Overexposure to Masala Bonds kills its forex boons

Masala bonds are nothing but another form of a debt instrument — the only difference being that these bonds are denominated in Indian rupees, but are issued in geographies outside India.

Such type of bonds were first issued by the International Finance Corporation (IFC) in November 2014 — the quantum of the issue was Rs 10 billion (Rs 1,000 crore) and the bonds were listed on the London Stock Exchange (LSE). The idea behind issuing the bonds was to raise capital to fund infrastructure projects in India. The name ‘Masala Bonds’ came about in IFC’s effort to give a bit of Indian flavour to the name, and therefore relying on the Indian culture and cuisine; basing it on the fact that Indian cuisine as represented by the ‘Spicy Masala Curry’, which is quite popular throughout the western world.

The chronology
Interestingly, Masala Bonds were not the first of such bonds issued internationally — while with respect to the Indian currency, the first Masala Bond issue was in November 2014 (as mentioned above). Similar bonds, denominated in the Chinese Renminbi (RMB) but issued outside China, were issued by the China Development Bank in 2007 — these bonds are called ‘Dim Sum Bonds’. Over the years Dim Sum Bonds have become very popular, with Hong Kong, London and Luxembourg being the major financial centres where these bonds are traded. According to a Citibank July 2016 report, at present there are a total of 110 Dim Sum Bond issues trading in the market with a par value of RMB 183.10 billion and a market value of RMB 185.22 billion — the average coupon is 4.10%, the Yield to Maturity (YTM) is 4.05% and the average life is 3.34 years, with over 75% bonds being of the investment grade. Interestingly, these bonds are an offshoot of the Eurobonds that have been in existence since 1963 with some modifications and choice of currencies.

According to one of the world’s leading stock exchanges, currently, as many as 30 offshore Indian rupee bonds have listed in total on the LSE, raising an approximate amount $3.5 billion. The major Masala Bond issues till date are:

*A Rs 10 billion ($150 million) issue in November 2014 by IFC to fund infrastructure projects in India
*A Rs 3.15 billion ($47.25 million) issue in August 2015 by IFC to be used for private sector investments that address climate change in India.
*A Rs 30 billion ($450 million) issue in July 2016 by HDFC — the first Indian company to issue Masala Bonds
*A Rs 20 billion ($300 million) issue in August 2016 by NTPC — the first corporate Green Masala Bonds
For Masala Bonds, as in the case of Dim Sum Bonds, the currency risk is borne by the bond investors. This is unlike normal foreign currency bonds, where the borrower bears the currency risk.

The game changer
Masala Bonds, while still in its infancy, can turn out to be a significant game changer for the Indian economy, going forward. The bonds are issued to foreign investors and settled in US dollars. Thus, as stated earlier, the currency risk lies with the investor and not the issuer, unlike external commercial borrowings (ECBs). While ECBs help Indian companies raise debt capital internationally by taking advantage of the lower interest rates in international markets, the cost of hedging the currency risk can be significant and has to be borne by the issuer — if unhedged, adverse exchange rate movements can have significant negative impact to the borrower and thus the “all – in” cost of borrowing through ECBs land up will be much higher than the international market rates. However, in the case of Masala Bonds, as the currency risk is borne by the investor, the cost of borrowing can work out much lower compared with ECBs.

The obvious two questions that come up are whether avoidance of the currency risk a significant advantage for the issuer and second if the currency risk is borne by the investor, what is in it for investors?

To address the first question about the significance of currency risk, one should go back a few years, to around 2006–2007, when the Indian rupee was appreciating against the US dollar. Based on this information and appreciation, as observed in the market, a number of Indian companies raised money through ECBs — particularly using Foreign Currency Convertible Bonds (FCCBs). However, subsequent to the ‘Global Financial Crisis’ in 2008 and more recently the ‘Tapering Crisis’ in 2013 the Indian rupee significantly devalued against the US dollar causing huge distress to all those entities who had gone the ECB route to raise capital. The 2013 Tapering Crisis was of great worry, as within three months the Indian rupee depreciated by about 15% causing huge losses arising out of the currency movements.

Where is the edge?
Now to the second question, given that the investor will bear the currency risk, what benefit entices the investor to invest in Masala Bonds? To make the bond attractive to the investor, the issuer offers a significantly high yield (coupon rate) — much higher than otherwise available in the market to compensate for the risk arising out of currency depreciation. The high returns therefore serve as an attraction to investors to invest in such bonds. For example, the HDFC issue offers an ‘all – in’ annualised yield of 8.33% per annum as against the average yield of just under 2% per annum of 10-year securities in the UK market. The additional return in the order of 6% cover for both default risk as well as the currency risk. Interestingly, the demand for such bonds seems to be very high — the HDFC issue for example was about four times oversubscribed.

Finally, what other impacts could Masala Bonds have that one should be cognizant of. In a sense Masala Bonds can have impact on the Indian rupee value, the interest rates and the economy at large.

Some benefits of Masala Bonds can be that international competition could hasten the development and maturity of the fixed income market in India, making the market more broad-based and active. Further, if the Masala Bonds really become popular with overseas investors, then they can be a huge support to the Indian rupee. This has been exemplified by the rising demand for Dim-Sum Bonds, which significantly promoted the use of RMB in global trade and investment as well as offered investment avenues for RMB holders based outside of China.

However, like everything there is a potential downside as well. Too much of reliance on external debt (including uupee denominated) aided by the issue of Masala Bonds apart from the traditional ECBs can lead to serious negative impact on the sovereign ratings of India, and thereby creating a problem of attracting investments to India.

In conclusion, Masala Bonds are a good idea to protect the issuers from exchange rate risks, but like anything else, overexposure to the same could lead to undesired adverse outcomes.

(The author is Professor of Finance and Accounting, IIM Bangalore)