Noting that the lack of depth and liquidity in India’s corporate bond market is leading to “significant dependence on bank financing”, the Second Quarter Review of Monetary Policy 2013-14 by the Reserve Bank of India (RBI) proposed the issuance of guidelines to allow banks to offer partial credit enhancements (PCEs) to corporate bonds by way of credit facilities and liquidity facilities.
On 20 May 2014, the RBI issued draft guidelines allowing banks to provide PCEs to corporate bonds issued by companies and special purpose vehicles (SPVs) for financing infrastructure projects. The circular accompanying the draft guidelines notes that this is an initial measure. Presumably based on the success of the final guidelines, the RBI will expand the ambit of such PCEs to sectors other than infrastructure.
Why this measure?
The draft guidelines note that bond financing rather than bank financing should be the “natural choice” for fund raising in the infrastructure sector because insurance companies and pension funds with long-term liabilities are more suited to provide financing to the sector than banks, which are exposed to liquidity risks due to asset-liability mismatches. However, regulations require insurance companies and pension funds to invest in highly rated instruments, and bonds issued by infrastructure companies and SPVs do not normally get high ratings due to risks at various stages of the implementation of the project.
The draft guidelines envisage PCEs to improve the credit quality of the bonds issued by the project company. By providing PCEs that are subordinated to senior bonds issued by the project company, the credit rating of such bonds would improve. This would enable insurance companies and pension funds to subscribe to the bonds.
Under the draft guidelines, PCEs can only be provided by way of loans or contingent facilities and not by way of a bank guarantee (to prevent “piggy-backing” on the bank’s credit rating). PCEs would be limited to improving the bonds’ credit rating by up to two notches or 20% of the aggregate bond issuance, whichever is lower. PCEs would be subordinated to the repayment of the senior bonds but would rank ahead of other liabilities of the project. Banks must also ensure that the project assets in relation to which the PCEs are provided are ring-fenced, and the cash flows are subject to an escrow account mechanism.
The draft guidelines contemplate PCE by way of a subordinated loan to fund construction and other project costs, which will then be repaid during the operation of the project. As the loan will be subordinated to the senior bonds, it will, in effect, act like a “first loss piece” during both the construction and the operation phases, reducing the probability of default during the project operation phase and therefore improving the credit quality of the senior bonds.
Banks can also provide PCE in the form of a subordinated non-funded contingent facility that is irrevocable and revolving in nature. Such PCE can only be used on the occurrence of predetermined project risks or credit events such as a cash shortfall during construction or debt service shortfall post completion of the project. The draft guidelines further specify that contingent facility PCEs should not be used to meet recurring expenses other than the servicing of the senior bonds and the purchase of additional assets.
Similar to the subordinated loan PCE, the contingent facility PCE will also be subordinated to the senior bonds. The draft guidelines contemplate that the contingent facility PCE will benefit the senior bonds by mitigating the risk of cash flow shortfall. Further, as the PCE will be revolving in nature, amounts repaid would be available for further use.
The draft guidelines provide that if any interest or principal instalment in relation to a PCE is overdue for a period exceeding 90 days the PCE facility will be classified as a non-performing asset. It would be preferable if this stipulation applied after the commencement of commercial operations of the project and the repayment of the senior bonds by the project company. Further, the final guidelines should take into account the recently issued “early warning system” for distressed loans, which envisages that banks can take action against a borrower if its facilities are overdue for more than 60 days.
The draft guidelines also prescribe that PCE can be provided either in the form of a subordinated loan or a contingent facility, but not both. No rationale is given for this stipulation. Some projects may require a mix of both fund-based subordinated loans and non-funded contingent facilities. As long as the overall limits prescribed by the draft guidelines are adhered to, the choice of facilities should be left to the banks and the borrowers.
In spite of such teething issues, the issuance of these draft guidelines is a step in the right direction to strengthen and deepen the corporate bond market so as to facilitate infrastructure financing by institutions other than banks.
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