by Ritika Chhabra and Anjali Sharma.
On January 04, 2017, SEBI released a discussion paper titled "Public Issuance of Non-Convertible Debentures having credit rating below Investment Grade" (hereafter, discussion paper) for public comments. The proposals in the discussion paper focus on retail investors' participation in public issuances of sub-investment grade non-convertible debentures (NCDs). Each of these terms is technical and its useful to understand what they mean before analysing SEBIs proposals:
While protecting retail investors' interest in securities markets is one of SEBIs stated objective, there is no standard definition of a retail investor which is consistent across securities. For example: for equity public issuances, a retail investor is one whose bid does not exceed Rs. 2 lakhs. For issuance of tax free bonds, the IT Act, 1961 defines retail investor as one whose bid does not exceed Rs. 10 lakh.
A public issuance is defined as per Section 42 of Companies Act, 2013 as one where securities are issued to more than 200 investors. Typically, public issuance of corporate debt securities is in the form of NCDs. The issuance process is laid down by the SEBI Issuance and Listing of Debt Securities (ILDS) Regulation, 2008. As per ILDS Regulation 4(2)(c), for public issuance of debt securities, the issuer has to get at least one credit rating.
A sub-investment grade rating is one that is below BBB-. Debt securities with this rating are commonly referred to as junk bonds.
In the discussion paper, SEBI makes two proposals with regard to such issuances. First, the introduction of a pictograph, known as the risk-o-meter, to disclose credit rating in the offer document. Currently, credit rating is disclosed on the first page of the offer document in text form. Second, the introduction of a two level restriction on retail investor participation - an investor level restriction: Rs. 2 lakh; and an aggregate restriction on all retail investors: 5% or 10% of the issue size.
In this article, we evaluate SEBIs proposals and offer our analysis of key issues that this discussion paper highlights.
Analysis of SEBIs proposals
The proposals are relevant for a very small part of the corporate bond issuance market: The market for public issuance of sub-investment grade NCDs is small, both in absolute terms and relative to the corporate bond market (Table 1). In 2015-16, 2 of the 20 public issuances were sub-investment grade and these accounted for only 1.3% of the public issuance volume. As a proportion of the total corporate bond issuance volume, these were less than 0.1%.
When we look at the identity of issuers and the rating profile of their issuances, we find that the public issuance market is dominated by highly rated issuers. These include large public sector entities like NTPC, NHAI, NABARD, IRFCL and 3-4 private non-bank finance companies (NBFCs) who are regular issuers. There are only 2-3 NBFCs which issue in the sub-investment grade category and these are repeat issuers.
Retail investors, for whom investment limits are proposed, are the main investors in publicly issued sub-investment grade NCDs: We find that retail investors are the primary investors in these issuances. For example: 16 unique ISINs were generated as part of 2 issuances in 2015-16. An analysis of the ownership pattern of these ISINs, using data from NSDL, shows that in 15 ISINs, retail investors' subscription was more than 90% of the issue size. In the remaining one ISIN, it was more than 70%.
SEBIs problem identification is unclear and not supported by data: In the discussion paper, SEBI states:
Unlike private placement of debt securities, retail investors participate in the public issues. These public issues which are rated below investment grade (i.e. below BBB-) give high coupon rate. The advertisements of such issues also focus mainly on the coupon which lures the retail investors to invest.
Further, certain issuers with credit rating below investment grade, have issued both secured and another unsecured NCD through same offer document with different credit ratings. Thus, for a retail investor to differentiate between secured and unsecured tranches within the same offer document and with different credit ratings may be a complex task and may affect their investment decision.
It is felt that there needs to be an additional layer of protection for the retail investors, who get attracted towards such debt securities which though on one side pay higher coupon but on the other side have a below investment grade credit rating.
From these statements, it appears that SEBI identifies three problems: (1) the manner of disclosure of credit rating in sub-investment grade issue advertisements; (2) issuers offering secured and unsecured tranches within the same offer document, which makes in complex for retail investors to understand credit rating; and (3) retail investors getting attracted to the return and investing in risky securities.
There are two issues with SEBIs problem identification process. First, it is not supported by any data or analysis. For example in case of problem (1) and (2), there could be two issues: with the visibility of the text based disclosure, or with investors' understanding of the meaning of a credit rating or both of these. It could also be that there are more problems with disclosure quality than just credit rating or that disclosure quality is not a problem at all. Retail investors are attracted by high returns, are aware of the risk, yet invest because of other considerations, such as fact that these are repeat issuers and their past performance is known. Second, the problem identification does not evaluate whether a regulatory intervention is needed. For example: in case of problem (3) if retail investors are attracted to risky securities, it is unclear why the regulator should step in.
Cost benefit analysis is missing: Proposal 1 -- introduction of a risk-o-meter, seeks to address problem (1). Credit rating is currently displayed in text form on the first page of the offer document. The table that explains the implications of the rating is placed inside the offer document (Figure 1).
Figure 1: Current disclosure of credit rating in offer document
The proposed NCD risk-o-meter makes the credit rating more clearly visible than a text based disclosure (Figure 1 and Figure 2). However, it does not necessarily improve investor understanding of the credit risk. In case of the mutual fund risk-o-meter, from which this proposal is inspired, the risk of the offer can be clearly understood from the risk-o-meter (Figure 3). As mentioned earlier, its possible that investors do not understand credit risk or that there is no problem with the current disclosure format. In both these cases, the inclusion of a risk-o-meter adds no value. The modification of the offer document format may create costs for issuers. However, no cost-benefit evaluation is offered in this regard.
