[By Ansh Chaurasia]
The author is a student of Dr Ram Manohar Lohiya National Law University.
Introduction
The Securities and Exchange Board of India (“SEBI”) has actively endeavoured to ease and promote access for the general public in pursuance of an announcement made as part of the FY 2023-24 budget. On 9 December 2023, SEBI introduced a consultation paper (“paper”) aiming to make sweeping changes in the bond market. The proposed amendments have the potential to bring unprecedented levels of non-institutional investors’ participation in the bond market. Retail investors played an essential role in the recent sustained rally in the stock market indices, making a case for their inclusion within the bond market.
Bonds are fixed-income securities, i.e., debt securities that pay fixed interest, called coupon rates at regular intervals. They are an essential financial instrument for governments and corporations to raise funds without giving up a share in the equity. The value of the bond decided by the issuer is called ‘face value’. It is the amount promised to the bondholder upon the bond’s maturity, and the coupon value is evaluated from the face value. SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021 (“NCS”) enables the issuance of debt securities or non-convertible securities to raise funds (Reg 2(1)(k) and Reg 2(1)(x)). The listing and issuance of bonds are governed by a circular of SEBI that lays down procedural requirements, listing obligations, and disclosures to be made by the issuer of such instruments. These time-bound disclosures and procedural requirements provide an opportunity for informed investment decisions. Crucial disclosures regarding financial results and defaults on repayment of loans mandated under the circular have a significant bearing on investment
Bonds play an important role in diversifying an investor’s portfolio. Although stocks offer greater returns, they are proportionately riskier. However, bonds, specifically as suggested in the paper, reduce the risk by ensuring a lower yet stable coupon rate and predetermined maturity date. The opportunity to invest in the bond market for retail investors that primarily invest in the stock market would provide their investment with a cushion from frequent stock market shocks. However, the success of this proposal is concomitant with multiple factors that are discussed hereafter. The paper includes multiple proposals concerning the bond market; however, the analysis in this blog focuses primarily on issues regarding the entry and participation of retail investors into the bond market.
Recent Changes in the framework of the bond market
The gradual change within the bond market began in 2022 through a decision in a board meeting to decrease the face value of privately placed debt securities and subsequent amendment to the circular. The board considered the high face value’s deterrent effect that withheld non-institutional investors from the bond market. Consequently, face value was reduced from Rs ten lakh to Rs one lakh. The next significant change was the introduction of the regulatory framework for the online bond platforms to ensure transparency, disclosure and availability of redressal mechanisms on platforms that facilitate buying and selling on such platforms. These changes aimed to attract and benefit the participants and facilitate a secure transaction. However, during June-September 2023, the share of non-institutional investors in funds raised through bonds was four per cent compared to the general average of less than one per cent. Institutional investors dominate the corporate debt market in India because a large portion of bonds are issued to selected investors or institutional investors through private placement. The paper reveals a worrisome figure of ninety-five per cent of the issuers resorting to the private placement account for ninety-eight per cent of the funds. The participation of non-institutional investors remains abysmally low at just 2 per cent. The average participation by non-institutional investors for FY 2021-22 and FY 2022-23 remained below two per cent (Annexure III).
There are strong economic reasons to push for retail investor participation; not only do they help to diversify the portfolio for the retail investor, but they also allow the issuer (government or corporation) to diversify and distribute their risk. The burden distribution from the central bank or the conventional investors becomes crucial during economic hardships when overreliance on a particular set of mainstream investors can further aggravate the situation.
The proposed impetus to retail investors by SEBI
SEBI has proposed to further reduce the face value from Rs one lakh to Rs ten thousand to do away with the barrier of face value. It has specified such bonds to be ‘plain vanilla’ bonds. Plain vanilla instruments have simple interest rates and predetermined maturity dates thereby containing the risk. After the 2008 financial crisis, economies across the globe are more inclined to issue plain vanilla debt instruments. The US introduced the Dodd-Frank Wall Street Reform and Consumer Protection Act that promoted the issuance of plain vanilla debt instruments and raised the burden of disclosures and compliance for non-vanilla debt instrument issuers.
The securitised debt instruments, i.e., bonds backed by assets such as loans or leases that generate cash flow, are also being increasingly issued with corporate bonds as the underlying asset. Given the prevalence of securitised debt instruments, all proposals concerning bonds have been made applicable to such instruments as well. These recommendations to safeguard potential retail investors are crucial, but they only deal with seemingly overt threats.
Risks intrinsic to the retail investors
Multiple factors have a bearing on bonds, and most of which are not apparent on the face of it. There lies the problem. The significant factors for consideration in the case of stocks are market risk and company-specific risk, information about both of which is readily available and easily comprehensible.
In the case of bonds, the major factors are interest rate and credit rating. The interplay of interest rate (the repo rate decided by RBI in India) on the one hand and bond price and yield to maturity, on the other hand, is difficult to comprehend for a retail investor. However, the interplay can be summarised as an inverse relation between the market rate and the value of the bond. Since bonds are long-term investments, an informed decision on bond investment and a deeper understanding of interplay are required, which helps to predict the long-term factors and what the future holds for the corporation. Another critical factor is credit-rating. It suggests a corporation’s likelihood of fulfilment of debt commitment. The best rating for a bond is ‘AAA’, suggesting the highest degree of safety for an investment, and the lowest rating of ‘D’ suggests the likelihood of the company defaulting. There is evidence from the US of loss on investments made by retail investors based on credit ratings. A study suggested the unreliability of credit ratings as a comprehensive indicator of risk and the inability of retail investors to timely detect the risk when bond yields are high. The empirical study pinpointed that the availability of credit ratings does not rule out the risk, and as the saying goes, the devil lies in the detail; in this case, it lies beyond the comprehension of inexperienced retail investors.
Conclusion
The desirability of including retail investors in the bond market lies in risk diversification for investors and corporations, which benefits the economy at large. The intention and endeavour of SEBI are commendable, and it has taken adequate steps to mitigate the overt risks. Risks directly associated with bonds are mitigated by the issuance of plain vanilla instruments and extending these proposals to securitised debt instruments. Nevertheless, a few crucial risks remain in place, which may render the initiative counterproductive. Unless obscure risks specific to the bond market are considered, any investment would be exposed to an unknown degree of risk. The study on the US bond market highlights the strategies of retail investors, exposing them to making wrong and untimely decisions. Retail investors who invest through a fund manager can make the most out of the proposed amendments, given that the expertise of a fund manager would mitigate intrinsic risks. However, individual participation is on the rise, as suggested by an increasing number of demat accounts, which further strengthens the propensity of realisation of the highlighted risks.
An adequate spread of financial awareness should accompany such proposals to prevent such change from turning into a half-baked measure.. Credit rating agencies must be brought into the public discourse, and risks apart from credit ratings must be emphasised equally The technical interplay of interest rate and bond yield must be brought within the observation of retail investors. While face value might have been an active deterrent, a lack of systemic knowledge about the bond market may become a potential deterrent in future by keeping retail investors from profitable transactions. If these proposals are effected at all, there must be an unambiguous exposition of risks.