Nearly three years after the government permitted the Employee Provident Fund Organisation (EPFO) to invest in double A rated bonds, hardly any funds have flown into them.
Even after a quarter of a century of mutual funds, promoted to improve returns for investors with better designed products, about 80% of debt funds are still locked in triple A rated, sovereign bonds or cash, even when they are free to invest in junk bonds.
The sorry state of affairs is as much due to apathy as it is due to risk aversion. Finance minister Arun Jaitley's decision to permit regulated institutions to take a leap towards investment in lower-rated papers for better returns and to deepen the bond market has raised hopes for many.
"If large corporates are mandated to meet their one-fourth funding requirement through bond market, it will improve the supply of bonds as more companies will tap the debt market," says Pawan Agarwal, senior director and chief analytical officer at Crisil. Ideally, the move should provide insurance companies, provident and pension funds an opportunity to invest in high yielding instruments, open up a new funding source for lower-rated companies.
But it may end up being just another enabling legislation, which would fall short if not accompanied by development of auxiliary elements such as rationalisation of stamp duty and kindling of animal spirits in fund managers.
"As of today, even the provision to invest in up to AA-rated instruments is hardly explored by most of the larger investors," says Amit Tripathi, head-fixed income, Reliance Mutual Fund. "We need to put in place a robust credit research infrastructure to take advantage of these opportunities."
Insurance and pension industries traditionally have held securities to maturity without helping much in developing liquidity in the market. The state dominated institutions were satisfied by just protecting the principal, though in some years returns fell below the rate of inflation.
The EPFO was given the go ahead to invest in equities only in fiscal 2016 when the government said it could invest 5% of its incremental corpus into equities. This was subsequently increased to 10% in 2016-17 and to 15% in the current fiscal.
Though there is no official data, it is estimated that EPFO manages assets worth Rs 10 lakh crore and attracts Rs 1.2 lakh crore of fresh money each year. Currently, it is estimated that it has invested just Rs 30,000 crore in equities through exchange-traded funds, which is a fifth of the permitted sum.
"We should always maximise returns without taking unacceptable high risk as we deal with public money," said V Joy, commissioner, EPFO. "There are supply constraints in the corporate bond market for papers now." The EPFO can invest 35% of its corpus into corporate bonds, as mandated by the Central Board of Trustees. Although the government allowed it to invest in AA-rated papers a few years ago, the Central Board of Trustees has mandated corporate bond investments up to AA+ grade, a notch higher from the lowest permissible grade.
STUCK IN THE PAST
In a market where investors have been used to assured and safe returns from bank deposits, even mutual funds, which are expected to design higher risk products, remained cautious.
Unlike insurance companies and pension funds, mutual funds have always been allowed to invest in below investment grade or junk securities, provided their fund has the mandate. But out of the Rs 13.31 lakh crore of all investments in debt as of December 2017, only Rs 2.67 lakh crore, or 20%, has been invested in securities rated below AAA, according to data from Value Research, a mutual fund research company.
This is despite the fact that every notch of lowered rating could result in at least 40 basis points of higher yield. A basis point is 0.01 percentage point.
The financial ecosystem in India does not support risk taking because of various factors like an illiquid debt market, lack of investor awareness and bad press in case of a default.
"Most of the fixed income securities, barring those in liquid and ultra-short term funds, are illiquid," says Dhirendra Kumar, chief executive at Value Research. "Investing in poor credit is particularly risky for these funds as experience in recent cases like JPMorgan shows that it can generate bad press and could lead to a run on the fund."
In 2015, JPMorgan restricted withdrawals in its bond fund following a default by Amtek Auto, which led to a run on the fund though it constituted just 1.32% of its total assets. Subsequently, the fund was sold to Edelweiss. Even though insurance companies have long-term funds, they are no different from mutual funds.
Insurance firms are allowed to invest in lower-rated securities up to AA with board approval, while three-fourths of their debt investments have to be in AAA-rated securities and government bonds. But there's just no enthusiasm from the insurers to earn higher returns by buying lower-rated bonds.
"After the government announcement, the regulations will need to be liberalised to allow more investments in less than AA-rated securities,'' says Jitendra Arora, executive vice president-investments at ICICI Pru Life. "This change will impact pension and provident funds more because they, so far have largely invested in AAA-rated securities.''
MYTH OF HUGE LOSSES
So, what will it take for this new source of funding to open up for lower-rated companies? The government and regulators should take small steps rather than just asking investors to put money in risky assets.
"Things like unifying stamp duties and bringing their cost down can help small companies to look at this market seriously," says RK Nair, former Sebi executive director and member of IRDAI. "Right now, it is just too simple for a lower-rated company to tap a bank because bonds involve costs like stamp duty, illiquidity premium and fees for investment bankers, which in some cases add 2% to interest payments."
The corporate bond market has tripled over the past seven years — to Rs 26.47 lakh crore in Dec 2017 from Rs 8.53 lakh crore in Dec 2010. But the concentration has been in triple A and double A-rated segments. These together contributed 85% of the total Crisil-rated issuances, data from the agency showed.
The fear of default is also blown out of proportion as data shows that lower-rated bonds have defaulted, but not to the extent that it could dent returns so badly to scare away investors. Triple A-rated companies did not default at all, while for the double A segment, the default rate was 0.99%. For single A, it was 0.4% and 1.5% for BBB. The default rate jumped to 20.85% for C-rated securities, Crisil data shows.
"Investor's risk appetite is key to improving participation in lower-rated bonds," said Badrish Kulhalli, fund manager-fixed income, HDFC Life Insurance. "Relative pricing between bond market and bank loans will also play a role in issuers' choice of borrowing." Fund managers may have to design products such as closed-ended funds and educate investors that risks in these instruments are justified by the returns. If fund managers stay away citing a lack of liquidity, it would be a classic case of chicken and egg. Which one comes first? Do fund managers begin to take risks and show that the risk of investing in lesser-rated papers justifies the returns?
"The whole regulatory and market framework is flawed," says Kumar of Value Research. "Ultimately, fund managers are slaves of investors and investors should be given a choice of where they want to invest. It is the whole ecosystem which needs a change and it will not happen in one budget speech."