Masala bonds are rupee-denominated bonds that are issued to overseas buyers. The interest payments and principal reimbursements are denominated in rupees. This nomenclature has come from the International Financial Corporation (IFC), the financing arm of the World Bank, after it issued rupee-denominated bonds under the name. Recently, there have been three issues worth around Rs 70 billion by Indian companies – NTPC Limited, Housing Development Finance Corporation Limited (HDFC) and Adani Transmission Limited. Although the masala bond market is in its infancy, these issues are likely to mitigate initial market concerns about liquidity. Ratings agency Standard & Poor’s expects the issuance of masala bonds to touch $5 billion annually over the next two to three years.
Why masala bonds?
Before masala bonds, corporates had to rely on avenues such as external commercial borrowings (ECBs) to raise funds. The entity raising money through this route faces a currency risk, as the amount has to be raised and repaid in dollar terms. Therefore, only those companies that had earnings in international currencies preferred the ECB route. It was easier for them to absorb the risk of fluctuations in currency valuations as they had earnings in the same currency too. Companies which did not have this advantage had to spend extra amounts on hedging, making foreign loans an expensive proposition.
Masala bonds provide a means to raise offshore capital at a cheaper cost vis-à-vis domestic loans. It is an attractive source of finance as issuers do not have to worry about the currency risk; it is borne by the investors. As for the investors, the withholding tax on the interest income from such bonds has been reduced from 20 per cent to 5 per cent. Moreover, capital gains from rupee appreciation are exempt from tax. Since investors are facing flat or negative yields in Western markets due to weak economic conditions globally, there are very few investment options left. Amidst this scenario and optimistic about India’s growth prospects, they would like to take advantage of this by investing in masala bonds.
In September 2015, the Reserve Bank of India (RBI) introduced guidelines for the issuance of rupee-denominated bonds (masala bonds) by Indian corporates to overseas investors under the ECB route. In a bid to encourage the overseas rupee bond market, RBI, in August 2016, permitted banks to issue masala bonds overseas for their capital requirements and for financing infrastructure and affordable housing. These will constitute additional Tier I and Tier II capital for lenders. The maximum amount that any eligible borrower can raise through the issuance of these bonds under the automatic route is Rs 50 billion or its equivalent during a financial year. The overall guidelines for rupee-denominated bonds are the same as those for ECBs.
To prompt RBI to authorise Indian companies to issue masala bonds in offshore markets, IFC, in March 2016, raised about Rs 2 billion through 15-year masala bonds. This was the third masala bond issuance by IFC, which has raised a total of Rs 110 billion by issuing bonds with maturities ranging from three to 15 years. However, masala bonds were not a hit to begin with. When the guidelines for masala bonds were unveiled in 2015, a number of companies tested the waters, but did not offer bond issues due to lack of investor interest. Some of these were HDFC, the Indian Railway Finance Corporation (IRFC), NTPC Limited and Shriram Transport Finance Company Limited.
Later, in July 2016, HDFC became the first Indian company to offer masala bonds. It raised Rs 30 billion through the issue of unsecured rupee-denominated bonds which were oversubscribed by 4.3 times. The issue gave the new instrument a badly needed boost, though masala bonds still face doubts over liquidity and tax concerns. So far, HDFC has made three such issuances worth around Rs 45 billion, followed by Adani Transmission’s issue of Rs 5 billion.
A number of Indian firms are gearing up for raising funds from masala bond issues. Among government bodies, the Ministry of Road Transport and Highways and the National Highways Authority of India (NHAI) have announced plans of raising funds through these bonds.
New focus area – Green bonds
In January 2016, the Securities and Exchange Board of India approved new norms for the issue and listing of green bonds on the stock market. As per the these norms, companies issuing green bonds will have to make additional disclosures related to the end-use of proceeds, project evaluation and selection, management of proceeds, and report the use of the proceeds on an annual basis.
Green masala bonds are gaining traction due to corporates now focusing on renewable energy. In August 2016, NTPC Limited raised Rs 20 billion through the issue of rupee-denominated green masala bonds in the overseas market. The company had initially targeted raising Rs 10 billion, however, following strong investor support from the Asian market, the company upsized the issue to Rs 20 billion.
NHAI is planning to list its rupee-denominated green masala bonds on the London Stock Exchange. Reportedly, NHAI expects to raise between $500 and $750 million in the first tranche. Further, state-owned Energy Efficiency Services Limited plans to sell green masala bonds worth Rs 7 billion to overseas investors in November 2016. Other companies, such as Delhi International Airport Limited, Power Finance Corporation, Rural Electrification Corporation and IRFC are also mulling over tapping this route for meeting their financing needs.
Concerns around masala bonds
Masala bonds are no silver bullet and it is too early to conclude that they will have no downside risks, particularly if a huge amount of debt is issued suddenly. Sovereign rating will influence the pricing of these bonds. The long-term roadmap of the government’s ownership pattern of public sector banks needs to be developed and disclosed before large-scale issues of masala bonds by public sector companies. This is essential because, in the future, if the government’s stake is reduced significantly without much notice, the banks’ credit rating may get affected. Adverse price actions on a large number of public sector companies’ masala bonds may create a significant currency disturbance.
Another cause for concern is the high cost of hedging against currency risks which will limit the instrument’s appeal to some investors. The current cost of hedging rupees in the offshore non-deliverable forward market ranges from 5.5 per cent to 6 per cent. This high cost erodes the higher yields that masala bonds promise. Future masala bond issuers will likely have to offer a yield that covers the cost incurred by the investor as well as gives an attractive return compared to other instruments. This could potentially reduce the benefit of borrowing abroad compared to raising money from the domestic bond market. Investors, therefore, can either keep the currency risk unhedged or could hedge dynamically instead of buying an outright hedge for the bond tenor.
Outlook and the way forward
Banks such as Credit Suisse and Nomura are finding new ways to sell masala bonds by structuring this debt issued abroad into “credit-linked notes” derivatives. Under this arrangement a bank provides funding of 80 per cent and the investor puts in only 20 per cent to buy the derivative. After paying the bank fee and hedging cost, the eventual landed return for the investor comes to 12-13 per cent, which is much higher than that offered by unleveraged masala bonds.
Masala bonds have received public support from the Indian government. But the government has chosen a gradual approach to its promotion of masala bonds, opting to push state-backed companies towards issuing them instead of issuing sovereign bonds (as China has done to encourage the dim sum bond market). Allowing Indian firms to raise rupee-denominated loans from overseas markets is a step towards full convertibility of the Indian currency and RBI is supportive of this experiment. Given that the rupee has traded in a relatively narrow band over the past few years due to India’s rapid economic growth and RBI’s efforts to contain inflation, the currency risk is somewhat contained, thereby making masala bonds relatively safe.