The music has abruptly stopped in a smoky corner of the bond market – a dense world that interested no one beyond Mumbai’s financial districts. That changed last week when the regulator unexpectedly chose to call out a murky truth. On the firing line was one of the oldest and well-connected I-banks, JM Financial, for a sharp, yet common, practice.

As a banker selling the bond issue of a Piramal company, JM had allegedly lined up and financed an army of individual investors who sold the securities immediately after receiving allocation to another JM company which in turn offloaded the papers at a loss to a bunch of corporate investors.

Indeed, bank accounts linked to 920 out of 1,748 investors who applied using the JM’s brokerage arm were held at a ICICI Bank branch in South Mumbai. This charade – first making a set of apparently mule HNI investors put money in the issue and then selling the papers to wholesale investors at a lower price – helped the bond offering masquerade as a ‘public issue’ against the more prevalent practice of ‘private placement’ where companies raise money by directly placing bonds with larger investors like fund houses and insurers. JM was not the first bank which managed such a so-called public issue, though chances are it would be the last following Sebi’s strongly worded order denouncing the practice that has been going on for years. Indeed, it was an open secret.

COMPLEX PLANS
Why do companies and their bankers indulge in such complex transactions instead of choosing private placement which is a simpler avenue to mobilise funds? First, not all corporate issues are lapped up by wholesale investors –some like mutual funds, retirement pools and insurance companies scoff at corporates with less than ‘Double-A- plus’ credit rating.

Second, most wholesale bond buyers are tough negotiators who demand a better return. Third, a bond issuing company may prefer sending out a signal that it’s capable of raising debt at a fine rate while being fully aware of the back-to-back deal its banker would cut with corporate investors to sell papers at a lower price (which means a higher yield).

For the players involved it was a win-win game. The corporate could claim a diversified, non-institutional investor base for its bonds. The I-banking group could take the credit for pulling off a public issue and make money despite selling bonds to corporate investors at a loss. How?

The combined earnings from brokerage and interest from financing passive individual investors is far more than the loss it takes. And, authorities, emphasising on retail participation in corporate bonds, threw a long rope. Till now. With growth forecasts up and markets on a roll, regulators are on a spring-cleaning mode. JM would probably argue there is no major violation: financing of public issues (where the loan size depends on the value of underlying securities) is allowed; there is no law that stops retail investors from selling within minutes of allocation, or a group firm offloading the papers at a loss. But regulators are in no mood to buy this. They have taken a textbook counter-cyclical approach of taking tough measures when the going is good (particularly in the wake of the recent review by the Financial Action Task Force).

The message is simple: the spirit of regulations has been trampled upon and one can’t get away playing the old games anymore. All this could reduce the number of public issues of corporate bonds for some time, force many companies to offer higher (and, therefore more realistic) coupon interest on bonds to attract wholesale investors, and allow only genuine, fewer public investors – though their numbers will be a fraction of the retail frenzy one sees in equity IPOs.

Over the years, eye-catching regulatory actions have served as crash courses on the bond market – be it g-sec or corporate bonds which largely derive their pricing from g-secs. As stuff happened, things changed. The bond market has become comparatively cleaner than what it was 20 years ago when high-street banks parked bonds with brokers to hide losses and play around with valuations of thinly traded papers to cushion the books before March 31. The JM fiasco – amid buzz that more I-banks could be pulled up – is a reminder that it’s work in progress.