Masala Bonds: The Kerala Story

If one were to be asked whether Dim Sum, Matador, Samurai, Kangaroo, Maple and Bull Dog share anything in common, one would be hard-pressed for an appropriate reply. To answer the question posed, the above are all international bonds. International bonds are debt investment instruments issued in a country by a non-domestic entity, in the currency of that non-domestic country. These bonds have been colourfully named, as demonstrated, to evoke an association with their home country. “Dim-Sum” bonds are the Chinese variant, the Japanese version are the lofty “Samurai” bonds, and one can probably guess which countries Matador, Maple and Kangaroo belong to.

In the Indian context, the Reserve Bank of India (“RBI”) permits the issue of Rupee Denominated Bonds (“RDBs”). RDBs are debt instruments which are denominated in Indian rupee but settled in foreign currency and are issued to overseas investors by Indian entities. Similar to other international bonds, RDBs are denominated in Indian rupee even though they are issued to offshore investors. Due to their Indian origin, these bonds have been dubbed “Masala bonds”.

Why then, is it beneficial for foreign investors to invest in Masala bonds? One of the principal reasons that Masala bonds appeal to foreign investors is the higher rate of interest provided on these bonds as compared to the standard rate of interest prevailing in the market. It has been noted that, on average, Masala bonds have an interest rate that is 2-3% higher compared to the standard LIBOR (London Interbank Offer Rate). This is important because London has pitted itself to become the foremost trading ground for Masala bonds. The coupon rate is higher to compensate for the risk associated with currency depreciation. Overall, a foreign investor can reasonably expect to earn better returns as compared to investment returns from his home country. Furthermore, it is in the interest of the investor for the Indian currency to appreciate so as to maximise his return on the investment.

It benefits the country if more Indian entities issue Masala bonds as it promotes internationalisation of Indian rupees as foreign buyers will deal more in the currency while purchasing these bonds. It also works in the favour of the Indian entity as the risk associated with fluctuations in currency is assumed by the investor and so Indian entities are spared from worrying about currency depreciation, a significant area of concern. Thus, in case the rupee weakens by the time the payment against the bonds is to be made, the borrower/investor will need to pay more rupees to repay the dollars. This in turn implies that the RBI will realize marginal saving if the rupee depreciates. In addition, it helps Indian entities in widening their bond portfolio and also attract a significant investor base in offshore markets.

While Masala bonds fall under the definition of “debt securities” contained in Section 2(30) of the Companies Act, 2013 (“Act”), Indian entities issuing RDBs under the RBI’s extant policy on External Commercial Borrowings (“ECBs”) are not required to comply with provisions of Chapter III (Prospectus and Allotment of Securities)of the Act. The RBI has clarified that Masala bonds can either be privately placed or listed on the exchanges as per the host country regulations. The regime for Masala bonds has been further strengthened by the revised ECB Guidelines issued in January 2019, as it did away with the verification process for issuance of Masala Bonds by the RBI that had been in place earlier. The minimum average maturity period was also decreased to 3 (three) years which should kindle foreign interest. Further, the list of eligible borrows was updated to include any and all entities eligible to receive foreign direct investment (“FDI”), irrespective of the type of ECB. This is a welcome change from the earlier narrow list of borrowers.

Let us examine how the Kerala Infrastructure Investment Fund Board (“KIIFB”), a state-owned organisation, has utilised Masala bonds to raise funds for financing the infrastructure needs of Kerala.  KIIFB was established with the purpose of providing investment for critical and large infrastructure projects in Kerala. KIIFB acts as the primary agency of the Government of the State of Kerala to facilitate development of both the physical and social infrastructure in Kerala. What is noteworthy is the fact that KIIFB has become the first State Government body from India to issue Masala bonds. In its debut Masala bonds issue (via private placement), it raised INR 2,150 Crore, and for its second fund raise through Masala bonds, KIIFB headed to the London Stock Exchange’s International Securities Market (LSE – ISM), thus becoming the first sub-sovereign entity to access the debt capital markets. As mentioned earlier, the success of international bonds is contingent on the sovereign rating assigned to the country. However, in a novel development in the India context, such success is also reliant on the public international credit rating assigned to the state-owned organisation, i.e. KIIFB. S&P and Fitch have assigned KIIFB a long-term foreign currency rating of BB with stable outlook, which, for comparison’s sake, is only a few rungs below India’s rating of BBB.

However, the above fund raise has faced its fair share of controversy. It has been asserted that this fund raise by KIIFB runs afoul of the Constitution. Article 293(1) of the Constitution of India, 1949 states that “the executive power of a State extends to borrowing within the territory of India”. Therefore, states are not permitted to borrow directly in the overseas debt market. Referring back to the new ECB Guidelines, the list of borrowers includes all entities that are eligible to receive FDI can borrow via offshore bonds, including registered State Government enterprises. This conundrum hinges on whether the borrowing entity is a surrogate for the State Government. It ought to be noted that though in the case of KIIFB, the guarantor is the State Government of Kerala, KIIFB does not come under the purview of the State Government’s budget.

Irrespective of the debates and controversies that have swirled around KIIFB’s move, it has sparked a definitive interest in other states to explore this option to meet their infrastructural demands.