Masala Bonds

Masala Bonds are Indian Rupee (INR) denominated debt instruments that are issued by Indian entities in the overseas capital markets. The term ‘Masala’ is a Hindi word for spices and hence, these bonds were named Masala Bonds by the International Finance Corporation (IFC) to popularize the culture and cuisine of India. The objective of this bond is to fund the infrastructural program, fuel internal growth, and internalize the Indian currency. The current top issuers of Masala Bond are HDFC Ltd., NTPC Ltd., and Indiabulls Housing Finance.

The concept of Masala Bonds started nearly six years ago by the Government of India and IFC to stem the record fall in rupee due to capital flight and a severe hike in the current account deficit. In June 2013, the rupee closed at a record high of ₹66.24/dollar. Hence, the UPA government came into action. The Government after consulting with IFC decided to launch a rupee-denominated bond in the international markets. Since FY14, IFC has issued seven tranches of the offshore rupee-denominated bond.

The unique feature of this bond is that the rupee currency risk is borne by the foreign investors instead of the bond issuer. Hence, benefitting most of the Indian companies. To understand the benefit, let’s assume an Indian company XYZ Ltd. issued a dollar-denominated bond to the tune of $300 million at a 7% interest rate and the exchange rate at that point was ₹60/dollar. Thus, the company effectively raised ₹1800 crore and deployed it into XYZ Ltd.

Now when the bond was redeemed 5 years later, the prevailing exchange rate was ₹70/dollar. XYZ Ltd. will require ₹2100 crore to repay $300 million to the bondholders. Therefore, XYZ Ltd. will have to pay an additional ₹300 crore due to rupee depreciation. Obviously, this is the kind of currency cost which most Indian companies cannot afford and at times like those Masala Bonds come to the rescue.
There might be a question, as to why will anyone be willing to invest with such risk? There are two reasons. Firstly, foreign investors are tempted by high returns offered by Masala Bonds and secondly, foreign investors are betting that INR will either be stable or appreciate against the dollar at the time of maturity. Let us see some of the advantages and disadvantages of this bond.

Advantages of Masala Bonds

  • Helps in building up foreign investors’ confidence in the Indian economy and currency.
  • Benefits the Indian company to diversify their bond portfolio.
  • Reduces the finance cost for Indian companies as the interest rate of Masala Bonds is less than bonds issued in India.
  • The foreign investor can also benefit from the bond if the rupee appreciates at the time of maturity.

Disadvantages of Masala Bond

  • Too much reliance on external debt aided by Masala Bonds can lead to a serious negative impact on the sovereign rating of India.
  • Overexposure to Masala Bonds can hurt investment conditions in India, thereby creating a problem in attracting investments.
  • Foreign investors can be hurt from the bond if the rupee depreciates during the time of maturity.

From the Investors’ point of view

Masala Bonds are typically bought by non-resident Indians and foreign investors. When looking at a local currency bond, foreign investors generally look for a relatively stable local currency and economy. Some of the benefits to the foreign investor from these bonds are:

  • These bonds offer an additional interest of 4-5 % above the London Interbank Offered Rate (LIBOR). (from an international perspective)
  • The investor has to pay a lower tax rate of 5% instead of 20% earlier.
  • These bonds are issued outside India and are settled in US dollars. Thus, provide convenience to foreign investors.
  • Foreign investors can take exposure by investing in Indian assets from their offshore locations via Masala Bonds without any constraint.

Despite the benefits, foreign investors seem to have lost their appetite for this bond. The recent interest rate cuts by Reserve Bank of India in the efforts to revive the economy and currency fluctuations have stripped the value-add of Masala Bonds for Foreign Investors and have resulted in a ‘Dual Loss’.

These rupee-denominated bonds carry interest rates up to 5% above the SBI’s base rate (from the Indian perspective). However, after the numerous rate cuts by RBI in March, SBI’s base rate has fallen from 8.45% to 8.15% which implies that the highest rate that Masala Bonds can offer in the lower tax bracket has fallen from 13.45 to 13.15%. According to an article released in Economic Times, several deals were happening around 13.4% interest rates until mid-March. As investors were willing to sacrifice additional return from this bond as returns greater than 13.45% (8.45% + 5%) were subject to a greater tax bracket (15-40 %) based on their country.
As we know, the issuer of the bond is shielded against the currency fluctuation as the same is borne by the investor. If we compare the Rupee-Dollar exchange rate of 7th August 2019 to 26th August 2020 which was ₹69.2/dollar and Rs 73.8/dollar respectively, foreign investors have been earning lesser real returns because of rupee depreciation in terms of dollar.

However, if we see the future implication, Masala Bonds can be less palatable for the foreign investor currently because of the inherent currency risk and increased volatility of Rupee to Dollar exchange rate. Conversely, factors like India’s growth potential & a favorable business environment along with different projects like ‘Make in India’ might stimulate the investors’ confidence in rupee hence, providing a huge market for this financial instrument in the coming years.

Contributor: Team Leveraged Growth
Co-Contributor: Devansh Bihani & Mukul Gupta
Research Desk | Leveraged Growth

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