A Study of the Indian Corporate Bond Market

In any developing economy, it is imperative that a well developed bond market with a sizable corporate bond segment exists, alongside the banking system, as - (1) a developed and freely operating corporate bond market may judge the intrinsic worth of investment demands better in view of the disciplinary role of free market forces; (2) the corporate bond market could exert a competitive pressure on commercial banks in the matter of lending to private business and thus help improve the efficiency of the capital market as a whole; and (3) the debt market must emerge as a stable source of finance to business when equity markets are volatile. However, most countries do not have corporate bond markets comparable in efficiency to their equity markets, as the secondary market for corporate debt is mostly over-the-counter (OTC and/or telephonic), rather than exchange traded and it is extensively dominated by a few institutional investors and professional money managers. The market for non-sovereign debt (particularly the corporate debt segment) in India also has a number of shortcomings - a primary market structure where private placements, sans mandatory credit ratings, dominate in an overwhelming manner; lack of transparent market making and a tendency on the part of institutional investors to hold securities to maturity - the secondary market is thus prone to suffer from low liquidity and fragmentation, information asymmetry and consequent pricing anomalies. In this paper, we make an attempt to understand the nature and extent of imperfection of the Indian secondary market for corporate bonds by examining the following aspects: (1) the depth of the market, in terms of frequency of trading of outstanding bonds; (2) composition of the market, in terms of trading of debt of various risk categories as indicated by their credit ratings; (3) relationship between YTM and volatility of return; (4) nature of the spread between YTM of different risk categories of bonds; (5) relationship between market depth and price/YTM and (6) market pricing of risk. For our purpose, data on exchange-traded transactions was of greater relevance, since it is the exchanges, which provide the basis for efficient market making by reducing information asymmetry, hence, we used available data on the fraction of trading in corporate bonds that were routed through the major stock exchanges of the country, namely, the BSE and the Capital Market (CM) and Wholesale Debt Market (WDM) segments of the NSE. Tracking daily data, for a period of 38 months between April 1997 to March 2001, we find that the secondary market for (exchange traded) corporate bonds is characterized by shrinking depth and width in recent years. This is borne out by the decreasing frequency of trades per month and the rising concentration of trading in an increasingly lesser number of securities as revealed by the 5, 10 and 15 bond concentration ratios in each month. Examining, the month-wise frequency of trading of bonds of different ratings, among the most frequently traded bonds during a month, and also, the share of bonds of different rating categories in the total frequency of trading, shows that our sample period witnesses a qualitative change in the composition of the market. This change is characterized by dwindling of trade in highly rated bonds and a rise in the trading of downgraded bonds, concentrated, in particular, in bonds which have better liquidity (irrespective of their present credit quality). Our estimates of yields to maturity (YTMs) based on the available bond price data, suggests that on the whole the pricing mechanism of the Indian corporate bond market, in spite of its underdeveloped state, was consistent with the theory of bond pricing. Thus, for example, it was found that for all categories of rating, YTM of a bond declined as the bond approached maturity and also, given the number of years to maturity, YTM of a higher rated bond was lower than that of a lower rated bond, on an average. The usual distortionary effects of a shallow market are seen to be manifest in the high volatility of YTMs, this being more severe for bonds with higher credit risk compared to the ones of high credit quality. The observed patterns of over time movement of the spreads over default risk free returns suggest that though the YTMs allowed for the expected risk premium over government securities, in a number of instances private information/expectations work strong enough so that investors tend to ignore the public information contained in the declared credit rating of corporate bonds. Further, our estimates of Sharpe ratios for different rating/maturity categories of bonds indicate that the market fails to evolve a uniform market price of risk across categories. We observe that much needs to be done for ameliorating the problems of information asymmetry, low liquidity and consequent distortions from the corporate debt segment of the Indian capital market, to give the debt market a much stronger base than it presently enjoys.