The Lacklustre Gilt

Government securities seem to be one of the most investment-worthy instruments for companies to park their short term surpluses in. Why then are corporate treasurers apathetic towards gilts?

Cash flow management could easily be termed as one of the crucial functions of any corporate finance division today. Corporate finance managers are scouting around for suitable instruments to park their surpluses in, more actively than they have ever done before. Most of them are fastidiously looking for a combination of features such as liquidity, safety and suitable tenures. Says Dipankar Basu, chairman, Securities Trading Corporation of India (STCI): Government securities provide an ideal instrument to corporate treasurers in this context, particularly after the reforms that the gilts market has undergone since the early nineties.

And Basu is right. Minimising the mismatches between cash inflows and cash outflows without sacrificing on the profitable deployment of liquid funds occupies the central focus of treasury experts. And with recent reforms in the financial system, their task is getting more complex. In particular, as banks move away from the earlier cash credit to loan system, the cash management function will become even more crucial.

The crucial point is that there is that there is no dearth of instruments; in fact, today, treasury departments have access to a variety of instruments with which to manage short term cash flows. Each treasurer decides upon his choice depending on volumes, rates of interest and the risk profile. Inter corporate deposits, certificates of deposit, commercial paper, bank deposits, mutual funds and bonds are some instruments available to the corporate treasurer today. But although there is a wide range available, none of them offer a corporate finance manager a combination of features such as liquidity, safety or duration (see box The untapped potential). And that is precisely where gilts score over other instruments, argue money market players. The fact, however, remains that not many corporates are active investors in this market, today.

The gilt advantage ...Yet, the existing players in gilt-edged securities perceive a whole host of advantages in this market for corporates. For starters, government securities offer the multiple benefits of market-related yields, fairly good levels of liquidity, transparency and safety. All this should figure high on the corporate agenda.

Some players also point out that the delivery versus payment (DVP) system of settlement introduced by the RBI in 1995 has reduced the counter party risk in securities trading. They refer to the securities scam of the early nineties, when some banks did not receive the delivery of securities against the payment made by them, which resulted in huge losses for them. Such possibilities hardly exist in the new set up. In addition, the beginning of trading in gilt securities on the National Stock Exchange on the wholesale debt market segment, and easy access to market information on aspects such as volumes traded and prices, have made the system more transparent.

Given this conducive scenario, it is surprising that corporates have not taken to investing in gilts in a major way. In fact, their perception of the market is at considerable variance with what money market players would vouch for. For one, they do not share the view that the market is ripe for corporate investments. The more vocal ones go a little further; they point out that apart from this factor, there are many other problems that they have to face while investing in this market. ... and the disadvantage

Take the case of yield, for example. Few corporates bite the argument that the yield on gilts has improved, and are comparable with other instruments of short term deployment. Corporates can hardly make any money in this market, according to S V Venkatesan, director (finance), Essar group. Interestingly, Essar had considered investing in this market two years ago but found that the returns were not worthwhile. Many others agree. Says S K Shelgikar, director (finance), Videocon group: It is all right for banks and non banking finance companies (NBFCs) to deploy their short term funds in gilts, as it is a statutory requirement for them. It is not likely that corporates will look at these instruments, where returns are low. Can you expect a return of 20-25 per cent on these investments?

But this level of returns is possible only in the inter-corporate deposit market, which according to N. Gopalkrishnan, managing director, SBI Gilts, is high-return, high-risk business. Moreover, there is a cap on the amount which a corporate can raise through this route, he points out.

But its not just the yield. There is also the cost of funds to be considered. If a corporate has raised money at 17 to 18 per cent, it would be unwise to invest it in treasury bills, at a yield of 7 to 8 per cent. And if the money has come through the cash credit portion of the working capital account, the corporate may as well repay the surplus money in that account, saving on the total cost of funds, says the treasury manager of a company with large internal cash accruals: If I have cash surplus for a period of less than thirty days, I would first prefer to put it back in my cash credit account, where I have to pay interest at 16-17 per cent, she says. Sound logic, but will that hold good for long?

Corporate treasurers are now moving into a scenario where it is only a matter of time before the cash credit system is eased out totally by the demand loan system, where the loan cannot be paid off before six months, or a year. Money market players point out that it in such a case, it is better for a corporate to put its surplus cash in treasury bills if there is no immediate deployment in projects. The point is, by doing it the treasury head will reduce the cost of funds for his company, says Gopalkrishnan.

And what about liquidity ? Until recently, banks used to invest in gilt securities and did not trade in them, keeping the investment idle until maturity. The recent shift in focus on their profitability, as also the partial mark to market rules have compelled them to take a relook at this stand. The appointment of primary dealers has added further liquidity to the market, as they are expected to give two way quotes for securities held by them. And the likely appointment of satellite dealers in the near future should only increase the liquidity further.

This would mean that corporate investors will be able to move in and move out of the market at will. In case of need, the security could either be disposed off, or, held to maturity, which, depending on the purchase time, may not be very far. Also, since the National Stock Exchange began its wholesale debt market segment, volumes of trade in securities has steadily increased . The expected emergence of money market mutual funds as also special gilt funds is expected to bring about more players in the field, adding to the liquidity.

The seamy side

Not all these positive factors can convince corporates fully, however. They point out that the primary dealers (PDs) give quotes only for a handful of securities, leaving investors in other securities in the lurch. This could be a serious problem, as there are as many as 111 securities floating in the market. For those corporates who have invested in these securities, the exit route is blocked, as they can hardly be traded in absence of price quotations. And even for securities for which they give quotes, the PDs have a quantum ceiling beyond which they will not make a deal.

