Today, the market is essentially that of paper rated AA and AAA. One way to give a boost is to get investors to accept lower quality paper. This is the fundamental conundrum of market development as there are only a handful of companies that have high ratings. The logic today is that if investors only prefer higher rated papers, it will be difficult to change mentalities.
So who are these players? Provident and pension funds and insurance companies combine their funds with long-term investments, but are the depositories of their members’ money and cannot take undue risks. Therefore, they are careful with their investment. Mutual funds can go lower, but they would look at the net asset value (NAV) all the time because any default can set them back significantly.
Interestingly, regulators pushed the regulated down the pecking order. This is not fair since the latter will then become responsible for everything that goes wrong, such as a defect. So what’s the output?
Ideally, we need improvements or guarantees that a lower rated paper will be notched. For business, if we are dealing with a large group, the parent can provide comfort to family members which can improve the rating. But this does not apply to all companies. The anomaly in the system is that the lowest rated companies still receive funds from the banks, albeit against collateral. To make low-rated bonds acceptable in the bond market, raising the rating is essential. This should be on the agenda of regulators.
The Securities and Exchange Board of India (Sebi) introduced Credit Default Swaps (CDS), but it did not work. In a CDS, a guarantee is given by the insurer so that in the event of default, there is compensation. The other option tried was improvements where banks were allowed to give a certain amount of first loss indemnity guarantee up to a certain limit. Needless to say, the success has been limited.
We need to move forward and think differently. For improvements to work, there must be an institution that provides this support and interfaces with the borrower. The problem today is that when a borrower defaults, it is the bank that must seek recovery, not the custodian. If a bond defaults, bondholders don’t know what to do.
This is why no one wants to invest in lower rated bonds. The Insolvency and Bankruptcy Code (IBC) was to open a way out to deal with bankruptcy. But post-Covid progress has been pretty lukewarm once the low-hanging fruit has been picked.
A specialized financial institution – say the Bond Enhancement Corporation (BEC) – could be created. Here, the GoI is expected to create BEC, which will provide such improvements to lower rated companies. This can be initially financed by the budget and banks, and foreign investors can be brought in later as shareholders.
The advantage is that BEC will have a bilateral agreement with the company and will carry out due diligence as banks do when lending. The warranty may also be taken into account when setting the warranty fee. And in the event of default, while BEC will make payment to bondholders, it will also deal with the borrower for recovery. Therefore, there will be institutional intervention here, and comfort will be provided by BEC.
What kind of paper should I process? Here, BEC should start with investment grade paper, which is BBB and A rated companies. If we look at the cumulative default rate of these papers, it is less than 2% over one year and would be lower than the average ratio banking non-performing assets (NPA) over a longer period. BEC may select companies for this purpose.
It will be a win-win situation because today these companies can borrow at notional spreads of 300 to 500 basis points above government securities in the bond market. By charging a fee of 100 to 200 basis points, any rating upgrade will reduce the cost to the business and, more importantly, bring it into the universe. This can be the big idea that the budget can resume in 2023.