Movement on corporate bonds

Shilpy Sinha and Swapnil Mayekar have a story in Business Standard offering some optimism about the corporate bond market. They point out that in the six months from April to September 2009, corporate bond turnover was Rs.1.6 trillion, when compared with Rs.0.5 trillion in the same period of the previous year.

SEBI has decided to force many market participants to do netting by novation at a clearing corporation when trading on the corporate bond market. From 1 December 2009 onwards, there will be two possibilities for a trading mechanism:

1. OTC trade, reported on one of the three trade-reporting systems, run by BSE, NSE and FIMMDA, or
2. Order book trade, run by BSE or NSE.

But regardless of how trading takes place, counterparty risk will be eliminated, and netting efficiency obtained, through the clearing corporations. This will be a big win compared with the awful settlement mechanism that's used today. It should reduce transaction costs on this market.

The deeper problems of corporate bonds remain:

1. The lack of a liquid GOI yield curve along with interest rate derivatives, so as to be able to layoff interest rate risk when holding a corporate bond portfolio,
2. The low values for loss-given-default, given the lack of a bankruptcy code and
3. The ban on credit derivatives.

The workaround for #2 is: to stick to trading in short dated bonds from issuers where the failure probability is very low. A workaround for #3 is: to utilise information about credit risk embedded in the stock price.

The right way to think about the corporate bond market is in the context of the Bond-Currency-Derivatives Nexus, which emphasises the interlinkages between the government bond market, interest rate derivatives, corporate bonds, credit derivatives, the currency spot and currency derivatives. All these markets have to achieve liquidity with active arbitrage. The key ingredient for getting there is unifying the regulation and supervision at SEBI. This should address the bulk of the problems of corporate bonds -- other than the problem of loss-given-default.