to banks under a repo arrangement. RBI made the repo
arrangement `targeted' so as to ensure that the funds raised by the banks were made available
to the NBFCs.
These policy actions increased the credit supply to all issuers. Consequently, by the 3rd week of
June, the credit spreads on both NBFC and corporate bonds came down from their respective
peak levels of mid-May by about 50 basis points.
However, the RBI and government actions notwithstanding, the credit spreads for NBFCs and
private corporate sector continue to be substantially high. In fact the spreads in June 2020 were
similar to the spreads in December 2018 in the aftermath of the IL&FS default. For PSUs the
spreads have come down to around the same levels that prevailed before the IL&FS crisis.
This shows that the bond market remains concerned about the riskiness of the corporate sector
and the NBFCs. PSUs on the other hand, benefit from implicit government guarantee. The
significantly lower credit spreads they are experiencing in the time of the pandemic reflect a
`flight to safety' by the bond investors.
Credit spreads and funding costs
As we interpret the bond market data, it is important to understand the difference between
credit spreads and funding costs. Credit spreads going up does not necessarily mean that the
cost of funding for the issuer is going up. Cost of funding for a company that raises capital in the
debt market depends on the market determined yield on the security it issues This yield on
debt consists of two components: risk free rate and credit spreads. RBI's monetary policy
impacts the risk free rate but not the credit spreads. Credit spreads reflect the premium that
the investor charges over and above the risk free rate, taking into account the inherent
riskiness of the underlying bond.
Since the IL&FS episode, the risk free rate has been coming down steadily due to the actions by
the RBI such as reduction in the policy interest rates (repo and reverse repo rate) and large
scale open market operations to inject liquidity in the financial system. Figure 4 below depicts
the yield on 5 year and 3-year government securities from the April 2018 to June 2020 period.

The 5-year risk free interest rate has come down from about 8.4% in September 2018 (before
the IL&FS episode) to about 5.5% in June 2020 indicating a decline of 300 basis points. The 3-
year risk free interest rate has declined even more to about 4.5% over this period, a decline of
nearly 350 basis points.
Since RBI's monetary policy does not affect the credit spreads, the impact of policy action on
the actual cost of funding will not be the same as the reduction in the risk-free rate. If risk
aversion in the market goes up, then investors will demand higher price for the credit risk which
will result in rising credit spreads. Thus, the net cost of funding for an issuer may decline to a
lower extent compared to the reduction in the policy rates.
This is what has been happening since the IL&FS episode. Risk free rate has been declining but
owing to high risk aversion, credit spreads have remained elevated. As a result, funding costs of
companies have not come down by as much as the risk-free rate. This implies that in an
environment of high and rising risk perception such as the ongoing Covid-19 period, the
effectiveness of policy rate cuts will be constrained.
The widening gap between the credit spreads on PSU debt versus private sector points to lower
risk perception for PSU entities which are perceived to have implicit sovereign guarantees. The
combined effects of rising risk perception, widening gap between credit spreads of identically
rated issuances and reduction in the policy interest rates would mean that the debt market will
skew towards government owned issuers who might experience the greatest reduction in
funding cost.
Conclusion
Bond market credit spreads provide important information about the risk perception of an
important class of investors. Sustained high credit spreads (compared to long term average
levels) suggest elevated risk perception and imply heightened risk aversion. Specifically, it also
points to the role that individual episodes of corporate defaults and the associated policy
responses (or lack thereof) play in shaping risk perceptions.
Wide spreads between bonds of the same ratings issued by private companies and those
owned by the government clearly indicates a strong perception of the implicit government
guarantee enjoyed by public sector companies. This raises important questions as to whether
the debt of government owned companies should be treated as a part of government's debt.
Finally, economic recovery in India in the post Covid-19 period will depend crucially on the flow
of credit in the economy. The economic package recently announced by the government
depends largely on the financial sector. Nearly 70% of the 'benefits' of Rs 20 lakh crore in the
package are expected to be routed through the financial sector. In a recent article we discussed
the rise in risk aversion in the banking sector. With both the banks and the bonds markets
showing high levels of risk aversion, growth of credit may be less than envisaged in the
package. This may dilute the overall effectiveness of government's monetary and fiscal policy
actions.