[Ranak Banerjee is a third-year law student at West Bengal National University of Juridical Sciences, Kolkata]
The Securities and Exchange Board of India (“SEBI”) allowed mutual funds to participate in repo transactions in the corporate bonds market via its Circular in November 2011. This step was taken with a view to expanding the corporate debt market. Very recently, on June 8, 2023, the SEBI issued a Circular (“latest SEBI Circular”), further increasing the scope of repo transactions by mutual funds in the corporate debt market. This development motivates a relook at the corporate bonds market and the effect of the latest SEBI Circular on them.
Mutual Funds, Repo Transactions and the Corporate Bond Market
Repo or sale repurchase transactions of any security (in our case, corporate bonds) is an agreement by the seller to repurchase that security at a future date but at a predetermined price. The transactions are essentially “reversed”. The underlying corporate bonds are instruments which are usually issued to raise short-term debt. The latest SEBI Circular allows mutual funds to invest in repo transactions for Commercial Papers (“CPs”) and Certificates of Deposit (“CoDs”). CPs and CoDs are issued by private firms and the RBI, respectively.
The corporate bonds market has been steadily growing over the past ten years. There has been an increase of 29 Trillion Rupees from 2012 to 2022. However, there is a lack of participation from retail investors, restraining even further growth of the corporate bonds market. Many experts involved in the industry believe that the corporate bonds market is currently at an “inflexion point”, with the involvement of retail investors possibly leading to exponential growth. Such would greatly benefit the banking system, which presently takes on an excessive amount of corporate risk. Retail investors may be encouraged by higher participation by mutual funds.
Mutual funds are well involved in the corporate bonds market, having a share of 15.89% (third highest of any body of investors) at the end of the Financial Year 2022. Repo transactions in the corporate bonds market have also been rising, according to the latest data. The latest SEBI Circular, thus, comes as a point where the corporate bonds market is looking to expand. And opening up more repo transactions for mutual funds in the corporate bonds markets is a move by the securities regulator to capitalise on this opportunity. To better understand the full effect of the latest SEBI Circular, it is pertinent that we look at all the changes introduced.
The SEBI Circular
The primary change introduced by the latest SEBI Circular is the expansion of the scope of investments available to mutual funds. This increase in the scope of possible investments in repo transactions in the corporate bonds market has been done before. Via its Circular in November 2012, the SEBI allowed mutual funds to invest in repo transactions for AA or above-rated corporate debt securities from the previous mandate of AAA-rated corporate debt securities only. This lowering of the credit rating requirement increased the base of securities mutual funds could engage in repo transactions for. The SEBI, thus, has taken steps before to expand and grow the corporate bonds market.
The latest SEBI Circular does also bring about ancillary changes to support mutual funds, which choose to engage in repo transactions in corporate bonds generally or in CPs and CoDs specifically. A welcome introduction is a set of guidelines to formulate the credit rating of exposure on these repo transactions. The latest SEBI Circular lays down that the Potential Risk Class (“RPC”) matrix, liquidity ratios, Risk-o-meter, etc., of the underlying securities, should be considered on a look-through basis. This is an addition to the original Circular of November 2011, which did not lay down any criteria for calculating the credit rating of the exposure on repo transactions in corporate bonds.
Such a guideline increases the trust that financial institutions can place in short-term debt instruments. This is especially true for CPs, which are unsecured and issued by private firms. The secondary market for CPs is small, even though CPs are an important instrument for raising short-term debt by firms. The latest SEBI Circular allowing mutual funds to invest in repo transactions for CPs, aided with a structured risk evaluation, would increase this secondary market and make it attractive for other institutional investors. The next change introduced by this Circular is the accounting of the exposure of repo transactions in corporate bonds if they are guaranteed by a clearing corporation. Such exposure will not be included when calculating the investment limits for a single issuer, group issuer or sector-level limits. This encourages mutual funds to invest in such repo transactions. It also adds an additional level of safety as the particular clearing corporation guaranteeing the transaction would carry out its own diligence before doing so. This change, on the face of it, might seem obvious, but its true impact can be understood when we jointly analyse another Circular, which was issued by the SEBI on April 17, 2023.
Via its Circular on April 17, 2023, the SEBI set up a dispute resolution mechanism for the nascent Limited Purpose Clearing Corporation (“LPCC”). A dispute resolution mechanism would create a sound LPCC. Along with the already established Clearing Corporation of India’s Tri-party Repos (“CCIL Treps”), a developed LPCC would allow mutual funds to pick their clearing corporation based on their rates. This further adds liquidity to the corporate bonds market. Increased liquidity would attract higher investment by mutual funds and other institutional investors. This step, combined with the changes introduced by the latest SEBI Circular, is a combined move to add liquidity to the corporate bonds market and encourage investment.
The latest SEBI Circular, however, has its sceptics. Joydeep Sen, an expert, believes that this Circular will not have much effect on investors and the market. He thinks this is just another step the regulator has taken for the development of the market, which would not work out. Others see the move as a step towards a more accessible corporate bonds market. The latest SEBI Circular is considered noteworthy by others and has even been covered by the Global Investor Group. The true impact of the latest SEBI Circular will be revealed once we receive Mutual Fund data for the following Financial Year.
A healthy corporate bonds market benefits the economy by providing flexibility to firms when raising capital. They can deal with the vagaries of the market and other unforeseen situations at a lower cost than engaging a traditional line of credit. Repo transactions help a market grow and encourage investors to undertake short-term risk. The latest SEBI Circular is a step taken by the regulator to expand and develop the corporate bonds market. It broadens the scope of possible investments and reduces risk for mutual funds. Its true impact will be visible soon.