Basel II - a catalyst in bond market deepening

Analytical contact:
Somasekhar Vemuri
Senior Manager, Criteria and Product Development - Ratings
Tel: +91-22-6691 3106 Email: svemuri@crisil.com

Executive Summary
CRISIL believes that Basel II has opened up wider avenues for investors in the Indian bond market:
the growing number of Bank Loan Ratings (BLRs) has reinforced the acceptability of ratings in the
mid-range, A and BBB categories. Already, around 150 companies that were hitherto not covered
1
under bond/commercial paper (CP) ratings, have been assigned BLRs by CRISIL . Nearly 65 per
cent of these BLRs are in the A and BBB categories. Bankers have been lending to these entities
for a fairly long time; this underscores the bankers confidence in the credit quality of these entities.
It also lends credence to CRISILs belief that BLRs will continue to play a catalytic role in the
deepening of the Indian bond market.

The Story so Far

The Indian bond market is significantly concentrated in government securities and securities rated
2
in the AAA and AA categories. In 2007-08 , securities rated in the AAA and AA categories
accounted for 92.5 per
Chart 1: Rating distribution of new bond issuances
cent (by value) of new
AAA & AA
A & BBB
bond issuances, and
100%
almost 70 per cent of
total issuances (see
80%
Chart 1). However,
60%
the share of securities
rated A and BBB in
40%
new bond issuances
20%
have declined steadily
to 7.5 per cent in
0%
2007-08 from 13 per
1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08
cent in 2000-01. This
is because investors in marketable debt instruments have begun to focus on investments in securities
rated AA and upwards.

1
2

Data as on May 27, 2008

Refers to financial year, April 1 to March 31

Table 1: RBI's new capital adequacy framework

The guidelines for Implementation of The
New
Capital
Adequacy
Framework
(popularly referred to as BASEL II), issued
by the Reserve Bank of India (RBI) in April
2007, encourage banks in India to enhance
the calibration of credit risks in their books
3
(see Table 1 ). In the wake of the BASEL-II
guidelines, a large number of new companies
have availed of BLRs.

Long Term Ratings

AAA
AA
A
BBB
BB & Below
Unrated

Short Term Ratings

P1+
P1
P2
P3
P4 & P5
Unrated

Risk
Weights
20%
30%
50%
100%
150%
100%3

Almost 65 per cent of BLRs assigned by CRISIL, so far, carry ratings in the A and BBB category.
Several companies with credit ratings of A and BBB have been in operation for more than a
decade now and their bankers have had lending relationships for a fairly long time; this reinforces
the bankers confidence in the credit quality of these entities. These companies have debt protection
measures (see Table 2) that are strong enough to attract the attention of capital market investors as
well.
Table 2: Financial medians for companies with A and BBB ratings
Median values

Units

Years in operation

Years

Turnover

Rupees (billion)

Net profit margin

Percentage

Net worth

BBB

22

20

2.64

1.42

5.9

3.5

Rupees (billion)

0.80

0.21

Gearing

Times

0.90

1.14

Net Cash Accruals to Total Debt

Percentage

24

14

Interest Cover

Times

5.17

3.01

Ratings of AA and lower are now better populated than before, providing a more even distribution
of ratings, and benefits for market participants. CRISIL believes that this development presages a
significant deepening in the bond market in India.
The Benefits...
Chart 2: Defaults witnessed in late 1990s

...for borrowers
Total no. of defaults NBFCs which defaulted Steel companies which defaulted
The late nineties were witness 50
to
significant
structural
40
changes in the Indian
corporate sector, and to large 30
defaults (see Chart 2).
20
Subsequently, capital market
investors became increasingly 10
averse to investing in low0
rated debt instruments. Thus,
1997
1998
1999
the low-rated companies
Year
found themselves excluded
from the bond market, and forced to rely heavily on bank loans to meet their funding needs.
However, these companies can now obtain BLRs and showcase their credit quality to investors and
3

Quantum linked risk weights have been stipulated for unrated exposure

counterparties. The capital savings that banks enjoy will be reflected in the pricing of loans. CRISIL
believes that some entities may seek to diversify funding sources, and test the capital markets with
CP or bond issuances.
Given the increasing number of companies with mid-range ratings, and the growing realisation in
the market of the risks associated with such ratings, the markets acceptance of these companies will
improve significantly over time. This is likely to result in more of these entities issuing bonds and
CPs.
...for market intermediaries
Over the past three years, market intermediaries, including investment bankers, brokers and traders,
have successfully brought the small and medium-sized companies to the equity capital markets
through initial public offers (IPOs) and private equity. Now, with BLRs arriving on the scene,
CRISIL believes that these intermediaries have a great business opportunity to replicate the same in
the debt capital markets, with bond issuances of entities with mid-range ratings. BLRs provide an
independent third-party opinion on the credit quality of these entities; this makes it easier for
intermediaries to bring these entities to the debt capital markets. Entities with mid-range ratings
have displayed a robust track record in servicing bank loans for several years, and have strong debt
protection measures; these factors will help market intermediaries place these entities debt issuances
in the capital markets.
...for investors
BLRs present a significantly wide range of investment options in the mid-range rating categories.
The risk of default by an entity is heavily cushioned by the far greater potential for diversification
that investors now possess. Investing in low-rated debt instruments fetches higher risk-adjusted
yield than investing in, say, an instrument rated AAA or AA. For instance, a one-year paper, rated
4
A+, trading at a spread 2.57 per cent above the risk-free rate , will fetch an excess risk-adjusted
yield of 1.44 per cent (see table 3) even after the credit costs and capital requirements, as per BASEL
II, are factored in. The yield, thus, more than compensates for the incremental risks that these
papers carry.
Table 3: Excess risk adjusted yield for A+ and BBB ratings
Excess risk adjusted yields
Ratings

Basel II Capital
Year 1 Year 2 Year 3

A+

1.44% 1.48% 1.38%

BBB

0.25% 1.06% 1.29%

CRISIL believes that the various market participants, acting for their own benefits, are likely to help
develop the Indian bond market.

The Environment, More Conducive than Ever

The Securities and Exchange Board of India (SEBI), which regulates the capital markets, has sought
to facilitate a deepening in the bond markets. The market now has the required infrastructure in
place. Consider the following:

Debt instruments can be listed on exchanges such as the National and Bombay Stock
Exchanges (NSE and BSE); because of recent banking regulations, all debt issuances in
recent times have, invariably, been listed
On-line trading platforms are provided to investors to trade anonymously
Clearing and settlement systems for trading are well-established

(Source: CRISIL bond matrix)

Some fund houses are considering the launch of dedicated funds, such as fixed maturity funds
(FMPs), which have specific mandates to invest in debt instruments carrying mid-range ratings.
CRISIL, therefore, believes that the regulatory and market environment is now more conducive,
than ever before, to a deepening in Indias debt market.

Conclusion
Until not very long ago, the number of key participants issuers, intermediaries and investors in
the bond market was low at the A and BBB categories. However, the implementation of BASEL
II, and the resultant advent of BLRs, will play a catalytic role in the deepening of the bond market
in India. These factors will help generate renewed investor interest in papers in the mid-range rating
category. The regulatory environment is now conducive for a deepening in the corporate bond
market. CRISIL believes that these factors augur well for a significant deepening in the bond
market in India over the medium term.

Disclaimer
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