The SEBI (Securities and Exchange Board of India) has proposed changes that could make corporate bonds more accessible. So in today’s Finshots, we talk about how this new change could plausibly affect the world of corporate bonds.
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The Story
A couple of days ago market regulator SEBI proposed to make some tweaks to how corporate bonds could be issued. We’ll break down that term for you in a bit, but for now, just think of it as a way for companies to borrow money from investors. SEBI simply suggested lowering the face value of these corporate bonds. Face value is the basic value of any financial instrument. So if a company wants to raise ₹10,000 by issuing 1,000 bonds to its investors, you could say that each bond has a face value of ₹10. If this bond is listed in the market it could trade at a different price depending on the demand and supply, which becomes its market value.
Now, the SEBI’s consultation paper intends to lower the face value of privately issued corporate bonds to ₹10,000 a pop. Simply put, this applies to corporate bonds that won’t get listed publicly. This value was ₹10,00,000 until last year. And was reduced to ₹1,00,000 in October 2022. And Zerodha’s* CEO Nithin Kamath even shared his thoughts on X and described it as a move that could “lead to greater retail participation in the bond markets.” So, what’s happening and why does it even matter?
Well, to get to that, we’ll first have to understand the world of corporate bonds. See, companies can raise money in many different ways. They could borrow from banks or other financial institutions. They could issue their shares to the public. And if they don’t want to go either way, they could simply borrow from people. Basically, they tell investors why they need the money. Maybe they want to expand production capacity, open new branches in unreached towns and cities or have a promising project.
Now here’s the thing. Investors don’t get a share in the profits that these projects generate. The company simply tells them “Hey, lend us the money now and we’ll return it a couple of years later.” The couple of years may be 2 years, 3 years, 5 years, 10 years or more. But they get an interest every year for the amount they loan to the company.
Okay, but why would investors want to dabble with corporate bonds if they can do the same by investing in fixed deposits or earn better returns by simply investing in the stock market, you ask?
It’s simple really. Corporate bonds offer a different risk/reward profile. Let’s assume that an FD offers you a 7% interest every year. A corporate bond is slightly riskier, so it offers you a higher interest rate of say 10%. And costs are rising at an average inflation rate of 6%. After 3 years, both your FD and bond interest rate will be taxed at a rate depending on the income tax slab you belong to. So if we assume that you belong to the highest tax slab of 30%, you effectively end up earning only 4.9% from your FD. On the flip side, the corporate bond will easily fetch you 7% interest even after tax. It beats inflation, something which the FD interest doesn’t.
And if you were to compare corporate bonds to the stock market, the premise is simple again. Stocks are risky. Not that bonds aren’t. But bonds have to be rated by a credit rating agency. So bonds with a good rating can be less riskier than the volatility of the stock market.
That explains why a corporate bond could be attractive for retail investors like you and me. It could be the sweet spot between the extremely safe FD and the extremely volatile stock market.
But there’s a problem. Retail investors have never been able to participate in the corporate bond market so easily. The reason? There were quite a few entry barriers.
For one, companies like raising bond money privately more than publicly. They don't have to file an offer document with SEBI when they do it in private. They don’t have to market their bonds so much. It saves time, effort and money. But this also means that these bonds are offered to a small number of investors. Typically less than 50 investors who have a lot of money to pour in. So retail investors may simply be unaware of such an investment opportunity. To put this in perspective, in FY22 the amount of money raised through publicly issued corporate bonds was just a measly 2%. The remaining funds came through the private route.
Another huge barrier is the price itself. If you remember, we told you earlier that these bonds came with high face values. Folks like you and me may not have that kind of money. So we wouldn’t be able to afford to invest lakhs of Rupees in a single investment option. But SEBI’s new proposal intends to reduce that, so it won’t be hard to think of it as an investment avenue.
All that is okay. But what will SEBI get by making corporate bonds more accessible?
You see, India’s corporate bond market isn’t as big as its global counterparts. For context, over the last decade, the corporate bonds outstanding in the market have grown 3x to ₹40 lakh crores as of FY22 from just ₹12 lakh crores in FY12. But if you were to talk of it as a percentage of GDP, it only forms about 18%. For comparison, the corporate bond market to GDP market ratio is a whopping 120% in the US, 80% in South Korea and 36% in China. And the only way to grow it further is by getting more people to invest in it.
Lower face values could easily be that bait. SEBI has proof too.
Its consultation paper suggests that between July and September this year, retail investors subscribed to 4% of the amount raised by corporates through bonds. The average otherwise is lower than 1%. And that could simply be a result of SEBI reducing the face value of corporate bonds from the earlier ₹10 lakhs to ₹1 lakh last year.
If the face value dips again, the corporate bond market could swing up even more. It could help companies including government entities to raise capital for infrastructure expansion without overtly depending on banks. Lesser project loans from banks could reduce the pressure of NPAs (non-performing assets), a situation which occurs when companies borrow and are not able to pay up. Sure, it could shift the burden to the retail investor. But maybe that’s what investors have to sign up for when they want to aim for higher returns.
Anyway, it’s just a consultation paper for now. So, we’ll only have to wait and see if SEBI's proposal is something the comments on the paper will favour.
Until then…
*Zerodha, through its Rainmatter Fund, is an investor in Finshots.
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