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Masala bonds to spice up offshore borrowing

Published: Aug 24, 2016

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Why rupee bonds?

Rupee bonds are instruments denominated in Indian rupees (rupees) issued to lenders in abroad. Companies operating in India need funds to expand and diversify their business. Arranging funds entail several options. One of the most important sources is overseas borrowings through bonds, commonly known as external commercial borrowings (ECB). Offshore borrowing is popular among Indian businesses due to lower interest rates in developed jurisdictions and lack of developed corporate bond market in India. However, since these borrowings are denominated in foreign currency they are subject to constant foreign exchange fluctuation risk. For instance, if at the time of redemption of bonds, the Indian currency witnesses a depreciation due to any reason, the financial burden on the issuer shoots up abruptly as the borrower would have to shell more in Indian rupees to service debt obligations in dollars. In 2007-08 due to global crisis, rupees plummeted considerably. Since most of the foreign bonds issued by the Indian companies are denominated in dollar, they had to suffer considerable loss. Therefore, masala bond is considered as an offspring of this economic crisis.

How does it work?

Masala bond is a potent alternative medium of raising funds abroad with insulation from currency fluctuation risk. Bonds are issued by Indian borrowers which are placed in the offshore bond market through foreign depositories/international financial centers in dollars on the prevailing spot exchange rate. But thereafter the interest payment and final settlement are made in Indian rupees. Therefore, the instrument does not require the Indian borrowers to enter into derivative contracts for risk hedging which is otherwise required in foreign currency denominated instruments. The need for hedging under such instruments is a major component of borrowing cost, so much so that Indian companies have chosen in the past to stay unhedged. Under the rupee denominated bonds lenders are paid higher coupon or interest rate as a compensation for the risk of currency depreciation and risk hedging cost. The issue of masala bonds can be better understood with the help of this illustration.

Company XYZ wants to raise Rs 1000 from an investor Company PQR in UK. XYZ sells Rs 1000 rupee bond to PQR. The bond assures Rs 1100 at the end of three years. When PQR buys bond, the payment is made in foreign currency, let's assume in USD at the prevailing exchange rate. 1 USD is equivalent Rs 67.14. After three years, the borrower XYZ repays PQR Rs 1100 which is converted into USD at the then prevailing exchange rate. For XYZ, the appreciation or depreciation of Indian rupee on the date of redemption will not make any difference. But PQR will constantly monitor the USD INR exchange ratio. If rupees appreciate, PQR will gain as Rs 1100 can fetch more dollars upon conversion but if rupees depreciate, PQR incurs losses. This is the basic dynamics of rupee denominated bonds.

From an investor's perspective, first, the bond offers interest rate much higher (7.5-8% yield) than the LIBOR interest rates and US treasury bond rates (ranging from less than 2% to negative interest rate)1; secondly, there is an overall bullish sentiment in favour of the Indian market which encourages them to invest.

Role of IFC and masala bonds

While the recent issue of masala bonds by HDFC was widely reported, the history of masala bond dates back to 2013 when RBI allowed International Finance Corporation (IFC) and Asian Development Bank to issue rupee denominated bonds and use their proceeds for investment in India. IFC issued USD 160 million in rupees linked bonds. IFC coined the unique term masala bonds based on the popularity of Indian spices in overseas. Later in November 2014, IFC raised Rs 10 billion under its offshore rupee program which were listed on London Stock Exchange (LSE)2. The bonds were issued for a duration of 10 years which made them the longest dated rupee bonds to be listed on LSE. Under the IF rupee bond program, IFC converts dollar proceeds into rupees and then uses them for investment in infrastructure in India. Since 2013, thirteen rupee denominated bonds have been issued by IFC. Looking at the positive acceptance of rupee bonds in offshore bond market, RBI decided to allow the India companies to issue rupee denominated bonds (Bi-monthly statement April 7, 2015). But it was on September 29, 2015 RBI finally came out with formal guidelines under the ECB Policy - Issuance of Rupee denominated bonds overseas.3

Regulatory aspect

Although the rupee denominated bond is regulated by the RBI under the ECB Policy - Issuance of Rupee denominated bonds overseas, yet it is free from several restrictions applicable to other forms of ECB.4 Any corporate or body corporate as well as Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts can qualify as eligible borrower. These instruments are not subject to strict end use restrictions like in other forms of ECB except for a small negative list.5 This stands out as a great contrast to the traditional forms of ECB. The eligibility for an investor is that it must belong to financial action task force6 compliant jurisdiction. Banks incorporated in India have not been allowed access to these bonds in any manner whatsoever. However, they can act as arranger and underwriter. This has been done keeping in mind the rising graph of non-performing assets (NPAs) in the banking sector. The original minimum maturity period was five (5) years which has been recently reduced to minimum three (3) years to align it with the present regime of foreign portfolio investment (FPI). This will make the instrument more attractive and also serve as an alternative to the FPI route. 7Further, there is no cap on 'all in cost' (rate of interest, other fees, expenses, charges, guarantee fees) and it only needs to be commensurate with the prevailing market conditions. RBI has adopted a less interventionist approach which means the international market practice and contractual arrangement between borrowers and lenders will govern the terms of issue.

