SEBI's Amendments to the AIF Regulations 2012: Backstopping the Bond Market
[Goutham and Vedant are students at Hidayatullah National Law University.]
The Securities and Exchange Board of India (SEBI) has amended the Alternative Investment Fund Regulations 2012 (Regulations) via a notification dated 15 June 2023 bringing about the Securities and Exchange Board of India (Alternative Investment Funds) (Second Amendment) Regulations 2023 (Amendment). The Amendment has introduced a new type of an Alternative Investment Fund in Chapter III-C to the Regulations, namely the corporate debt market development fund (Fund).
The objectives of including the Fund in the Regulations have been laid down in the SEBI Board meeting dated 29 March 2023. SEBI has created the Fund with the objective of establishing a backstop facility, which is a financial arrangement that provides additional funds if the primary source fails to meet essential demands, serving as a final support option. The backstop facility is specifically designed to buy investment-grade securities when the market is experiencing financial difficulties. It has been brought in to enhance trust among participants in the corporate bond market and enhance liquidity in the secondary market as a whole.
The Fund shall be established as a trust, and shall be close-ended with a tenure of up to 15 years. Units of the Fund shall be offered to asset management companies and specified debt-oriented schemes of the mutual funds. During periods of market dislocations, the Fund shall in proportion to the contribution made in it at a mutual fund level, buy corporate debt securities from schemes of mutual funds that are listed and have an investment grade rating, the residual maturity is not more than 5 years from the date of purchase and have no material possibility of default or adverse credit news or views. Such securities are to be held by the Fund till maturity or they can be sold in the secondary market upon reversal of the market dislocation.
The Fund has been empowered by the National Credit Guarantee Trustee Company Limited (NCGTC) with a leverage to borrow funds up to ten times the size of its corpus provided that the guarantee shall not exceed INR 30,000 crores.
In ordinary circumstances, the Fund shall invest in liquid and low-risk debt instruments. Such instruments shall not be bought at distress prices but at fair prices that may be adjusted for liquidity, interest-rate, and credit risk provided that the investment by the Fund in any investee company shall not exceed five percent of its fund capital at the time of investment. Furthermore, the Fund may also be permitted to undertake various activities related to the corporate debt market including repo, securities lending and borrowing mechanism , etc., as may be permitted by SEBI Board from time to time, subject to suitable risk management measures.
With the premise of SEBI's establishment of a backstop facility and its intended benefits set forth, it is imperative to contend that the proposed changes, in and of themselves, may fall short in adequately addressing the underlying issues at hand.
Can the Fund Handle Redemption Pressure?
The corporate bond market in India is still in its developmental phase. There is a lack of confidence among Indian investors regarding corporate bonds. In market dislocation events, such lack of confidence gives rise to unprecedented risk aversion. This puts significant redemption pressure on the open-ended mutual schemes that usually buy these corporate bonds.
Even though the Amendment has worked towards the objectives laid down in the Board meeting, it is evident that the backstop facility is, but a limited contingency plan in times of emergency in a market that is growing and is larger than the backstop facility guarantees.
Based on the Indian experience regarding debt markets, the redemption pressure during market dislocation is in the range of INR 80,000 crores to 1,00,000 crores. Given that the guarantee provided by NCGTC has been capped at INR 30,000 crores, it seems unclear as to how SEBI is planning to alleviate the conundrum of redemptions during market disruption. This is because it is also unrealistic to expect the government to guarantee a larger quantum in such situations without a pre-existing mechanism.
A healthy bond market requires liquidity, and accurate risk assessment. A mitigation of the risk usually prevalent in emerging markets such as India has been addressed by the introduction of the Amendment. As asserted above, the growth of the corporate bond market in India is heavily dependent on AAA and AA rated bonds being issued by major corporations. This has been recognised by the RBI as well. However, there have been no concrete measures so far as to ensure a better market for lower yield bonds issued in the market, despite this issue having been raised since 2011.
Moreover, when faced with substantial redemption pressure due to market dislocation, mutual funds encounter difficulties in selling their investment grade bonds with lower ratings, primarily because investors are highly risk-averse in such situations. As a consequence, they are compelled to offload their high-quality assets, leading to a greater proportion of low-rated instruments in their overall portfolio. In the Backstop Facility envisioned by SEBI, the Fund will not be able to stop such undesired allocation of low-rated instruments in the portfolio as through the Amendment, they are prohibited from buying securities that have a material possibility of default or adverse credit news or views. This is because the credit views on an instrument are influenced by the economic, political, and regulatory environment. This in turn is contingent on the levels of risk aversion and the subsequent redemption pressure in the market. Thus, the Fund may be prohibited from buying low-rated instruments during market dislocations because of their adverse credit news or views.
“Swap”ing for More
Issuances of non-investment level bonds have not yet picked up momentum in India even today, and it is arguable that for a comprehensive development of the bond market, the issuance of small-scale non-investment grade bonds must also be factored in. The primary reason for this stunting is due to the high credit risk associated with these bonds. There is also the fact that these defaults in the corporate debt market are usually only remediable through legal means, and there is no market remedy that provides liquidity to high-risk bonds. That is why, even though the Fund has, in a restrained manner, addressed the issues associated with the bond market with respect to high grade investment bonds, SEBI must also take parallel steps to ensure investor confidence and alleviate credit risk in such lower credit rated bonds as well in order to ensure a holistic development of the Indian corporate bond market.
A step towards this is to encourage and ensure the development of a healthy credit default swap (CDS) market. Even though the CDS was recognised as a credible form of credit derivative through the Bilateral Netting of Qualified Financial Contracts Act 2020, there have been no measures to promote their trade in the market.
It can be argued that making CDS mandatory as a form of insurance for high-risk bonds, and ensuring a healthy secondary market for CDS instruments for investment level bonds to alleviate default risk are steps that are recommended to be taken. The reason behind this is that an active and developed CDS market provides liquidity in the corporate bond market as well, which has also been observed by the International Organization of Securities Commissions (IOSCO), since the CDS instrument traded in that market is interconnected with the underlying bond itself. In other countries, such as the United States with a healthy and developed bond market, it can be seen that the market for CDS instruments is also booming.
Strengthening Credit Rating
Another major issue that the Indian corporate debt bond market suffers from is the unreliability of the credit rating agencies that operate in the grading of debt bonds. The credit rating of bonds traded in the secondary market is essential in its price discovery and liquidity. There is evidence to the fact that CDS instruments are complementary to credit rating agencies in ensuring a much more credible and accurate credit rating of bonds in India. This can help with the ailment of credit rating of bonds in India that is also a symptom of how nascent and underdeveloped the market is, so far.
In conclusion, while the SEBI’s introduction of the Fund through the Amendment is a step in the right direction to address certain issues in the corporate bond market, it may fall short in adequately resolving the underlying challenges. The backstop facility, though valuable in times of market dislocation, has limited capacity and may not fully alleviate redemption pressure. To achieve a comprehensive development of the bond market, SEBI should consider promoting a healthy CDS market, encouraging the issuance of lower-rated bonds, and addressing concerns related to credit rating agencies. Such measures can enhance investor confidence and foster a more robust and liquid corporate bond market in India.