Prospects for Indian corporate bond markets

In a blog post in February, I argued that we have been witnessing the gradual onshoring of the Indian corporate bond market. A decade ago, the Indian corporate bond market was in New York, but it is now increasingly in Mumbai. In the past, an Indian company wanting to borrow the rupee equivalent of say a billion dollars had no choice but to borrow in the global market in foreign currency and either bear the currency risk or hedge it. Today, it is possible for even a relatively low rated borrower to raise that kind of debt in Indian rupees in the onshore market. I concluded that Indian credit markets have now reached the stage where Indian equity markets were 15 years ago: the investors are predominantly (but not exclusively) foreign, but the market is in India.

We know that over the last 15 years, the Indian equity market evolved into one in which both the markets and the investors are predominantly Indian, and we also have a good understanding of the process through which this happended. That obviously raises the question whether a similar evolution would happen in the corporate bond market as well, and what such a process would look like. I had an email exchange on this matter with Abhijeet Katte who runs an AI sim lab working on economic and social policy questions. This post expands on those discussions and presents my assessment of the prospects of success.

Governance

A major part of the equity market development story was one of governance reform and institutional development that were a prerequisite for everything else. The equity market had its share of setbacks and scandals, but policy makers responded to each of these with regulatory reforms that spurred market development. A lot of institutional development has to happen in the credit markets as well:

• Credit ratings must be seen to be credible. During the Covid-19 pandemic, some AA rated bonds issued by large non bank finance companies traded at distressed yields (credit spreads of over 10% above risk free yields) while the rating agencies had not even placed the bonds on rating watch. The issue is not whether the rating agencies were right, the issue is that the markets simply did not believe them.
• Bankruptcy law must be seen to work smoothly. The Insolvency and Bankruptcy Code 2016 has been a huge improvement over the previous legal framework where the discounted value of the ultimate recovery was close to zero, but there is a lot more work to be done. Ideally corporate bond investors should be able to obtain ultimate recovery within a reasonable time after default, and the recovery should be predictable to a great extent based on the seniority of claim and the financial position of the borrower. We are not there yet, but hopefully, we will get there over a period of time.
• Debt mutual funds Net Asset Values (NAVs) must be believable. Both in the Global Financial Crisis and during the pandemic, investors lost faith in debt mutual fund NAVs, and there was a widespread perception (largely justified) that sophisticated well connected investors exited distressed funds at par before redemption was suspended. There have been some reforms after that, but these have not yet been tested in a stressed environment.

We have gotten to the point where a large Alternative Investment Fund (AIF) is probably comfortable navigating through the governance deficit in the debt market, but a small investor is not. Reforms are impeded because unlike in the equity markets of a generation ago, the incumbents in the debt market are deeply entrenched, and enjoy the benefits of regulatory capture. Even in the equity markets, it took a series of scandals and crises to make reforms politically feasible. I like to believe that debt market reforms are moving in the right direction, but realistically, one must recognize that there are immense obstacles.

Liquidity

For a long term investor, a debt mutual fund has some liquidity advantages over a fixed deposit. If you put money in a 5-year FD and need a premature withdrawal, that comes with a significant penalty. If you buy a mutual fund that invests in long term bonds, redemption carries no penalties once you get past the point where the exit load goes away. The investment carries interest rate risk but not liquidity risk. Just as the equity investor has some view of the direction of the stock market, the debt investor has some view about interest rates that makes this risk palatable. An investor with a one year cash surplus and a favourable view on interest rates can invest in ten year bonds (directly or through a mutual fund), and capture the term structure premium embedded in an upward sloping yield curve.

At the really short end, debt mutual funds have a serious disadvantage because it takes two business days to receive the redemption proceeds of a mutual fund, while premature withdrawal of a bank deposit is instantaneous. With instant electronic fund transfer and shortening settlement cycles in the wholesale financial markets, the two day delay is an abominable anachronism that I hope will shrink over time. Also, the two day delay is not very serious for somebody who can predict redemption needs a few days in advance.

In global markets, the solution to bond market liquidity has been the bond Exchange Traded Fund (ETF). The innovation that the ETF brings to the table is that investors trade a portfolio of bonds on the exchange instead of trading a specific bond. This exploits the fact that there are serious information asymmetries and challenges in valuing a specific bond, but it is far easier to value a diversified portfolio of bonds which is exposed primarily to macroeconomic risks. During the Covid-19 pandemic, bond ETFs in the United States traded smoothly even as liquidity was severely dislocated in the underlying bonds. Unfortunately, bond ETFs have yet to take off in India.