Some primary dealers readily admit this situation. For example, Ashish Pitale, managerfixed income, ICICI Securities, agrees that the complaint is valid, but points out that only a few scrips are actively traded, and therefore they can not afford to go beyond a limit in them. Adds N Gopalkrishnan: The PD system is hardly a year old and these dealers have yet to stock up many securities. They can give two way quotes only in securities which they have in stock. But while Pitale and Gopalakrishnan do have a point, from the corporates point of view, this is a major deterring factor.

Market practices also deter corporates from entering the gilt scene. The minimum denomination of securities traded is Rs 5 crore. Not many companies have this kind of cash surplus they can consider for deployment. And though some companies do put through deals for lesser sums, the market considers them as odd lots, and the returns are therefore, lower, says Ashok B Sharma, vice president, PNB Gilts. Another market practice that puts off corporates is the voucher practice, arising out of tax deduction at source(TDS) on interest payable. Applicable to securities bought in the secondary market, this practice reduces the yield. It has been an irritant for the bankers as well, but their long pending demand for removal of TDS has not been heeded by the authorities.

The settlement system for security trading, operated by the RBI, also leaves doubt about its efficacy in case a large number of corporates were to take to these instruments. Banks maintain special accounts with RBI under the delivery-versus-payment (DVP) system, and are credited or debited as the case may be, when banks sell or buy securities from the market. But corporates are not allowed a direct entry in the DVP system. They have to operate through their banks. The banks can open a constituent subsidiary general ledger (SGL) account with the RBI and trade on behalf of the corporates. The SGL is a clearing system that does not normally result in physical certificates. If at all an investor needs the physical certificate, it takes at least three to four weeks for the system to deliver it, during which the corporate obviously cannot trade in it, says Sharma. Moreover, even the existing SGL system takes considerable time. With FIIs expected to flock into the gilt market corporates fear that the SGL system will come under pressure and cause delays in trade settlement.

For the corporates desiring to invest short term cash in gilt securities, there is another point to consider. It relates to the tax and accounting aspect. There is an anomaly in the treatment of accrued interest on securities between the income tax and accounting standards. Says D D Rathi, president, Indian Rayon: Under income tax laws, interest accrued and paid to the seller at the time of purchase is treated as part of purchase cost of the security. Similarly, interest realised at the time of sale is treated as part of selling price. Not only does this make accounting treatment of interest under tax laws difficult but can also land corporates in huge, incidental losses that arise from tax incidence.

Rathi adds that this would depend on the volume of interest accrued on purchase and sale. On securities purchased with higher interest accrued and sold, excess interest would result in payment of tax on interest which is not actually earned by the corporate. This, in turn, would entail a capital loss in the hands of the seller, which undoubtedly, may not be set off at all. At times, the incidence on tax can exceed the real interest earned by the corporates.

The shorter end

Notwithstanding all these problems, some corporates have gone ahead and invested in gilts. They have confined themselves to

treasury bills, mostly of 91 day duration, and strictly avoided the dated securities segment. This is because of the large fluctuations witnessed in their prices, that interest rate uncertainties entail. Taking positions in such

dated securities is like taking a position on interest rates, says Shelgikar.

And according to Sanjay Bhasin, headdebt and money markets at Standard Chartered Bank, dated securities are for traders, not for investors. A 10 to 15 paise fluctuation in the price could wipe off the capital base of a corporate player, unless the market is monitored closely. And market monitoring is not the core business of these corporates. Besides, in times of liquidity pressure, corporates may find it difficult to sell, as the exit route gets blocked up. As it is, corporates are on unequal ground vis-a-vis banks. Banks fund their investment from the call market, where interest rates are low, but corporates have to fund them through cash credit or demand loans, where they pay interest as high as 16-17 per cent.

As against this, treasury bills are a good instrument to park short term liquid funds in. There is no profit making here, but cost of funds can certainly be reduced. A corporate treasurer spells out a simple strategy: if a corporate has liquid funds for a few days, it could look at this market where the yield would be less than 8 per cent but the investment is safe and liquid. At this level of earning, the corporate will not be making profit but reducing its overall cost of funds.

The idea is not to let the cash remain idle even for a day. Additionally, it helps to spread the risk. Some companies are known to have put a cap on the amount of investment it would make in each instrument, and there is a shift in stance that is obvious. Gilts do find a place in their list of investment avenues.

Would corporates always remain peripheral investors in gilts? There are two things that have to be taken into consideration here. One, with the cash credit component on its way out and the loan component likely to take over, the frequency with which companies find themselves in a temporary cash

surplus position will go up. And that may lead to an increased interest in gilts. Two, the yields on gilts are low because the RBI has been keeping them artificially low. The high levels of devolvement witnessed at various auctions of treasury bills bears this out. This obviously can not go on for ever, particularly with ways-and-means system (under which the centre will have to pay market related rates of returns to banks) ready to take over from the current system of ad hoc treasury bills from the next financial year.

That would mean that the yields on gilts will be more realistic and reflect market realities. And there is every reason to believe that this will be the time when corporates feel the urge to take a closer look at the gilts market.

The drag factors

Yields are lower than market rates Liquidity is not sufficient Minimum denomination at Rs 5 crore is too high

Voucher system reduces the yield even further Tax treatment of accrued interest not clear. Risk of capital loss Rapid fluctuations in prices and yields Settlement system not adequate