New, tighter regulations on foreign holdings of Indian rupee-denominated corporate bonds and offshore issuance will reduce options for companies to diversify their funding sources, at least temporarily, Fitch Ratings says. The rules will also prevent the use of certain complex transaction structures, which have recently gained popularity among corporate issuers.
The Securities and Exchange Board of India (SEBI) announced last week that foreign purchases of rupee-denominated corporate notes would only be permitted through auction once foreign holdings reached 95% of the cap. At present, foreign portfolio investors can invest up to INR2,443 billion (USD51 billion) in corporate bonds issued by Indian companies. Foreign ownership is already above 95% of the cap, which means these restrictions have come into effect. Issuance of offshore 'masala bonds' will also cease entirely until foreign ownership falls to 92% of the cap. A separate ruling earlier in the month by the Reserve Bank of India (RBI) had already tightened the rules on masala bond issuance, banning their sale to related entities, lowering the cap on spreads over government bonds, and extending the minimum maturity.
Borrowers can still tap rupee debt via the Track III External Commercial Borrowing (ECB) route. However, this option subjects borrowers to a higher withholding tax on interest (of 15% as against ongoing 5% for corporate notes), a minimum maturity period of five years for amounts raised in excess of USD50 million, and greater administrative requirements - and thus procedural delays. Moreover, if the investor in debt securities is a corporate entity (i.e. not a bank, financial institution or investment fund for example), such investors will need to have a minimum ownership interest in the onshore borrower or a common overseas parent; this requirement will prevent many companies from using this route as most Indian onshore issuers do not have off-shore incorporated holding companies. Even for those that can use this option, we do not think the ECB Track III route will be the first port of call; however, given the limitations introduced on other options, issuers looking to raise large amounts of funds may use a combination of the options, including ECB Track III, to meet their needs.
The hiatus on masala bond issuance triggered by SEBI's regulations has put the plans of some large corporates on hold. The decision could dent confidence in the instrument and hold back the market's medium-term development. The first masala bonds were only issued in mid-2016, and the market still lacks the depth that would make them more attractive to foreign investors. Better-quality issuers, such as NTPC Limited (BBB-/Stable; an active masala bond issuer) should be able to reconsider masala bonds, if and when the cap on foreign ownership of rupee bonds is eventually raised or foreign ownership falls sufficiently.
The RBI's regulations were more targeted, and aimed at ensuring that only relatively strong corporates tap the offshore market. Restrictions on maturity and cost will prevent issuance by lower-rated companies, while the ban on sales to related entities will tackle the issue of circuitous structures. Some companies have sold masala bonds to linked special-purpose vehicles, which in turn have raised funds for the purchase by issuing dollar-denominated debt. This structure allows issuers to take advantage of cheaper offshore borrowing costs, but effectively results in them assuming currency risk, which negates masala bonds' intended function. Again, it is lower-rated entities that have tended to use this structure.
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