Equitization of debt

The quickest way to jump start the bond market in India would be to tap the well developed equity culture in the country. By tranching a portfolio of investment grade corporate bonds (with say single A or even BBB ratings), it is possible to create a bottom tranche with equity like risks and returns that could attract investors from the equity market. The upper tranche would then be AAA or AA rated which could attract investors with low risk appetite. Unfortunately, this kind of financial engineering got a bad name in the Global Financial Crisis, and Indian regulators developed a deep aversion to it. Even as India has taken tentative steps towards creating a credit derivative market, the attempt has been to ensure that this market does not disintermediate the banks. Regulatory capture has been at work!

Taxation

Over the years, most of the tax advantages of debt mutual funds have been eliminated, but two advantages still remain.

1. For the patient investor, a debt mutual fund offers tax deferment. If both the bank deposit and the debt mutual fund yield 6% and the tax rate is say 20%, the bank deposit compounds at 4.8% (80% of 6%) because you pay tax on the notional interest every year. The mutual fund compounds at 6% and you pay 20% tax on the accumulated interest when you redeem. Over a 10-year horizon, this amounts to an annual yield pick up of a quarter percent, and over a 20-year horizon, the annual yield pick up is about half a percent.
2. It is hugely tax efficient to combine debt and equity into a single hybrid fund that receives equity tax treatment because now even the debt interest is taxed at equity capital gains rate and that too only at redemption. The alternative of an equity mutual fund combined with a bank deposit has a massive tax disadvantage.

On the flip side, the taxation regime for investment income has been quite unpredictable in India, and it is possible that some top bureaucrats are already working on a plan to eliminate the favourable tax treatment of mutual funds.

Cost

Mutual fund expense ratios are much lower than bank Net Interest Margins (NIM) and as mutual funds achieve larger scale and compete more aggressively, this cost advantage will only increase. If you think of the mutual fund yield as being the interest rate paid by the industrial borrower less the expense ratio, and the bank deposit rate as the interest rate paid by the industrial borrower less the net interest margins, it is apparent that the mutual fund should yield more for the same level of credit risk.

High Net Interest Margins are partly (but only partly) due to weak price competition among banks when it comes to Current and Saving Accounts (CASA) deposits. Historically, there has been enough lazy money in the economy for non-price competition to be an equilibrium strategy in this segment. There is increasing evidence that the situation is changing. It is not clear how banks would respond to this changed environment. As I argued in an earlier blog post banks could simply accept a loss of market share in financial savings and shift to a fee based model. Alternatively, interest rate on CASA deposits could move closer to the interest rate in the money markets, with bank shareholders taking the pain in the form of a reduced Net Interest Margin. This would reduce the attractiveness of money market mutual funds without affecting other debt mutual funds. It is also possible that low cost CASA deposits are currently being used to subsidize the interest rate on term deposits, and banks could reduce term deposit interest rates when this subsidy is no longer available. That would be a boost to debt mutual funds. It appears to me that some combination of all of these strategic responses might play out.

Customer Loyalty

There are some countries in the world where it is said that you are more likely to divorce your spouse than change your bank. India was never like that, and customer loyalty to the bank was quite limited. These days, that loyalty is shrinking even further. The rise of the Unified Payment Interface (UPI) for peer to peer and person to merchant digital payments means that customer loyalty is more to the UPI App than to the underlying bank account that actually moves the money. In the beginning, banks were shortsighted enough to let the UPI App own the customer, and despite their best efforts to promote their own payment apps, there is little evidence of their ability to claw back the limited customer loyalty that they had earlier. UPI and other apps provided by Fintechs clearly provide a better customer experience, and these apps allow the customer to seamlessly access a variety of investment options including mutual funds and direct stock market investment. Mutual funds are today delighted by the inflows coming in through these channels, but years in the future, they may also come to regret the fact that they too do not own the customer.

Conclusion

Where does all this leave us? I think fundamental economic forces are pushing towards the rise of an Indian corporate bond market intermediated by mutual funds, and these forces will ultimately prevail. But governance problems, institutional weakness and regulatory capture stand in the way, and will definitely slow the process. What took 15 years in the equity market with a benign regulator might take longer in the bond market with a more hostile regulatory environment.

Posted at 6:26 pm IST on Wed, 15 Apr 2026         permanent link

Categories: banks, bond markets, Indian financial sector

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