Partial credit enhancement to bonds by RBI

 Context: The Reserve Bank of India (RBI) has allowed banks to provide partial credit enhancement (PCE) to bonds issued by systemically important non-deposit taking non-banking financial companies (NBFCs) registered with the RBI and housing finance companies (HFCs) registered with the National Housing Bank.

Significance:

The move is aimed at enhancing the credit rating of the bonds and enabling these NBFCs to access funds from the bond market on better terms.
PCE is expected to help NBFCs and HFCs raise money from insurance and provident or pension funds who invest only in highly-rated instruments.

Key facts:

The tenure of these bonds shall not be less than three years and proceeds from them shall only be utilized to refinance existing debt.
Banks shall introduce appropriate mechanisms to monitor and ensure that the end-use condition is met.
The central bank has restricted the exposure of a bank through PCEs to bonds issued by each such NBFC or HFC to 1% of capital funds of the bank within the current single and group borrower exposure limits.
Banks are allowed to provide PCE as non-funded subordinated facility in the form of a contingent line of credit to be used in case of shortfall in cash flows for servicing the bonds and thereby improve the credit rating of the bond issue.

Background:

The incentive comes at a time when NBFCs and HFCs have requested the government and regulators to ensure that confidence returns to the market. They have sought relaxations of the National Housing Bank’s credit rating norms related to refinance, lowering of the criterion on years of existence to one year, providing for 10% of the loan loss by the government and capital infusion in banks.

What is credit enhancement?

Credit enhancement means improving the credit rating of a corporate bond. For example, if a bond is rated BBB, credit enhancement, which is basically an assurance of repayment by another entity, can improve the rating to AA. This is done to provide an additional source of assurance or guarantee to service the bond.

RBI has now allowed banks to provide credit enhancement up to 20% of the total bond issue. This means banks (one or many together) can assure repayment of dues related to a bond issue up to 20% of the value. Other than banks, organisations such as India Infrastructure Finance Co. Ltd also provide this facility.

BENEFITS FOR THE ISSUER:

Typically, bonds issued by subsidiaries or special purpose vehicles (SPVs) of infrastructure companies seek enhancement. Since the projects take a long time to become operational and generate money, along with the risk of implementation, often their formal credit rating is not very high. Through the credit enhancement facility, the existing rating can be improved at an early stage, which enables the issuer to raise funds at a relatively lower yield. Higher the credit rating, lower is the cost of raising funds.

Since these bonds are long-term in nature, they appeal to institutional investors like pension funds and insurers. However, these investors, especially pension funds, invest mostly in investment grade securities which are at least AA-rated. Credit enhancement makes the bonds more attractive by improving the rating enough so that institutional investors become interested in adding these to their portfolios.

BENEFIT FOR THE INVESTOR:

For the investor, the facility provides a sort of insurance in case of hard times. Basically, the credit enhancement gets used only when there is a shortfall in either paying interest or repaying principal. Hence, investors are more secure about repayment even if there is uncertainty regarding cash flows for some time.

BENEFITS FOR THE BOND MARKET:

The bond market will benefit as more issues get placed, which will help in developing the secondary market. This is useful in giving investors an early exit route, and in adding stability to secondary market transactions in long-term corporate bonds. At present, however, there is not much trading happening in long-term corporate bonds from infrastructure companies in the secondary market.

By: Priyank Kishore