Now's an excellent learning opportunity for Indian credit markets

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Taponeel Mukherjee | 06 May, 2019
News on Indian credit markets over the last few weeks provide us with pointers that should help shape policy and business strategy. The struggle to get bidders for Jet Airways and the tepid response from investors towards Indias fledgeling municipal bond market point towards the need for a better-structured credit market, especially as the nature of businesses evolve even as the demand for credit rises to finance consumption and infrastructure needs.

The lack of investor interest in Jet Airways, driven in no small extent by a lack of clarity around how the carrier will resolve its debt issues points towards the need for better assessment of risk scenarios by lenders moving forward. Reassessing risk scenarios are essential as businesses such as Jet Airways that have relatively fewer tangible assets utilise the debt markets. From a lender's perspective, not finding a prospective buyer for Jet Airways implies potentially sending it to the bankruptcy court. But for businesses that do not have a significant quantity of fixed assets, the value realisation from bankruptcy courts can be meagre.

The fact that Jet Airways has a lower value realisation in the case of bankruptcy begs the question as to what changes do lenders need to implement in their credit models to deal with such companies going forward. As the economy evolves, businesses that borrow will have balance sheets that perhaps hold more intangible assets. In the case of Jet Airways, unlike say a steel business, a majority of its fixed assets, i.e. planes are leased, and therefore bankruptcy proceedings can realise limited value. The pertinent point is that lenders must do a better job in pricing these risks moving forward as lending to companies with more and more intangible assets picks up.

In other relevant news, the lukewarm investor interest in the municipal bond market in India is one that merits attention. Given the scale of urban infrastructure required, municipal bonds could be a critical financial instrument to plug the financing gap. However, given the current challenges and the stage of evolution of the bond market, a vibrant and functional municipal bond market will require significant groundwork.

Clarity around municipal funding, or more specifically, the payment mechanism of the municipal bond, will be vital to attracting investor interest. Answering the fundamental questions of "who pays" and "are they willing to pay consistently" will alleviate a majority of the concerns people have with municipal bonds. Ensuring an adequate payment mechanism will require a lot of work to help cities plan and budget financing efficiently.

Depth of the benchmark government bond curve will also be vital towards increasing investor appetite for municipal bonds since investors will utilise the government bond curve as a benchmark. The eventual aim is to create a market and an ecosystem for municipal bonds that encapsulates market makers, price transparency, risk-benchmarks and mechanisms for redressal of problems.

The issues around both Jet Airways bankruptcy and the municipal bond market point towards critical areas that credit markets in India must resolve through innovation in capital markets. Given the dynamic nature of business, lending standards and procedures that worked for companies in the more traditional industries may not be well suited for new age businesses.

The question isn't merely about how much to lend, but also is one about security design whereby the question arises as to whether collateralised debt instruments allow lenders to truly hedge their risks in a world where asset-light models abound?

As credit markets get more sophisticated, more attention will have to be paid to security design above and beyond what standard debt instruments have to offer. Security design implies bespoke instruments designed to reflect both the cash flow risk of businesses and the ability for recovery in the case of default.

Dynamic pricing of credit risk through secondary markets as is the case with equity will be essential to ensure that both credit charges reflect the appropriate risk undertaken by the lender.

Additionally, credit instruments utilised to lend to businesses must be able to better factor in the inability of the company to service debt as the credit financing capacity of the business declines, and not as a jump to default event. Essentially, credit instruments have to be designed to reflect their seniority in the cash flow waterfall. Better security design will allow lenders better recovery of money since rarely is a credit default a sudden event. As mentioned earlier, the ability of the market to factor in the declining credit profile of a company will ensure that debt burdens for low-quality credit businesses aren't ramped up at the wrong time.

Astute utilisation of credit markets and effective credit security design will be a fundamental driving force for boosting the Indian economy. The government, businesses and individuals all stand to benefit immensely from robust credit markets. Current trends provide an excellent learning opportunity.