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The heart of the problem, at an economic level, is asymmetric information between borrower and lender - about the probability that the borrower will default, and the expected loss given default. In the most extreme cases - credit rationing - the credit market ceases to exist. Better credit information, better credit evaluation models will help contain asymmetric information.

Players in the 'Junk Bond' Market

At present, RBI and the regulator SEBI do not want banks and state financial institutions to invest in junk bonds as it would expose them to risky assets and trigger a possible crisis in the system in the event of a junk bond meltdown.

But RBI allows banks to raise subordinated debt as capital and it can be 50% of the core equity. This is an opportunity for banks since they can invest in these junk bonds which gives higher returns, and hence, their portfolio will also give higher returns.

Globally, it is observed that insurance and pension funds constitute a significant portion of holdings and activities in the bond market. The investment pattern of insurance companies and provident / pension funds in India are decided by the government or the regulators. Though the arrival of new insurance and pension funds augurs well for the fixed income securities market, much depends upon the flexibility given in investment decisions and pension reforms. Reforms are also being attempted in the pension schemes so as to move away from pay-as-you-go schemes that do not link the contribution and the benefit towards defined contribution schemes. While giving more flexibility in investment decisions, it has to be ensured that the transaction cost is low and no undue risk is being taken by the companies and funds.

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* Contributed by -
H. Sandeep Reddy & Puneet Jain,
Indian Institute of Management Kozhikode,
Kozhikode, Kerala.