For problem (2), where an unsecured and secured tranche is issued through the same offer document, SEBI offers no proposals. For example: it does not state whether such offer documents will have two risk-o-meters.
Figure 2: Proposed NCD risk-o-meter
Figure 3: Mutual fund risk-o-meter
In Proposal 2 -- introduction of a investor level and aggregate level investment limit for retail investors, SEBIs approach is contrary to its approach to retail investors in equity markets. An equity security is far riskier than a sub-investment grade bond, yet SEBI actively encourages retail investor participation in equity issuance. Further both the limits proposed: Rs. 200,000 per investor and 5% or 10% aggregate limits are arbitrary. The benefits of this proposal from an investor protection perspective are unclear. Yet the costs are obvious. Given that retail investors are the main investors in these issuances, these limits may cause the sub-investment grade issuance market to dry up completely. Also, regulatory interventions that seek to limit investor choice are a firm step away from SEBIs stated objective of being a disclosure based regulator and a step towards being a merit based regulator.
|Year||Issuance value||Private placement||Public issuance||Public issuance - sub-investment grade1|
|1 Sub-investment grade represents a credit rating below BBB-|
|2 Data till December, 2016|
A small survey: can key disclosures be easily found in offer documents?
Given that SEBI has identified the visibility of credit rating disclosure in offer document as a problem, we conducted a small survey to understand whether other key disclosures can be easily found from an NCD offer document. We gave respondents an offer document for a public NCD issuance, and asked them to find three details about the issue from it: (1) whether the issue is secured or unsecured, (2) what is the rate of return, and (3) what is the tenure. We asked them to measure the time it took them to find this information. 15 personnel from Indira Gandhi Institute of Development Research (IGIDR) and the National Institute of Public Finance and Policy participated in the survey. Table 2 provides a profile of the respondents and Table 3 shows they survey results.
|No. of respondents||15|
|Respondents with demat account||53%|
|Respondents who invested in equity securities in the last 18 months||40%|
|Respondents who invested in debt securities in the last 18 months||20%|
|Average time taken to respond to the survey||15-30 minutes|
|Questions||Correct (%)||Incorrect (%)||Can't say (%)|
|Is the issue secured or unsecured?||67%||20%||13%|
|What is the size of the issue?||47%||40%||13%|
|What is the minimum tenure of the NCD?||27%||53%||20%|
|What is the yield for minimum tenure NCD?||40%||40%||20%|
|What is the maximum tenure of the NCD?||33%||40%||27%|
|What is the yield for maximum tenure NCD?||20%||53%||27%|
The survey results point to a deeper problem in offer document disclosures than just the credit rating. Even locating basic information like yield and tenure is not easy.
As a separate exercise, we reviewed 5 abridged prospectuses from public issuances done in 2015-16 and 2016-17. An abridged prospectus accompanies the application form, and SEBI has mandated that the issue term sheet be disclosed on the first page. Even here, we found that in 1 case the terms of the issue were not on the first page. This was a case where issuance was done as part of a shelf prospectus. A typical abridged prospectus is around 40 to 50 pages in length, and even here it is not easy to locate key disclosures within it.
Conclusion: way forward for SEBI
SEBIs proposals in the discussion paper focus on retail investor protection. Globally, regulators follow a two pronged disclosure based approach to do this. First, reducing information asymmetry between issuers and investors by regulating the quantum and quality of disclosures. Second, enforcing disclosure standards and penalising violations of disclosure norms. Securities regulators, even in Asian countries, have moved away from the merit based approach of imposing investment limits.
Given SEBIs stated objective of being a disclosure based regulator, it needs to focus on improving disclosure quality, not on constraining retail investor participation. However, this requires adopting a systematic and research based approach to addressing the disclosure problem. Our survey findings suggest that SEBI needs to do the hard work of evaluating disclosure effectiveness more comprehensively. In undertaking this exercise, SEBI can take cues from the recommendations of the Sumit Bose Committee (2015) on improving disclosures and curbing mis-selling for financial products. Simply, introducing a risk-o-meter will be insufficient and ineffective.
Other measures, such as stepping up investor education efforts in the debt securities space, may also be relevant. In case of equity securities, SEBIs efforts in this area along with the efforts of a growing industry of equity analysts and proxy advisory firms has contributed to improving investors' understanding of risks and return. A similar effort for the corporate debt market may have greater long term benefits, for both investors and issuers, than introducing any investment constraints.
Finally, sound regulatory governance is critical to building participants' confidence in the financial system and fostering certainty. Regulatory capacity is finite and regulatory interventions not cost-less. Hence, regulation making needs to follow the discipline of a robust process of identifying a problem, proposing an appropriate solution based on research and analysis, evaluating costs and benefits and carrying out a public consultation process. This will ensure that only meaningful interventions, for which benefits exceed the costs, get enacted. SEBI has already started on this path by regularly seeking public feedback on proposed interventions. However, its proposals are not supported by robust problem identification. There is no cost benefit analysis, research or empirical evidence in support of the proposals made. It shows that SEBI has some way to go in meeting global standards of regulatory governance.
The Finance Research Group has submitted its comments on this discussion paper to SEBI.
Ritika Chhabra and Anjali Sharma are researchers at Finance Research Group. We thank all the FRG-IGIDR and NIPFP team members who took time out from their busy schedules to respond to our survey. We also thank Renuka Sane and Bhargavi Zaveri for useful discussions and suggestions.