India's NBFCs have grown their loan book at a rate of 18 per cent in the last five years, with the sector's contribution to total credit increasing from 15 per cent to 20 per cent in just three years. They play a pivotal role in meeting the financial needs of individuals and businesses that have traditionally remained underserved by banks.
While NBFCs are recognised as a distinct segment, their major source of funding even today is the banks. In FY2017, borrowings from banks made up 21.2 per cent of NBFC borrowings, which jumped to 23.6 per cent in FY2018 and 29.2 per cent in FY2019.
In recent years, this reliance on banks has come at the cost of inadequate funding, mainly due to deterioration in the credit profile of banks and the overall weakening of confidence in the sector following some high-profile defaults.
The solution is to deepen India's bond markets to free the NBFCs from excessive dependence on banks, and make the occasional failures (IL&FS, DHFL) less traumatic for the banking system. The development of an active and liquid corporate bond market can help greatly in the transparent and efficient financing of the businesses.
What prevents the growth of the bond market in India? Many factors have played a part, such as the dominance of banks in lending, the limited risk appetite of individuals, requirement of higher credit rating, tax arbitrage, and prescriptive regulatory limits on investments. But most importantly, retail participation in debt markets is minimal even as the mindset of the Indian investor favours fixed-income instruments (47% of annual household financial savings flow into bank deposits).
Why is then retail participation in our debt market so low and what can be done to remedy it? To begin with, there is not enough public interest as the Indian bond market is highly skewed towards institutional investors, effectively shutting out retail investors and their money.
This can be corrected by greater retail investor participation in the debt market, in the way that the equities market has managed to attract sizable retail participation. Today, more than 15% of issued equities in India are directly held by retail investors, but their direct participation is less than 1% in the debt market, be it on transaction volume or the size of investments.
How do we attract retail investors to the debt market? Here are some suggestions for Finance Minister Nirmala Sitharaman to consider in the Union Budget 2021.
Address the problem of plenty
There are just too many debt instruments in the market. Every issuer would have issued dozens of instruments in a year. In contrast, in the equity market, there is usually only one instrument to trade. This generates enough liquidity for retail participation, which is not the case for debt. Accordingly, the Budget may look at the long-pending proposal to allow re-issuance of debt instruments as in the case of equities. Companies will be able to re-issue listed bonds to raise funds or even buy-back in case of surplus.
Also, issuers should be required to set a uniform record date for interest payments so that every instrument shall pay interest on fixed dates (say, the first or last working day of the month). Further, there is a need to enforce standardisation of the debt market instruments in terms of their non-financial properties.
Consider restricting multiple issuances and have them clubbed under a few categories, say, three months, one year, three years, five years, and so on. In the equities derivatives market, there are only three instruments available for trading at a time. Likewise, there should be a limited number of debt instruments from each issuer in the market.
Currently, debt instruments trade on a dirty price method (which includes the accrued interest) which should be shifted to trade on a clean price basis (price of the instrument + accrued interest payable over the clean price) for which effective yields have to be published, just as we publicise the equity prices.
Perhaps the most important factor restricting retail participation in debt markets is tax arbitrage when dealing with interest-bearing instruments. Investors are liable to pay varying rates of tax depending on the route taken.
When an investor routes his investments via an institution (Mutual Fund or Insurance company), he enjoys the benefit of indexation and capital gains, and the interest earned is not clubbed with his income. But when he invests directly in the debt instrument, a significantly higher tax rate applies.
Accordingly, to enhance retail participation in the debt market, we must make the interest earned tax-free (irrespective of the investment channel) up to a defined threshold. Assuming that most retail investments would be of less than Rs 10 lakh, an exemption of tax on even Rs 1 lakh of annual interest income will attract hordes of direct retail participants. At the very least, there should be no preferential treatment to institutionalised investment, if retail participation is to be encouraged.
Retail debt protection fund
Retail investors may also be averse to investing directly in the debt market on account of the risk element. Here is a suggestion towards instilling investor confidence in debt markets.
The government may institutionalise an investor protection fund that would guarantee principal protection up to a limit (say Rs 1 million) to retail investors in case of default. Issuers can buy the protection at a cost from the agency, just like banks have access to deposit insurance.
Issuers buying the protection can get the benefit of enhanced retail confidence and the agency can charge the premium based on its credit evaluation or rating etc. Once the system stabilises, we may even make it mandatory for retail issuances to be insured and use the investor education fund to educate and encourage retail participation in the debt market.
(The author is MD & CEO of Manappuram Finance Ltd. Views are personal.)