DEBT is the flavour of the season in India, with investors (both institutional and retail), scalded by the over 50 per cent fall in market valuations in recent months, scurrying for low-risk and relatively low-return fixed income instruments.

Adding to the growing attractiveness of debt is the widening fiscal deficit of the central and state governments, which is pushing them to raise funds from the bonds market, resulting in increased yields.

And Indian corporates, which were on an overseas acquisitions binge over the past two years, are also entering the corporate debt market, raising funds through non-convertible debentures (NCDs) and fixed deposits (FDs), to manage the liquidity crunch.

“There are some signs that people will be issuing large debt,” remarks C.B. Bhave, chief of the Securities and Exchange Board of India (SEBI), the capital markets regulator. “We believe that a few more issuers are planning to raise debt. So there is scope that we might see the beginning of the debt market.”

The debt market will see enhanced retail participation, predicts the SEBI chief. According to him, retail investors have the money and would also prefer to put their funds into debt. Similarly, if there are reliable issuers wanting to raise funds, they will get a good response, he adds.

Company FDs were once very popular in India. Many companies were offering attractive returns of up to 20 per cent or even more in the 1990s. However, some of the firms defaulted on their interests and thousands of investors also lost their principal amounts.

Acting on the complaints of investors, the police in many cities rounded up promoters of the defaulting companies and put them in jail. However, for the retail investor - including thousands of retired people, attracted by the hefty returns - it hardly made a difference, as they lost their entire savings.

Company FDs are riskier compared to bank FDs, where the government provides some limited guarantee - of up to Rs100,000 - under the Deposit Insurance Act. When a company goes under, the depositors are left high and dry, as employees and other lenders - including banks, government bodies and institutions - get priority in case of liquidation of assets.

Not surprisingly, investors are wary of putting their money in FDs and NCDs and only companies and groups that have credibility - and a good track-record - attract a decent response.

The recent downward spiral in interest rates - the Reserve Bank of India (RBI), the country`s central bank, has been slashing the benchmark interest rates of late - has seen bank FDs lose their charm. Banks that were offering interest rates of 10 to 12 per cent have now reduced it to eight to nine per cent. So company FDs are once again drawing savers, especially as they fetch returns of even 12 per cent and more.

Tata Motors, which last year acquired the Jaguar and Land Rover divisions from Ford Motor Company, is offering a return of 11 per cent on three-year FDs (with senior citizens getting an additional half per cent), as it has to retire high-cost short-term loans abroad.

Another group company, Tata Capital, came out with a Rs5 billion NCD offer in February, the biggest in over five years by an Indian corporate. Investor response to the NCDs, with a return of about 12 per cent, was overwhelming. The NCD issue was over-subscribed six times; the company exercised the green-shoe option and retained subscriptions worth Rs15 billion.

“Based on the good response, we feel that such bonds will become an instrument of choice for investors and other corporates, leading to the development of a strong corporate bond market,” explains Praveen Kadle, managing director, Tata Capital.

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MORE than a dozen state governments last fortnight raised over Rs260 billion from the market, offering 10-year paper at rates as high as 8.9 per cent. Most of these governments are desperate for funds to bridge the widening fiscal deficits.

The yield on the central government`s 10-year paper has been pegged by the RBI at 6.6 per cent; the central bank has been rejecting higher bids at bond auctions, but state governments have not been so disciplined. The Assam government offered a yield of 8.89 per cent and Andhra Pradesh of 8.59 per cent, widening the gap between central and state government bonds.

According to the RBI, the combined gross fiscal deficits of state governments is likely to exceed Rs1.12 trillion in the current fiscal, up from Rs775 billion just two years ago. State governments have already raised over a trillion rupees from the bond market, as against a target of less than Rs600 billion.

The main reason for the growing fiscal deficit and the consequent surge in borrowing is the reckless spending on so-called social programmes, the hefty hike in salaries of government employees and the heavy subsidies that governments give farmers. Tax revenues are declining steeply in the current fiscal - which ends on March 31 - because of the sharp deceleration in the economy.

With the central government`s own finances coming under strain, it is unable to boost funding for states. Government paper is mainly bought by banks - who have to invest nearly a quarter of their deposits in government securities - and provident funds. With yields on the rise, most of them are happy to acquire these 10-year papers at auctions.

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LOOKING at the growing hunger for funds from corporates, the Indian government had recently raised the cumulative debt investment limit for foreign institutional investors (FIIs) in corporate debt from $6 billion to $15 billion.

Last week, SEBI allowed two-dozen FIIs to invest a total of almost Rs300 billion in corporate bonds, the highest-ever allocation for international investors. The FIIs bid for the allocations on the National Stock Exchange. They could have bid for a maximum of Rs410 billion.

Standard Chartered Bank (Mauritius) topped with bids of Rs53 billion, followed by Barclays (Rs50.5 billion), Kotak Mahindra UK (Rs41.5 billion) and Deutsche Bank (Rs35.5 billion). What attracted the international players was the high interest rates on corporate debt (about eight to nine per cent), as against negligible returns in the US, Europe and Japan (ranging from zero to a per cent or two).

Net investments of FIIs into India last year added up to Rs120 billion. But with bond yields turning attractive, they are expected to sharply raise their exposure to India over the coming months. FIIs are likely to invest in bonds issued by public sector undertakings.

Government-backed bonds are also becoming popular among investors. This is triggering off a rush of issues from different firms. India Infrastructure Finance Co Ltd (IIFCL) just launched a Rs26 billion bond issue; the tax-free five-year bonds offer a 6.85 per cent interest rate and are targeted at high net worth individuals.

The growing popularity of bonds is also reflected in retail investors ploughing huge sums into income funds of mutual funds. Income funds attracted the largest share of net inflows of almost Rs200 billion (of total net inflows of Rs340 billion) into the mutual fund sector in February.

Volatile stock market conditions have forced retail investors to divert their surpluses away from equity funds and into debt funds. The massive inflow of funds into fixed income plans saw the assets under management of the Indian mutual fund industry return to the Rs5 trillion-mark in February. The industry recorded a growth of 8.8 per cent in February (over the January figure), fuelled mainly by the debt segment.