Indian economy has left the recession concerns behind and showed resilience. The equity market indexes reflect this positive environment. FII’s are pumping money into markets and Indian economy. So why should our Indian companies remain behind? Shouldn’t they also try to get capital from different sources either by IPOs, QIPS, or equity, or bonds? And that’s what we are seeing these days. Every Indian company is trying to grab capital from financial markets. Some are raising capital by means of issuing corporate bonds!
As per an data published by AK Capital Services Ltd, in FY2009/10, public and private sectors combined raised close to Rs 172,000 crore of capital from Indian and foreign markets. In FY2010/11, this figure is expected to be Rs 350,000 crore i.e. almost double. Majority of this comes from foreign markets. I do not have exact numbers, my guesstimate is 80%+ comes from foreign markets.
Examples are: SBI, IDFC, Union Bank, L&T
One reader asked, why a company like SBI (i.e. a bank) issues bonds to raise capital? It is already in the business of collecting deposits from people?
Simple answer to this question is: Banks like SBI, need more money than they can collect from deposits.
Banks are go between investors and businesses. In a slang language, banks are nothing but middle man, who earns profit by difference in interest rates and economy of scale. For an investor, bank deposits are at lowest order of preference because of low interest rates. So investors are always removing money from deposits and diverting towards higher interest rates or higher returns. This is true for individual investors and large institutional investors. So banks, in particular, create bonds as an investment vehicle and offer higher interest rates. If you are a keen observer, these corporate bonds give only 3% to 4% higher interest rates than fixed deposits. Banks will lend that money at 12%+ to businesses. Those non-taxable bonds, who we all think are good for savings tax, usually have lower interest rates. So while people like you and me, will feel good that we saved tax, in reality, it is a zero sum game. The interest rates are less!
What does bank do with this capital?
Banks have many different purposes for giving loans some of which are new project/product capital, infrastructure projects, home loans, auto loans, working capital for businesses, etc. Like anything else, make sure you understand what are they going to do with the accumulated capital. This is stated in the prospectus. Infrastructure bonds are for long term capital allocation to infrastructure projects. Many times bank accumulate capital for working capital loans. Working capital loans are short term lending to companies which have higher interest rates and are typically on rolling basis. Let us take some examples.
- L&T Finance raised approximately Rs 1000 crore in August 2009. The funds raised through this Issue was to be used by the Company for activities such as lending its business operations, capital expenditure, and working capital requirements. The interest rate paid on those bonds are 8.4% to 8.5%. This company’s average cost of capital is approximately 8.25%. Meaning, if this company raised capital from banks or other private institutions, they would have paid interest rate of only 8.25%. So why go retail investors route? Among others, one of the objectives in this bond issue was to broaden their investor base. Raising money for working capital and interest rates is something that needs to be monitored.
- L&T Infrastructure Finance Company is raising another Rs 1000 crore in Oct 2010. These will be used to fund its infrastructure projects. In case of L&T (or any other conglomerate’s finance arm), these financial subsidiaries are created to fund their own products in other group companies. So when L&T engineering group bids for a medium or large size project, they will propose that they will help arrange some percentage of capital from its own subsidiaries. It makes their engineering proposal stronger because it includes some capital. Classic auto dealership model; when you go to buy auto to the dealership, they will usually have loans available for you from a different company; So they can entice you to sell their product which is Automobile.
- SBI raised approximately Rs 4700 crore (i.e. $1 billion) from US markets in July 2010. They raised this capital for its customers who need working capital loans in foreign currency outside of India. SBI will not bring this capital into India. But it remains within SBI’s foreign subsidiaries. It will lend this capital to many Indian companies who need foreign currency outside of India.
