New RBI Guidelines on Issuance of Masala Bonds

In June, the Reserve Bank of India (RBI) notified significant policy changes regarding the issuance of ‘masala bonds’, bringing them in alignment with the other elements of the External Commercial Borrowings (ECBs) framework.

Masala bonds are a popular debt-financing instrument used by Indian entities to raise funds in the overseas market.

Reasons for issuing and investing in masala bonds

Unlike other ECBs, such as ‘medium term note’ or a ‘floating rate note’ that are mostly dollar denominated, masala bonds are rupee dominated borrowings. That means that although masala bonds are settled in dollars overseas, the returns from it is determined by the rupee-dollar exchange rate and is repaid to the issuer (domestic entities) in rupees.

By issuing, or pricing bonds in rupees, the issuer is insulated from the volatile exchange rate and the associated currency risk; the risk is instead, passed on to the investor.

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Further, masala bond issuance allows domestic entities to access a large and diversified pool of global investors, apart from funding via banks and the corporate bond market in India.

For global investors, masala bonds are a high yield investment opportunity that offers easy access to India’s asset market and its rapidly growing economy.

If the rupee appreciates at the time of returns, an investor is likely to benefit from his investment in masala bonds. Besides, the government of India allows capital gains tax exemption on income accruing due to rupee appreciation.

Moreover, the withholding tax rate payable over and above the interest income of masala bonds has been significantly reduced from 20 percent to 5 percent.

Revised rules

• Maturity period

The RBI has raised the minimum maturity period for masala bonds issued over and above US$50 million equivalent in rupees to five years, while the same has been kept to three years for issuance up to US$50 million equivalent rupees. Earlier, a common three years minimum maturity period was allowed, irrespective of the size of masala bonds issuance.

Given that the foreign currency risk is borne by the investor, an increase in maturity period in an unpredictable market is likely to reduce the attractiveness of masala bonds internationally.

• All-in-cost ceiling

Earlier, pricing for masala bonds was determined by the prevailing market conditions. In general, the bonds were priced higher to counter the possible currency risk, which is borne by the investor.

The new amendments have now prescribed an all-in-cost ceiling for such bonds at 300 basis points over the prevailing yield of the Government of India securities (G-sec) of corresponding maturity.

G-sec is a debt-financing instrument issued by the Indian federal or state governments to funds their fiscal deficits. In other words, there is now a fixed cap on the maximum interest rate that can be paid on masala bonds, in correspondence with the prevailing interest rate paid on the G-sec of similar maturity period.  

According to the currently prevailing G-sec yield, ranging from 6.521 percent 6.793 percent, the corresponding all-in-cost cap for a masala bond would be in the range of 9 to 10 percent, depending on the maturity period. 

• Recognized investors

According to the new guidelines, the investors investing in the rupee denominated bonds cannot be a ‘related party’ to the issuer of such a bond, as per the definition provided under the Indian Accounting Standard (IND-AS) 24. 

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Broadly, a ‘related party’ means a parent or subsidiary company, joint ventures, group companies, or associate companies, which are controlled by a common entity.

There was no such restriction on limiting any intra-group transactions in the previous framework.

Further, any proposals for borrowings in masala bonds will be subject to examination at the foreign exchange department’s central office in Mumbai, and subject to the approval of the RBI.

New rules – a step forward or a step backward?

Given the rise in issuance of masala bonds and exposure of domestic entities to the international market, some analysts view the revised rules as a step forward in strengthening India’s regulatory system governing ECBs.

The new rules are intended to curtail the reach of low rated-domestic companies to overseas funding, and allow only companies with a good credit rating to raise funds abroad. 

However, for the masala bonds market that had just begun to make an appearance in the international market, the tightened regulations are a retrograde step that will only alter the RBI’s earlier efforts to stimulate the global demand for rupee denominated bonds. 

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