Oh, Let’s Look Beyond AAA: A new market-making framework could make lower-rated corporate bonds more investible

Launch of Sebi-RBI's Demat 2.0 pilot for tokenised corporate bonds on Sept 10 marked a significant evolution in the architecture of India's financial markets. The initiative uses distributed ledger technology, digital securities and central bank digital currency (CBDC) to bring securities and settlement legs of a transaction closer together.

The pilot has seen three issuances, raising around ₹1,025 cr, signalling that tokenisation is moving from an idea into a practical market experiment. But there's one question that needs to be answered alongside tokenisation: can we make bonds liquid after they have been issued?

Consider the dilemma faced by an investor looking at an AA, A+, or A-rated bond. The bond may offer higher yield than a comparable AAA instrument. The investor may be comfortable with the additional risk. But then there's the key question: if I need money before maturity, who will buy my bond? That uncertainty means investors demand an additional premium, or avoid the security. Low liquidity leads to fewer investors, higher liquidity premium and higher borrowing costs, further shrinking investor base. The answer is not to tell investors to take more risks, but to make the market more liquid.


Equity markets facilitate continuous buying and selling. Why should the corporate bond market be different? A new generation of professional corporate-bond market makers could provide investors with something missing in many lower-rated bonds: a credible 2-way market. This is where a targeted regulatory intervention can make a difference.

Every new listed corporate bond issue of ₹200 cr or more, rated AA and below, should have a professional market-making arrangement. A Sebi-registered merchant banker could be designated as the market maker for 3 yrs, or until maturity if the bond matures earlier. The market maker would provide 2-way quotes within a prescribed spread. The proposed maximum spread could range from about 75 bps for AA bonds to 150 bps for lower-rated bonds, reflecting greater risk and lower liquidity of the securities.

The market maker would be compensated for providing this service through a transparent fee paid by the issuer. This is not a guarantee against losses or of the issuer's credit quality, but a commitment to provide a functioning secondary market.

There's a major advantage in starting with new issues. Cost of market-making can be built into the economics of the bond at the time it's issued. The investor knows before subscribing that there's a designated professional market maker. The issuer knows the cost. The merchant banker knows the obligation. The regulator can monitor compliance. And the market gradually builds a stock of more liquid bonds. This is preferable to imposing retrospective obligations on thousands of existing securities.

A framework could have 5 pillars:

• ₹200 cr threshold Smaller issues may not have enough depth to justify the mechanism initially.
• AA and below: This is precisely where additional liquidity can make the greatest difference.
• 3-yr obligation: The objective is to establish secondary-market liquidity without imposing an indefinite balance-sheet commitment on the market maker.
• Rating-linked spreads: A higher- risk bond should command a wider market-making spread. The proposed range could be 75-150 bps.
• Limit on number of mandates: A merchant banker should not be permitted to undertake unlimited market-making obligations. A ceiling of 10 bonds at a time would help ensure that market making is genuine rather than merely contractual.

Investors price liquidity risk alongside credit risk, so better liquidity can reduce the premium embedded in yields.

The benefit can flow back to issuers. A company with a good credit profile but a lower rating shouldn't have to pay an excessive premium merely because investors fear that the bond will be difficult to sell. A deeper secondary market can, therefore, reduce the cost of capital while simultaneously improving investor choice.

This is important for India's next phase of growth. Its infrastructure, manufacturing, logistics, RE, real estate and financial-services sectors will require enormous amounts of long-term capital. Banks can't - and shouldn't - be expected to finance everything. A deeper corporate bond market is essential. But a bond market dominated by AAA and quasi-sovereign issuers cannot fully meet financing requirements of a rapidly expanding economy. India needs a broad credit spectrum.

The market should be able to finance strong companies rated AA, A, or BBB, not merely those fortunate enough to carry an AAA rating. That requires investors to have confidence not only in an issuer's creditworthiness but also in liquidity of the security.

The regulatory objective should, therefore, be to make AA, A, and other appropriately rated corporate bonds more investible, not by reducing credit standards but by improving market infrastructure. A transparent, regulated market-making framework for new issues above ₹200 cr could be an important step.

If successful, it could gradually change investor behaviour. The result would not be an abandonment of AAA bonds but something better: a shift from rating-driven investing to risk-adjusted investing.

The writer is former chairman, Metropolitan Stock Exchange of India (MSEI)