- SBI is also planning to raise Rs 1000 crore from Indian market in Oct/Nov 2010 timeframe. The purpose here is not to lend but shore up its Tier 2 capital adequacy. In a nutshell, it means SBI expects its T2 capital adequacy to reduce and it wants to shore it up. These T2 levels are regulated by RBI. Banks have taken savings/current deposits, FDs, etc from you and me. They should have enough capital, such that SBI can pay us back when needed. Raising capital for this purpose is something that is very subjective to analyze. Among many other tools that RBI has, T1 and T2 adequacy levels are set of tools to control flow of money into the system (i.e. controlling inflation). Higher inflation will make RBI to increase T1 and/or T2 levels. For more economic growth, RBI will likely reduce T1 and/or T2 levels. For now, let us assume Government of India backstops SBI so risk is low. But when this becomes a habit, it is a concern. Shoring up capital adequacy can come from many different reasons such as non performing assets, increased capital lending, higher internal operating costs, etc. In most cases, Nonperforming assets are usually the culprit. Last quarter, RBI asked banks to raise loss coverage ratio to 70% (from 65%) for NPAs. This measure alone is expected to pose Rs 13000 to 14000 crore of burden on banks. As of March 2010, SBIs NPA slipped to 3.05% from 2.86%.
How does bonds affect company or banks balance sheet? And/or what should an individual investor make of it?
I think a Chartered Accountant can provide a much more technically correct implications. But then, I always say, we as individual investors do not have to be correct to a decimal level. Bonds will increase either unsecured or secured debt of the company depending upon how the bonds are defined on prospectus. If you look at SBI, it’s borrowings have doubled (deposits have grown slowly). Even by doubling borrowings in last two years, its interest outflow does not show significant increase. Meaning it shows profitable lending operations. I expect this interest outflow to increase because the interest payment for this latest round of borrowings will kick in slowly in next few years. In case of L&T, the debt is gradually increasing along with the outflow of interest. It pays close to Rs 1000 crore in interest every year.
A substantially higher debt has many implications for businesses.
- Higher debt will result in higher outflow of interest. In almost all cases, interest is paid in cash. Unless the company is in bankruptcy, interest is never paid in derivatives! So, the company needs to have higher cash flow to service its debt load.
- Higher debt on balance sheet also increase risk for lender. Therefore, to borrow more capital, you will have to pay higher interest rates. For example, in 2009, Sundaram Transport Finance paid interest of 11%+ on its NCD offering. Why? L&T is paying less than 10%! That’s because L&T has a much stronger balance sheet and risk is low. While Sundaram balance sheet is not that strong. Therefore, to borrow capital, it has to offer higher interest rate. In summary, Sundaram is assuming it will be able to afford 14% interest rate because it expects to grow higher than that.
- Suzlon Energy is a very good example of how debt affects the company in long run. Suzlon made very over-optimistic assumptions of grow expectations. Based on this expectation it went of a debt binge to acquire foreign assets. Few years down the road, those growth expectation did not materialize and hence Suzlon is now busy selling assets to clean up its debt [added on Oct 16].
One key advantage of raising money by using bonds is that it does not dilute the ownership of company. The earnings does not get diluted. It may get reduced to some extend due to interest payments, but it is still likely to remain much much lower. And hence, the ownership is likely to continue similar level of dividends. In other words, they continue to profit more by borrowing money from you and me. Nothing wrong in it, this is what capitalism means.
Bonds also help reduce taxation for the company earnings. Before taxes are paid, bond holder first get their interest payment. This essentially, reduces their taxable earnings. [update on Oct 16, after feedback from Siddharth]
I have mentioned earlier, bonds play an important role in any individual’s portfolio. You should invest in bonds, but need to be careful of why you are investing! If you are looking to park your funds for 4 or 5 years or longer, then, yes corporate bonds or infrastructure bonds are a good vehicle. Bonds are not vehicle for wealth building, unless you are focusing fully on bonds and bonds trading. My purpose of investing in bonds is safety of capital and interest rate enough to keep up with long term average inflation. I also need rolling liquidity. It is for this reason, I prefer government bonds. I do plan on investing in some of corporate bonds – haven’t done yet.
I stay away from bonds that are (1) for working capital; (2) for shoring up capital ratios; (3) interest rates higher than my 12% expected growth; (4) Infrastructure bonds; and (5) tax savings never a driver for me.
Summary: When looking at companies for investing, understand the secured and unsecured debt in the context of cash flows and interest outflow. Most of the companies have details about bond interest payments in their annual reports. You should be able to make a call. A final piece of nugget – Indian bond market is still at a nascent stage.
bonds, larsen and toubro, LNT, SBI, sundaram finance, suzlon