To further augment the marketability of these instruments, the Ministry of Corporate Affairs (MCA) also chipped in and clarified that the rigours of Chapter III of the Companies Act, 2013 and Rule 18 of the Companies (Share Capital and Debenture) Rules, 2014 would not be applicable to these bonds.8 Previously, the MCA had issued circulars dated November 13, 2014 and March 18, 2015 which stated that Rule 18 of the Companies (Share Capital and Debenture) Rules, 2014 shall not be applicable to foreign currency convertible bonds, unless it is otherwise stated by the RBI. Since the clarification was issued in the context of foreign currency bonds, there was an ambiguity in the context of rupee denominated bonds. The recent clarification has put all apprehensions to an end. The benefit of this exemption is that the bond issuer will not have to appoint a debenture trustee or create debenture redemption reserve. However, a formal amendment of the Debenture Rules, 2014 to this effect is still awaited.

The final clarification came from the capital market regulator Securities Exchange and Board of India (SEBI) which issued a circular to exempt masala bonds from the purview of SEBI (Foreign Portfolio Investors) Regulations, 2014.9 As far as the interest earned on rupee denominated bonds is concerned, Section 194LC and 194LD of Income Tax Act, 1961 provides a concessional rate of 5% withholding tax. Further, the capital gain tax on these bonds have been exempted.10

First Indian issue

Housing Development Finance Corp (HDFC) became the first Indian company to issue masala bonds by raising INR 3,000 crore in July August, 2016. The HDFC bonds bear a fixed semi-annual coupon of 7.875% percent per annum and has a tenor of three (3) years and one (1) month. The all-in annualised yield to the investors is 8.33% per cent per annum. Following HDFC, several Indian companies are now gearing up to use this option, especially when the Indian banks are under huge stress due to rising NPAs and due to lack of well developed corporate debt market. On the other hand, masala bonds are offering Indian companies a combination of diversified portfolio of investors (spread across Asia and Europe) and easy liquidity because the instruments are mostly listed/traded in LSE. After HDFC, National Thermal Power Corporation became the first public sector undertaking to issue green masala bonds with a 7.48% yield rate. The total proceeds of the issue was Rs 2,000 crore to be used in renewable energy projects. Both the bonds have also been listed on LSE. The possible reason behind LSE being the number one choice is the successful track record of listing of rupee denominated bonds issued by IFC on LSE. LSE also offers a great credibility to the instrument which can increase the marketability of these instruments in the offshore bond market. LSE is also promoting these instruments because after Brexit vote the European companies have reduced their borrowing appetite making masala bonds a lucrative option for the European lenders. HDFC is already contemplating a second round of issue of masala bonds which only shows the acceptance of these instruments in overseas market.

Conclusion

The Government is taking all possible measures to promote these instruments in anticipation of several benefits. First, this instrument can help in internationalizing the status of rupee and second this could be a vital step towards full capital account convertibility regime in India. The success of these instruments will also reduce India's overall foreign currency denominated debt obligations which means a sigh of relief for RBI. But policy makers must be cautioned that they should not promote overseas borrowings at the cost of developing the Indian corporate bond market which is already in shambles. Moreover, the stability of Indian currency will influence the success of these instruments. If rupee depreciate constantly, the risk hedging cost for the foreign lenders will increase which will eventually reduce the appeal of masala bonds. In other words, the biggest benefit of masala bonds i.e., no exposure to currency risk may get offset by higher interest rate to compensate for enhanced hedging cost. Therefore, the stability of rupee is essential for the future growth of masala bonds which is intrinsically linked to the macro policies of India.

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1See, LIBOR Bank rate, available at: http://www.bankrate.com/rates/interest-rates/libor.aspx; U.S. Department of the Treasury, available at : https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield.

2IFC Issued First Masala Bonds in London to Attract International Investment for Infrastructure in India, available at :http://www.ifc.org/wps/wcm/connect/region__ext_content/regions/western+europe/news/ifc+issued+first+masala+bonds+in+london+to+attract+international+investment+for+infrastructure+in+india.

3RBI/2015-16/193 A.P. (DIR Series) Circular No.17 September 29, 2015.

4 RBI/2015-16/193 A.P. (DIR Series) Circular No.17 September 29, 2015.

5Real estate activities other than for development of integrated township/affordable housing projects; ii. Investing in capital market and using the proceeds for equity investment domestically; iii. Activities prohibited as per the foreign direct investment (FDI) guidelines; iv. On-lending to other entities for any of the above objectives; and v. Purchase of land.

6FATF is an inter governmental body to combat money laundering and terrorist financing.

7Issuance of Rupee denominated bonds overseas, RBI/2015-16/372 A.P. (DIR Series) Circular No.60, April 13, 2016.

8Minister of Corporate Affairs clarification dated August 03, 2016, available at: http://www.mca.gov.in/Ministry/pdf/GeneralCircular09_03082016.pdf.

9 SEBI Circular dated August 04, 2016, Foreign Investment in Rupee denominated bonds issued overseas by Indian Corporates, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1470299109414.pdf.

10http://www.incometaxindia.gov.in/Lists/Press%20Releases/Attachments/404/Press-Release-Off-shore-Rupee-Denominated-Bonds-29-10-2015.pdf.

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