Covered Bonds: A Liquidity Fix For NBFCs Amid The Pandemic
India's non-bank lenders have struggled with liquidity for the last few years for reasons ranging from the collapse of IL&FS to concerns around asset quality.
Now, as these lenders try to overcome their liquidity troubles and borrow at lower rates, covered bonds—a relatively new class of securities in the Indian markets—have come to their rescue.
Between April 2020 and March 2021, non-bank lenders raised Rs 2,218 crore, compared to Rs 400 crore raised in the previous fiscal, according to data from rating agency ICRA Ltd. The momentum did not weaken in April and May, as three more entities ended up raising another Rs 225 crore via the covered bond route.
So far, about 75% of such issuances have come from entities with a credit rating of A and above. The tenure of these borrowings ranges from 13-60 months.
As covered bonds gain wider acceptance, especially among long-term institutional investors, the appetite for these instruments could improve, said Abhishek Dafria, vice president and head - structured finance ratings at ICRA.
"Going by the way these instruments have been gaining popularity over the past year, there is a high chance that they could become a mainstay in the Indian bond market," he said. "But time will only tell.”
Why Covered Bonds Are Gaining Traction?
Covered bonds, common in overseas markets like Europe, are structured debt instruments. A pool of assets is set aside to back the bond and, in addition, specific collateral is assigned to the bond.
For instance, a pool of gold loans may be used to back a covered bond. The income from these loans will be used to pay the coupon. In addition, the bond will be backed by collateral in the form of gold, to cover investors in the case of a default.
This gives double recourse to investors.
The dual recourse benefit, according to Amit Tripathi, chief investment officer-fixed income at Nippon India Mutual Fund—one of the few mutual funds in the country with an exposure to covered debt instruments—is the “most attractive” feature of these bonds.
“A similar level of flexibility isn't available to investors in other debt instruments. Even in securitisation transactions, loan pools once assigned to an investor aren't replenished by the originator if their asset quality deteriorates," Tripathi said. "That risk is mitigated in covered bonds by regular substitution of assets that don't adhere to the pre-defined pool quality mandate on an ongoing basis."
The minimum security cover ranges anywhere between 1.2-1.5 times the bond amount, depending on the type of loans that are clubbed. "These covenants need to be maintained by the issuing entity at all times to avoid a trigger event," Dafria said.
Another attractive feature of covered bonds is the expected bankruptcy remote nature of the cover pool assets, said Vibhor Mittal, chief product officer at CredAvenue—an enterprise debt platform wholly-owned by non-bank lending entity Vivriti Capital Pvt.
The covered bond instrument is a hybrid between a secured corporate bond and a securitisation transaction. As per the legal view, under the Indian Bankruptcy Code, if assets are held in trust by a company for the benefit of an investor, then these assets won't form part of the liquidation estate of the company.Vibhor Mittal, Chief Product Officer, CredAvenue
Lower Cost Of Borrowing
Due to the benefit of security pool, covered bonds are usually rated higher than their issuer entities, in turn, reducing the cost of borrowing for issuers.
The cost of borrowing for NBFCs via the covered bond route, Mittal said, usually ranges anywhere between 8-11%, depending on the rating, perceived credit profile of the issuer, tenor of the paper and quality of the asset pool.
This could be 50-150 basis points below the cost of borrowing via other means.
Further, investors are preferring to structure these instruments as market-linked debentures with pay-outs at the time the instrument reaches maturity, compared to the regular coupon-bearing securities.
"Covered bonds structured as MLDs offer better net of tax returns compared to NCDs or other debt instruments that are available, besides offering relatively higher yields,” said Nimish Shah, chief investment officer-listed investments at Waterfield Advisors.
This, as MLDs, usually issued for a period of 13-60 months, are presently taxed at 10% plus surcharge. NCDs attract a 20% long-term capital gains tax applicable when sold after a year or before the maturity date.
Of the total covered bond issuances in the country, 69% by value were structured as MLDs, while the remaining as NCDs, according to ICRA. Close to 43% of the investments into covered debt instruments came from high net-worth individuals and family wealth offices, it said.
Cheaper Borrowing But For Select NBFCs
The instrument works well as a cheap funding source for non-banking financial companies, which are well-capitalised but rated lower in the BBB to A range, at a time when liquidity remains constrained.
For instance, Ess Kay Fincorp Ltd., that primarily focuses on vehicle financing and business loan segment, has in the recent past raised over Rs 300 crore through a mix of covered NCD and MLD issuances.
Borrowing costs via these instruments were 125-150 basis points below other funding avenues, said Vivek Singh, head of resource mobilisation and treasury at the non-bank lender.
Udaya Kumar Hebbar, managing director and chief executive at CreditAccess Grameen, shared that view. The microfinancier raised Rs 50 crore via a covered bond issuance that took its borrowing cost to 8.6%, which was 40-60 basis points lower than its average cost of funds.
The covered bond product, however, isn't a great fit for all kinds of NBFCs.
"Because of the short-tenor nature of covered bonds, they would not be the first choice product for institutions (NBFC/HFCs) that offer longer tenure loans," said Srikanth G, chief of strategy and finance at Five Star Business Finance.
Five Star has raised over Rs 200 crore via the covered bond route at a comparatively 75 -100 basis points lower than its average cost of borrowing by offering a covered pool of loans as security.
"While good from a diversification perspective, for entities like ours where typical loans range anywhere between 5-7 years, the product carries an inherent asset-liability mismatch," he said. "Therefore, we would not prefer to have a significant exposure to covered bonds beyond a certain percentage of our overall borrowing."
Data from ICRA also showed that based on the asset class, gold loans had the highest 46% share in market volume for covered bonds, followed by 28% for vehicle loans, 12% each for small business and wholesale loans, and just 2% for microfinance loans.
Covered bonds in the domestic market may not suit all kinds of NBFCs. Investors may have a preference for relatively shorter tenure bonds which would be more suitable for vehicle and gold loans, rather than housing and long-tenure small business loans.Abhishek Dafaria, Head - Structured Finance Ratings, ICRA
The extent of covered bonds that can be issued may also be restricted by collateral available.
"If the covered bond issuances increase, the ability of the issuers to maintain the security cover would remain critical given the tighter eligibility criteria stipulated for the contracts," Dafria said. "Otherwise it would be considered as a trigger event which could lead to a step-up on the coupon rate for the bonds."
Going by the current pace at which the covered bond instruments are growing, Mittal expects covered bond volumes to go up anywhere close to Rs 8,000 to Rs 12,000 crore in the current fiscal. "The number could be higher if large NBFCs decide to raise a substantial amount using the covered bond route."