Traditionally, whenever Indian companies wanted to raise money from overseas investors, they used something know as External Commercial Borrowings (ECBs). However, the key issue posed by ECBs are that they are mostly dollar-denominated bonds (or other major currencies such as Euro and GBP) and the currency risk is borne by the issuer, i.e., Indian companies. In 2008 and 2013, when the INR crashed vs. the US dollar, ECBs pushed many companies, such as Suzlon Energy, close to a financial meltdown.
To counter the risks posed by ECBs, masala bonds have emerged as a popular debt instrument among Indian companies in the recent years.
What are masala bonds?
Masala bonds are rupee-denominated bonds that Indian corporate borrowers can sell to investors in international markets (typically at major financial centers such as London, Singapore, and New York). Well-known Indian companies can raise money via masala bonds after taking approvals from the Reserve Bank of India (RBI). The primary benefit of masala bonds is that the currency risk is transferred to the lender.
Understand how rupee depreciation impacts Indian companies in ECBs
First, we need to understand the downside risk in ECBs with a help of an example:
Suppose XYZ Ltd issued dollar-denominated bonds worth $100 million at 5% interest rate. The exchange rate at that point was INR 50/$. Effectively, the company could raise INR 500 crores for business activities. But when the bonds matured after 4 years, the exchange rate was INR 60/$. In this scenario, the company will require INR 600 crores to repay its lender $100 million. Therefore, apart from the interest that the company was already paying, it will now have to shell out an additional INR 100 crores due to rupee depreciation.
It is this risk that can be mitigated by issuing masala bonds. If the company had issued masala bonds, its liability would have remained at INR 500 crores (equal to the original amount raised in rupee terms) at the time of maturity.
Upon maturity, it can return the lender an equivalent amount in dollars based on the exchange rate of INR 60/$. Hence it must return $83.3 million to the lender.
The loss of INR 100 crores or $16.7 million due to rupee depreciation is borne by the lender now. Hence, XYZ Ltd is immune to currency fluctuation.
First masala bonds issue in India
In 2013, the Indian government and the International Finance Corporation (IFC) decided to launch rupee bond programs in both the onshore and offshore markets to provide rupee financing sources for IFC projects in India, as well as to help develop Indian markets by creating an AAA yield curve via new borrowing.
Following are the issue details:
- The first offshore bond program worth $1 billion (62 billion rupees) was launched in October 2013
- The IFC would issue Indian rupee bonds in the offshore market for various maturities and bring the proceeds onshore for investment in the country
- From 2013 to 2014, the IFC issued seven tranches of offshore rupee-denominated bonds, settled in US dollars and pegged to the rupee foreign exchange rate, for maturities ranging from three to seven years
- Though these bonds were settled in dollars offshore, the dollar return were determined by the change in the rupee-dollar exchange rate as if they were rupee bonds. This enabled international investors to assume the exchange rate risk
But why would foreign investors take currency risk and invest in masala bonds?
- Foreign Investors are lured by the higher interest rates of masala bonds than AAA corporate bonds in Western countries such as the US. Hence, investors get an excess spread that they think will not be extinguished by a depreciating rupee. Investors speculate that the INR will either remain steady or appreciate from current levels vs. the dollar
- Foreign investors are likely to be bullish on the rupee on the back of the consistent GDP growth rates being enjoyed by India and its future potential. The strong government at the center has removed policy paralysis and important legislations such the GST bill are being cleared swiftly. The stock markets are on an all-time high, partly because of continuous FII inflows
- Concerns on credit risk are mitigated by sound credit ratings of companies permitted by the RBI
- The size of the issues are large, which in turn reduces liquidity concerns for investors
In the table above, we have tried to highlight the excess return generated by a US investor by choosing masala bonds of HDFC bank over AAA corporate bonds. Please note that in this case apart from the interest rate spread of 4.2%, there is also returns of 4% due to an appreciating rupee, taking the overall return to 8.2%.
An interesting thing to note is that for all the gains due to a higher interest rate on masala bonds to be set off, the rupee must fall 4.2% during this period. Foreign investors speculate that may not happen given the strong economic fundamentals of the Indian economy.
Success of masala bonds in India – the journey has just begun
After the IFC’s initial success, many Indian companies have started raising money via masala bonds, and there is a growing appetite for such issues among global investors. Some of the companies that have taken this route are:
- HDFC Bank became the first Indian company in July 2016 to raise INR 3,000 crores via masala bonds. The issue was oversubscribed by 4.3 times at an annualized yield of 8.33%. The tenor was 3 years and 1 month
- NTPC raised $300 million (INR 2,000 crores) via 7.48% “Green Masala Bonds” in August 2016
- India bulls Housing raised $200 million (INR 1,350 crores) via 8.58% masala bonds in September2016
- NHAI raised $800 million (INR 5,000 crores) in May 2017
Many other Indian companies such as PFC and IRFC are looking to follow suit and raise money via this channel.
Conclusion: The Masala Bond program has created a platform for internationalization of the Indian rupee, deepened India’s capital market, and made it more resilient. International investors and domestic entrepreneurs can benefit from India’s strong economic fundamentals.
The international demand for high-quality emerging market assets remains strong – notwithstanding global financial uncertainties – and is likely to support private sector development in emerging market nations through well-functioning onshore and offshore local currency bond markets.
The London Stock Exchange has been the preferred platform for all masala bonds because of its record in supporting issuances in local currencies from across the world, such as dim sum bonds (yuan denominated) issued by Chinese and non-Chinese companies.
We believe that the masala bonds will gain immense popularity over the next few decades, as India looks to become a global economic powerhouse.
Author – Vaibhav Aggarwal
Sources – Moody, IFC