Masala bonds
A number of Indian firms are gearing up to raise funds from issuing what are known as ‘masala bonds.’ Coinciding with Prime Minister Narendra Modi’s recent visit to the UK, organisations such as Housing Development Finance Corp., Yes Bank, and the Railways had announced they were going to raise funds through this route from the London market. Ratings agency S&P expects the issuance of masala bonds to touch $5 billion annually over the next two to three years. Here is an explainer on what masala bonds are all about:
What are masala bonds?
Bonds are instruments of debt - typically used by corporates to raise money from investors. Masala bonds have to be explained in the context of Indian corporates raising money from overseas investors. Before masala bonds, corporates have had to rely on avenues such as external commercial borrowings or ECBs. The challenge with the likes of ECBs is the entity raising money is faced with a currency risk - they have to be raised and repaid in dollar terms. A year is a long time in forex markets - currencies fluctuate sharply. So, imagine the risk a bond issuing entity, especially one with largely rupee earnings, if issue and repayment are years apart.
Enter masala bonds! They are rupee-denominated bonds issued to overseas buyers. This is how it is different from other instruments. With a masala bond, a corporate could issue Rs. 10 billion worth of bonds with the promise of paying back Rs. 11 billion in one year. But as the Indian rupee has limited convertibility, the investors will lend the dollar equivalent of the Rs. 10 billion. After one year, the Indian corporate needs to pay back the dollar equivalent of Rs. 11 billion. The currency risk is with the investor.
How did the tag masala come about?
The International Finance Corporation (IFC), the investment arm of the World Bank, issued a Rs. 1,000 crore bond in November last year. The purpose of the issue was to fund infrastructure projects in India. IFC named them ‘masala’ bonds to reflect the Indian angle to it. This kind of naming has been done before. This is, in fact, much like IFC's Chinese yuan-denominated Dim sum bonds. It isn't unusual in the foreign bonds market to encounter names such as Yankee and Bulldog. By the way, Japanese yen-denominated bonds are called Samurai. There was even much speculation about what the rupee-denominated bonds would be called before 'masala' was confirmed. Samosa, Ganga, and Peacock were apparently some of the names doing the rounds.
What has been the regulator's stance on this?
The Reserve Bank of India has issued guidelines allowing Indian companies, non-banking finance companies (HDFC, India Bulls Housing Finance are examples of such companies) and infrastructure investment trusts and real investment trusts (investment vehicles that pool money from various investors and invest in infrastructure and real estate sectors) to issue rupee-denominated bond overseas.
The rules put the issue limit to $750 million and also has a pricing cap for various tenures of issue. Experts say the move to permit masala bonds is an attempt to increase the international status of rupee and is also a step toward full currency convertibility (the freedom to convert Indian currency into other internationally accepted currency without any restrictions).
Why should investors look at masala bonds?
The Finance Ministry has cut the withholding tax (a tax deducted at source on residents outside the country) on interest income of such bonds to 5 per cent from 20 per cent, making it attractive for investors. Also, capital gains from rupee appreciation are exempted from tax.
Globally, there is ample liquidity thanks to lower interest rates in developed markets, but there are very few investment options due to weak economic conditions globally. India is that rare fast-growing large economy, and masala bonds is one way for investors to take advantage of this.
By the way, these bonds are bought by retail investors as well as big institutions overseas.
What do masala bonds mean to the issuer?
An important consideration for issuers is the access to cheaper funding than what's available in the domestic markets, according to ratings firm S&P. For corporates, who would be the main issuers, masala bonds will be one other key source of funding apart from banks and local debt markets. Another ratings firm India Ratings and Research says such bonds would lower the cost of capital over a period of time - the cost remains one of the highest in Asia. This also makes sense given that Indian banks are reluctant to lend to sectors facing weak demand and heavy debt.
Is there anything investors need to worry about?
Investors would need to keenly watch the credibility of the issuer. For example, it would easy for an HDFC or NTPC to easy to raise the bond when compared to a smaller firm. Higher the credit rating of a firm, the better would be the appetite for their issues. Since the currency risk is on the investors, they will like the rupee to be stable. S&P says the initial excitement over masala bonds will give way to the ultimate realisation that because currency and economic growth are external factors, investors will subject issuers to a lot more scrutiny.
To make masala bonds more attractive, the Reserve Bank of India (RBI) has reduced the minimum tenure of such bonds that an Indian company can issue offshore to three years from the previously stated five years.
“It has been decided to reduce the minimum maturity period for the rupee-denominated bonds issued overseas to three years in order to align with the maturity prescription regarding foreign investment in corporate bonds through the foreign portfolio investment (FPI) route,” the central bank said in a circular on Wednesday.
Money raised through masala bonds overseas will be counted in the overall investment limit for FPIs in corporate bonds, which now stands at Rs.2.44 trillion. FPI investment limit in corporate bonds will be expressed in rupees instead of dollars, bringing it on a par with limits in government bonds. The maximum amount a single issuer can raise through masala bonds is Rs.5,000 crore, RBI said.
According to bankers, the reduction in maturity of the bond may not make a big difference in terms of attracting investors.
“This was one of the demands but until the withholding tax and allowing domestic banks to invest is addressed, there is unlikely to be a significant improvement in demand for such bonds,” said a banker on condition of anonymity.
Masala bonds are issued in rupees but can be settled in US dollars and thus besides the credit risk of the issuer, risk of the exchange rate also falls on the investor. In addition, the investor also has to pay 5% withholding tax.
In the pursuit of adequate compensation for credit and exchange rate risk, and the cost of withholding tax, foreign investors have sought higher yield from companies that marketed masala bonds over the last five months.
But to match the yield demanded by investors, companies will have to forego their advantage of borrowing cheap from the offshore market compared with local rates.
Further, Indian banks can only act as arrangers or underwriters of such bonds and cannot invest in them. If an Indian bank does underwrite a masala bond issue, it will have to offload the investment in six months.
Indian companies were allowed to issue rupee-denominated bonds in the offshore market in September last year but so far no company has been able to raise funds through this route.
The idea of masala bonds was first floated by RBI in April 2015 following which the central bank issued guidelines for the same in September. Over the last four months, Indian Railway Finance Corp. (IRFC), Housing Development and Finance Corp., NTPC Ltd, Shriram Transport Finance and Dewan Housing Finance Ltd have all hawked masala bonds without success. Adani Transmission Ltd was the latest to market masala bonds overseas last month.
The guidelines allow multilateral agencies such as the World Bank to also borrow through masala bonds and invest the proceeds in the Indian infrastructure sector.
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