RBI proposes partial credit enhancement for corporate bonds

The Reserve Bank of India (RBI) on Tuesday released draft guidelines on allowing partial credit enhancements of up to 20 per cent on corporate bond issues, as part of the central bank's efforts to bring depth and liquidity to the bond market.

Credit enhancement could also be provided by improving the rating of bonds by two notches.

The limit on partial credit enhancement will be set at a maximum 20 per cent or the extent of funds needed to raise the rating of the bonds by two notches.

The RBI had, in its second quarter 2013-14 review of its monetary policy announced on 29 October 2013, proposed to allow banks to offer partial credit enhancements to corporate bonds.

Since the credit needs of infrastructure sector in India are huge, RBI said, bond market should be the natural choice for corporates to raise resources to meet the credit needs of infrastructure sector. However, the Indian corporate bond market is in a nascent stage of development. Therefore, there is a pressure on the banking system to fund the credit needs of infrastructure sector. Due to asset-liability mismatch in infrastructure financing, banks are exposed to liquidity risk. The insurance and provident/pension funds whose liabilities are long term, are better suited to finance infrastructure projects.

RBI said, as an initial measure of encouraging corporates to avail bond financing, it has decided to allow banks to partially enhance credit to bonds issued for funding infrastructure projects by companies / special purpose vehicles (SPVs) subject to certain guidelines.

For this, however, banks should have a board-approved policy on partial credit enhancements covering issues such as permissible types of credit enhancements, assessment of risk, setting limits etc. Banks should also have an overall exposure limit to the infrastructure sector i.e. on account of their direct exposures by way of fund-based and non-fund based exposures to companies including NBFC - IFCs, indirect exposures by way of sponsoring IDFs, partial credit enhancements, etc, RBI stated.

The regulatory requirement for insurance and provident / pension funds is to invest in bonds of high or relatively high credit rating. However, bonds issued for funding infrastructure projects by companies / SPVs do not get high ratings by the credit rating agencies (CRAs), because of the inherent risk in the initial stages of project implementation.

With a view to overcoming the limitation of long term providers of funds like insurance and provident / pension funds as also other investors in investing in the bonds issued for funding infrastructure projects by companies / SPVs, the RBI in its second quarter 2013-14 review of monetary policy, announced on 29 October 2013, had proposed to allow banks to offer partial credit enhancements to corporate bonds.

The mechanism of improving the credit rating of a bond issued for funding infrastructure projects by companies / SPVs is to separate the debt of the project company into senior and subordinate tranches. The credit enhancement provided by banks will be able to provide such bonds with partial credit enhancement in the form of a subordinated instrument – either a loan or contingent facility – to support senior project bonds issued by the companies/SPVs, and thereby improve their credit rating.

The objective of allowing banks to extend partial credit enhancement is to enhance the credit ratings of the bonds raised to set up the infrastructure project so as to enable corporates to better access the funds from corporate bond market.

Partial credit enhancement provided by banks should be limited to the extent of improving the credit rating of bonds (assigned by a recognised external credit rating agency) by a maximum of two notches, including modifiers ''plus or minus'', (e.g., migration from AA- to AA+ will be considered as an improvement by two notches) or 20 per cent of the entire bond issue, whichever is lower. The above restrictions would apply at the time of issuance of the bond as also when the senior bond amortises.

Credit enhancements are typically subordinated to the senior bond in terms of repayment priority, but should rank ahead of remaining liabilities of the project such as equity. These act as 'first loss piece' and improve the credit quality of the senior bond.

As a subordinated instrument, partial credit enhancement should serve to increase the credit rating of the senior bonds but not to extend the bank's credit rating to the infrastructure project. Banks cannot also provide partial credit enhancement by way of guarantee.

Banks may provide credit enhancement as a subordinated loan facility, subject to the maximum extent permitted, of the total credit enhanced senior bond.

This will benefit bond holders by considerable reduction in loss given default during both construction and operation phases as the amount of the senior bond drawn down / outstanding will be lower and the bank will be subordinated to the senior bondholders in terms of repayment priority. There will also be improvement in debt service coverage ratio of the senior bond, RBI said.

The arrangement of banks providing partial credit enhancement to corporate bonds will be reviewed after a period of two years.

RBI has sought comments and feedback on the various proposals enumerated in the guidelines latest by 30 June 2014.