Budget Expectations: What the Bond Markets want?

23 Jan 2024 , 08:02 AM

INDIAN BOND MARKETS: A STORY OF CONTRASTS

Indian bond markets are not small by any measure. With a total size of $1.3 trillion, which is nearly Rs108 trillion. In terms of capitalized value, that is a little under a third of the equity market cap. At $699 billion, the corporate bond market is half of the overall bond markets in India. However, the total FPI holding in bonds stands at just about $9 billion as of the date. Contrast this with nearly $750 billion of assets under custody in equities. The volumes in corporate bonds are expected to double in the next two years. 

However, there is already a huge demand gap of nearly Rs5 trillion in Indian corporate bonds. Being an interim budget, little can be expected in terms of long-term changes. However, it can surely set the agenda for the full budget in terms of the expectations of the bond markets. Here is what the budget can do for a start, with reference to bond markets. But, first a look at some of the key developments in debt markets in recent years.

KEY DEVELOPMENTS IN BOND MARKETS IN RECENT YEARS

As bond market volumes have picked up in the last few years, here is a quick look at some major announcements pertaining to the bond markets in recent years.

1. It is now confirmed that Indian government bonds will start to be included in the major global bond indices of JP Morgan, followed by an inclusion in the bond indices of Bloomberg. Budget muse provide a timetable and its implications. 

    

2. On a connected note, the inclusion in bond indices is expected to bring in global passive investments in government bonds to the tune of $30 billion to $35 billion. That is a lot of money and is likely to create volatility in flows and currencies. The government must have a back-up plan to handle this heightened volatility, without knee jerk reactions.

    

3. The Union Budget 2015-16 allowed the issue of tax-free infrastructure bonds for projects in roads, rail, and irrigation. These investments were subject to lock-in and the deployment can only happen in approved infrastructure projects. Such infrastructure bonds can also be issued as zero-coupon bonds.

    

4. For major bond investors like insurance companies and pension funds, the lower limit for buying bonds, is companies with AA ratings. In Budget 2018, the finance minister had urged the regulators to allow institutional investments in “A” instruments also to broaden their choice. 

    

5. In Budget 2020-21, NRIs were allowed to invest in government securities under the fully accessible route (FAR). This would be restricted to certain classes of debt only. Post the JP Morgan index inclusion, funds from NRIs into debt through the FAR route has grown by nearly 35% and that could be a swing factor for the future. 

    

6. Budget 2022-23 had announced the issue of sovereign green bonds as part of the overall government bond issue program. The proceeds of such green bonds were to be strictly deployed only in public sector projects which help in reducing carbon intensity. They will be for a longer maturity and the rate of interest will also be lower.

Some of the above changes like green bonds, inclusion in global passive indices and leeway in the rating categories can go a long way in deepening and broadening Indian debt markets. Let us now look at specific areas for Budget 2024-25 to focus on.

1. TIME TO CREATE A DEDICATED MUNICIPAL BOND MARKET

While announcing the last budget for financial year 2023-24, Nirmala Sitharaman had underlined that the government will incentivize the municipal corporations across India to improve their credit standing and be eligible to issue municipal bonds. Experts believe that one of the big challenge to the structuring of municipal bonds is to ensure that municipal corporations have their financials and audit trails available in a transparent fashion. 

The other constraint is rating. Banks, insurers, and pension funds would only invest in bonds with rating of AA or above. However, currently most municipal corporations will not even be able to get AA rating, which puts them out of the bond market. Today, only a handful of municipal corporations like Ahmedabad, Vadodara, Indore, and Pimpri-Chinchwad have been able to raise funds through municipal bonds.

The government needs the municipal corporations to address the issue of fund raising themselves, rather than depending on loans from the central government. Globally, municipal bonds are a big chunk of the bond markets, but it is almost non-existent in the Indian markets. Clear incentives in the Budget 2024-25 for developing municipal bond market can go a long way in making the debt markets broader and giving an additional product to choose from.

1. KEEPING GOVERNMENT BORROWINGS AND FISCAL DEFICIT IN CHECK

Between FY22 and FY24, the government borrowings hav gone up from Rs12 trillion to Rs15.5 trillion. The borrowing program for FY25 is also likely to higher by about 10%. Excess borrowings mean private bond raisings get crowded. Also, if the debt raising in the year is too high, it puts pressure on the base interest rates. Bond yields go up in tandem with the higher demand for funds and that increases the cost of funds. 

The other thing for the government to keep in check in this budget is the fiscal deficit or the budget deficit. For FY24, the fiscal deficit is pegged at 5.9% of GDP. What markets will want from the Union Budget 2024-25 is a clear glide path towards 4.5% in FY26, as originally committed. That would imply a fiscal deficit of around 5.3% for the upcoming Union Budget. The glide path is necessary to keep the rating agencies and FPIs satisfied that the government continues to be fiscally responsible. 

