A souring bond market is not exclusive to India

Two months on from Amtek Auto’s $121 million debt default, the head of the Association of Mutual Funds of India has said his organisation must review its risk management guidelines.

Among the casualties of the default had been JPMorgan Asset Management’s India unit, which was exposed to $30 million-worth of Amtek’s debt securities through two funds. Shortly afterwards, the funds had to temporarily restrict withdrawals by investors, because of the difficulty in selling those holdings.

To CVR Rajendran, AMFI chief executive, this is an Indian failing. “Defaults happen in the US markets, but liquidity isn’t a problem,” he told the local press.

“Investors know about defaulting companies’ positions, along with realisation possibilities. They exit bonds at prevailing market prices. In India, bonds become unsalable.”

One banker who knows Amtek well says it is not an isolated case. “There is a lot of totally illiquid high yield debt in debt funds which are supposed to be liquid,” the banker warns.

Investors appear to share his concern: in the wake of the Amtek default, risk premiums rose and the debt of unrelated companies sold off.

In some ways, Amtek is a cautionary tale of an Indian company that expanded aggressively both at home and abroad — and then used financial engineering to compensate for the lack of profitability on its operations.

Its Castex Technologies unit issued convertible bonds that are now the subject of a regulatory investigation into whether the Castex share price was manipulated to force the bonds to convert into equity. Amtek also took rescue financing for its offshore operations from private equity group KKR, in the form of expensive debt and equity warrants — a sign that the company could not tap more inexpensive and conventional funds.

Broader indication

However, its September bond default can be viewed as a broader indication of how corporate India is suffering from a surfeit of debt.

Most Indian companies rely on bank financing, rather than the debt capital market, yet banks are now reluctant to lend even working capital to already stressed borrowers. These debt worries — as well as capacity utilisation of more than 70 per cent — explain why the private sector is not investing and growth remains below potential.

“Companies are still way overleveraged while the banks fear throwing good money after bad,” says the head of one foreign bank in Mumbai.

As a result, bond markets can look attractive to cashstrapped corporate bank clients: they can often raise funds more cheaply, while still giving investors higher yields.

But bond markets can be risky for investors who do not do extensive due diligence.

Corporate circumstances can deteriorate with little warning and, all too often, the rating agencies — which should be the first to raise the alarm — fail to do so. Liquidity can vanish in a heartbeat.

In spite of the faith in US markets shown by Rajendran, the problem of liquidity is not confined only to India or, indeed, developing markets in general.

One sobering thought is that if two simple bond funds can suddenly restrict withdrawals, what about more complex investment products? Many on both sides of the Pacific have yet to be tested by a lasting bear market.

State of flux

That test may not be far off. Corporate bond markets in many places are in flux: China seems to have weathered the downdraft in the stock market, but there are increasing fears of a bubble in its corporate bonds. Analysts suggest it has been inflated by leverage of up to five times from the commercial banks in Shanghai.

Meanwhile, in the US bond market, yield spreads — how much higher corporate bond yields are, compared with safer government issues — have widened dramatically in recent weeks. Many analysts fear there could soon be a stampede for the exit, as worries over a Federal Reserve rate increase in December intensify.

That would test the liquidity of US high-yield bond funds and exchange traded funds.

Some funds will not be able to survive a sell-off without imposing limits on redemptions. For example, there are leveraged loan ETFs in the US promising instant liquidity, even though it takes a minimum of 20 days for deals in this debt to settle.

In corporate bond markets, the distinction between developing markets such as India and developed markets such as the US may not be as great as some believe.