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Offshore is on, onshore is off

01 Oct 2012

Indian issuers have managed to turn to both offshore and onshore investors to sell hybrid bonds, boosting their balance sheets and protecting themselves against potential downgrades. But while the outlook for hybrid issuance in the international market looks good, bankers are not so optimistic about domestic opportunities, reports Matthew Thomas.

India’s capital markets are, from some perspectives, in need of a lot of development. Most banks cannot issue senior bonds in the market, high yield issues are rare, and secondary trading is still thin. But the rupee debt market sometimes manages to excel in a way that other Asian local currency markets cannot: corporate hybrid bonds are one example.

Indian companies are still not frequent issuers of international hybrid bonds, structures which are sold to debt investors but are partially counted as equity. But both Ballapur International Graphic Paper and Tata Power have turned to dollar bond investors for hybrid financing, and offshore bankers are hopeful for more.

In most Asian countries, that would be the end of the story. But since early 2011, a domestic corporate hybrid market has started to develop in India.

Tata Steel became the first ever Indian company to sell a domestic hybrid, when it raised Rs15bn from a perpetual non-call 10 year deal in May 2011, later increasing this deal by another Rs7.75bn. That was the only rupee hybrid sold last year, but Tata Power reopened the market in the middle of August, selling a Rs15bn 60 year non-call 10 deal.

These deals represent an impressive step forward for a bond market that is still at an early stage of development. But bankers think the prospects for a big growth in rupee hybrid issuance over the next 12 months are limited. There are not enough investors to drive a rise in issuance from any but the most well-known local companies — and the dollar market is starting to look like an increasingly tempting alternative.

The rupee market may remain stilted for some time, but it is clear that local bankers’ loss will be international bankers’ gain. And that gain is likely to be a big one.

No longer scared of high coupons

Indian companies hoping to fund offshore face a wide array of rules that can often frustrate funding officials — and foreign bankers trying to win business from the country. The central bank publishes a long list of external commercial borrowing rules, imposing limits on the maturities companies can issue in, the interest rates they can pay and the size they can raise.

But perhaps more significantly for the hybrid market, India’s finance ministry charges withholding tax on the offshore bond issuance of Indian companies. The higher the coupons a company needs to pay, the more tax they have to stump up — and hybrid coupons are, by definition, among the highest corporations will ever face.

This partly explains why there have only been two dollar hybrid bonds from Indian issuers so far. But the announcement on September 21 that the government was cutting withholding tax for infrastructure companies from 20% to 5% gives a lot of potential issuers more breathing room when turning to the international hybrid market, and should lead to a big rise in hybrid issuance.

"The reduction in withholding tax will drive hybrid and perpetual issuance offshore," says Avinash Thakur, director of DCM in Asia Pacific at Barclays. "The swap market works very well, but the 20% withholding tax turned some issuers off selling bonds with high coupons. Now that the withholding tax [has been] reduced to 5% [for some issuers], they will have more leeway to offer high coupons."

That will not just give bankers a source of business, and investors a way to add some diverse structures into their portfolios, it will also help bolster the balance sheets of Indian companies. Hybrid bonds are a relatively new product in Asia; Cheung Kong Infrastructure raised $1bn from the first such deal in Asia in September 2010. But they have already proved a popular way for corporations in the region to reduce their chances of covenant breaches, bolster their ratings and add some stability to their balance sheets.

The value of hybrid bonds is especially useful for Indian companies at the moment. In June 2012, Fitch revised its rating outlook for India — and following that, a host of state-owned companies and banks — to negative, partly in response to the country’s slowing growth. Indian issuers and bankers are, perhaps unsurprisingly, still bullish about the country, but now is undoubtedly a good time for these companies to turn to the capital markets to improve investors’ views of the country further.

"Hybrids are a good way to protect your ratings," said a Mumbai-based DCM banker. "India is going through some policy uncertainty at the moment, especially in the power sector, and there is a risk that can have an impact on ratings."

This demonstrates one of the key features of hybrid bonds: they become increasingly more tempting the more a company is suffering — or worrying about suffering — from a downgrade or, more seriously, from problems maintaining strong accounts. That might make the slowdown in India’s economy, as well as the global economy, appear a boon for hybrid bankers. But this is not necessarily the case.

The format is still easiest to sell to ambitious companies: it works best for those that are planning overseas acquisitions, and it only seems appealing to funding officials willing to use innovative structures to help them fund. And even ignoring a slowdown in M&A activity, some bankers also question the ability of a vast array of Indian companies, rather than a few top ones, to tap the market.

But most DCM bankers still think there is enough supply to ensure a big rise in dollar hybrid issuance following the tax cut, earning them chunky fees in the process. The outlook for the domestic market is not so
optimistic.

Tata, Tata — and who else?

Tata Power and Tata Steel may have been able to appeal to the domestic investor base in hybrid format, but bankers say that Tata Group companies — among the biggest and best-known in India — stand out from the crowd.

There are few other Indian corporations that could pull off hybrid bonds at sustainable interest rates, and this is not just a problem that applies to the onshore market.

"The hybrid market is clearly open for Indian issuers, but it is really only an option for truly high-grade companies, whether we are talking about offshore or onshore issuance," says Maneesh Malhotra, head of debt finance in India at HSBC.

The definition of high grade can, however, be very different in the international market, other bankers argue. Most international hybrid bonds — whether issued by Indian issuers or those in the rest of Asia — are driven by high net worth investors, those who are willing to take a punt on a good company paying a high interest rate, and also willing to take the risk of more dicey structures. It does not hurt that most hybrid bonds also offer a rebate to private banks, which typically act as a conduit for high net worth investors to the international market.

"It is a very nascent market, so while it works for some well-known issuers it is not really open to the smaller companies," says Thakur. "Even in the dollar market, you need to be a well-regarded issuer. But the difference is that retail investors can drive dollar transactions, and you still don’t have that retail bid in India."

This was part of the reason that ICICI Bank, one of the lead managers, took a large chunk of the first ever rupee hybrid — Tata Steel’s Rs15bn offer — onto its own books, although the bank was confident it could sell some of the deal in the secondary market, said bankers.

But even some of those investors who watched the pricing of that debut issue with interest said that the pricing on Tata Power’s issue looked too tight. The original Tata Steel deal yielded 11.8%, and even though that got pushed down to 11.5% for the tap, the deal still offered more than the 11.04% yield paid by Tata Power in August.

"The pricing of the Tata Steel deal looked attractive, but already the second deal was not as tempting," said a Mumbai-based investor.

Investors are always going to fight back against falling coupons, and in the bond market, there will rarely be a time when both issuers and investors were happy. But without a natural investor base for hybrid issuance, a handful of accounts could have a big impact on the success of future deals. That does not bode well for future rupee hybrid supply.

This does not mean the developments in the Indian market should be overlooked. Tata Steel was not only one of the first Asian corporations to sell a hybrid bond, it was the first to ever close a deal in a domestic market.

But the fact that only one deal has followed — compared to the multitude that have been closed in Singapore after the hybrid market was opened there in April 2011 — shows that the rupee market has a lot more development to do before hybrid issuance becomes a regular occurrence.
01 Oct 2012