This is especially true, with the JP Morgan inclusion coming up. In fact, with robust revenues next year and lower fiscal deficit in FY25 (as share of GDP), the government can even be brave enough to either hold the total borrowings at the same level or even cut the borrowings marginally. That would send out an excellent signal to the bond markets.

1. BOND MARKETS APPRECIATE A TRAJECTORY OF BENIGN INFLATION

Over the last year and half, we have seen a lot of RBI intervention to manage inflation. Repo rates were raised rapidly from 4.00% to 6.50% in a span of just nine months in 2022. That did help the headline inflation come down sharply, but in recent months we have seen pressure from food inflation and fuel inflation picking up. The bond markets prefer inflation at a benign level or, at least, trending towards a benign level. 

What can the Union Budget do to give a hint of benign inflation through the Union Budget announcement? There are several things that can be done. For example, the government can outline a clear Plan-B for oil, considering the rising geopolitical tensions in West Asia and the Red Sea. It could be procuring supplies through Russia or through other sources, but that would help rein in inflation. 

On the food inflation front, the budget can announce measures like investments in post-harvest infrastructure, direct selling by farmers, facilities for better preservation of food crops etc. These can go a long way in bringing down the expected inflation. That will be overall positive for the bond markets.

1. ENCOURAGING RETAIL PARTICIPATION IN BOND MARKET

The government has taken the right step to encourage retail participation in the debt market through the user-friendly RBI-Retail Direct Account. However, that is only the start and a lot more needs to be done. Here is a sampler of the agenda for Budget 2024-25.

• The TDS rules on interest on corporate bonds should either be zero, like in the case of government bonds or the limits can be much higher as in the case of bank FDs. This can reduce the compliance burden of retail investors.

   

• Like there are special tax incentives for bank deposits for a holding period of 5 years or more under Section 80C, a similar exemption can also be extended to all bonds subject to lock-in of 5 years. That will bring in a lot of retail and HNI investors into the fold.

   

• Much of retail interest in debt gets channelled through the debt fund route. To help make debt markets broader, the government can either make dividends on debt funds tax free, or at least, reduce the rate of tax from the peak rate to boost post-tax yields.

   

• Over the last many years, a product similar to ELSS is being mooted in debt funds also. This will ensure that conservative investors can use the DLSS route to manage their tax liability. There is surely an appetite for such products.

   

• Finally, to channel more retail investors through the debt fund route, the budget can look to extend the same requirement for long classification of long term capital gains (holding of 1 year or more) to debt funds. This is the classification for listed debt.

Retail participation has been the key to the growth in equity markets and there is no reason, the same can be true of debt markets also. 

1. BUDGET 2024-25 MUST REVISIT THE IDEA OF SOVEREIGN BONDS 

With forex reserves of well over $600 billion and a fast growing economy, it is time India uses the sovereign bond route to raise funds. There are still a lot of apprehensions about sovereign bonds after the experiences during the Asian crisis. However, India is in a much better position today to raise sovereign bonds. The macros are largely favourable and the forex position and the trade deficits are also largely under control.

In the Union Budget 2019 the government had announced plans to raise $10 billion via offshore sovereign bonds (government debt in foreign currency). That was dropped due to pressure of macro concerns amidst the pandemic. With the government grappling with growth and inflation in the last few years, sovereign bonds were off the agenda. Now that the situation has largely stabilized, it is time that India seriously considers using them again. 

There is likely to be a lot of investors keen to put money in sovereign bonds issue by the Indian government. Today, India has the leeway to go aggressive through sovereign bonds. It remains to be seen, how government manoeuvres its borrowing program, but it is time the Union Budget gives its hesitation around sovereign bonds program.

1. INDIA NEEDS A BETTER SOVEREIGN RATING NOW

It presents a rather anomalous situation when foreign investors consider India the hottest market but rating agencies keep India just 1 notch above default classification. That is obviously not fitting in. It is time for the government to sit down with the top rating agencies and work out a time table for working towards improved rating. The onus is then on India to meet these targets and on the rating agencies to stick to their side of the bargain. Improved ratings would mean more foreign capital comes into India and also that Indian government and companies can raise debt capital globally at much lower cost. That exercise must be initiated in this Union Budget, since it is more of a long term investment.

To sum up, as India makes the next leap to massive infrastructure overhaul and $5 trillion GDP, shaping the debt markets assumes much greater importance. The check boxes are in place. The budget must be the first step to ensure debt markets are able to meet the challenges of a more complex tomorrow.