The impact of COVID-19 on borrowers

The global spread of novel coronavirus (COVID-19) and the subsequent lockdown in India has resulted in cash flow issues for a lot of Indian businesses as well as an immediate liquidity crisis and high volatility in financial markets, which factors have contributed to the expansion of domestic bond spreads, among others. This has also severely affected the ability of debt-ridden corporates to repay the principal and interest due on their loans and debt securities, particularly at the start of the first quarter of fiscal 2021.

Sensing the plight of borrowers, the Reserve Bank of India (RBI) has allowed banks to provide a moratorium on term loans extended by them to their customers - even providing relaxations to lenders who opt to do so. This has resulted in a cry from corporate India to allow a similar moratorium on the principal and interest due on their commercial paper and non-convertible debentures (NCDs), maturing or coming up for interest payment in the next few months. However, there has been no relief that has been provided so far to NCD issuers.

The NBFC situation

While the current crisis is a problem for all corporates who have issued NCDs, it poses a particularly peculiar problem for non-banking finance companies (NBFCs). Since the RBI direction provides a moratorium until June 30, 2020 on repayment of loans extended by such NBFCs, it significantly affects their receivables during this period. Further, NBFCs have also been restricted from classifying accounts of defaulting borrowers during this period as non-performing assets. At the same time, NBFCs are required to continue to repay principal and interest falling due on their NCDs during this three-month period.

Unlike banks, certain NBFCs do not accept deposits from the public at large. Such NBFCs usually depend on banks and debt capital markets as their primary sources of funds for onward lending. Clearly, any deferment or moratorium given to the borrowers of NBFCs has a direct impact on an NBFC's ability to service their debt. If defaults are called on NBFCs, they are likely to trigger cross default clauses across financing contracts raising the prospect of systemic defaults across the Indian financial services sector.

"In the face of a severe liquidity crisis brought about by the recent circumstances involving the pandemic, a systemic breakdown of the bond markets cannot be ruled out unless bondholders agree to a moratorium on payments. This will protect investor interests and help in further development of the Indian capital (bond) markets. If the pandemic leads to further cross defaults across facilities which in turn results in systemic defaults, it is highly likely that a significant amount of investor wealth will be written-off in addition to completely destabilizing the Indian bond markets. Such a move would therefore also find regulatory support in India." said Kaushik Mukherjee, President - Legal, Indiabulls Group.

Impact on debenture-holders

The NBFCs primarily raise Indian rupee funds from domestic debt capital markets by issuing money market instruments such as commercial paper and NCDs, which are subscribed by banks, mutual funds, insurance companies and other qualified institutional buyers. Particularly after the IL&FS liquidity crisis in 2018, there has been a marked increase in public offerings of NCDs (which typically see retail investor participation) by NBFCs.

While formulating any possible solution that can provide relief to NCD issuers, it is imperative for the Securities and Exchange Board of India (SEBI) to keep the interest of the public investors in mind. While only a fraction of the outstanding corporate NCDs have been subscribed to by retail investors directly, such retail investors are indirectly invested in a much larger share of this debt through mutual funds and insurance companies.

Double-edged solution

This means that if a moratorium is given to NBFCs from repayment of their NCD debt, not only will the retail investors with direct investments in these NCDs be effected, but it will also effect retail investors in mutual funds who have exposure to NCDs of such NBFCs. 

It is also unlikely to completely solve the liquidity problem in the market but will only transpose the issue onto mutual funds who, on the back of high redemptions from retail investors, will come under the same pressure that NBFCs are under right now.

The TLTRO framework

The RBI has made big strides towards addressing this liquidity issue through its targeted long-term-repo-operations (TLTROs) which it commenced in March 2020. Aimed at stimulating bank lending to the real economy, the RBI initially allocated ?1,00,000 crores to help banks subscribe to listed NCDs of investment grade issuers. This was met by a very positive response from the market and saw an immediate decline in bond yields which had earlier been rising consistently.

Following its success in the first phase, in mid-April, the RBI announced TLTRO 2.0 to channel liquidity to small and mid-size corporates (including NBFCs). Unfortunately, the first tranche of TLTRO 2.0 only received a bid to cover ratio of 0.5, indicating a lukewarm response to this stage of liquidity support. This indicates that banks are reluctant to lend to small and mid-sized NBFCs because of the associated risk profile. In the US, the Federal Reserve has already announced a similar relief package for junk bonds as well. Given that a lot of NBFC NCD issuers with high exposure to corporate and consumer debt have had their ratings downgraded in the last two years owing to a series of unfortunate events, the RBI might have to consider structuring a similar stimulus package for NBFCs in India as well.

More recently, following the decision of a prominent US mutual fund to close six of its credit fund schemes, the RBI has announced a ?50,000 crore special liquidity facility for mutual funds. The fund availed under this scheme will be used by banks exclusively for meeting the liquidity requirements of mutual funds - by extending loans and undertaking purchase of repos against collateral of investment grade corporate bonds, commercial paper, debentures and certificates of deposit (CDs) held by mutual funds. However, this may just be the tip of the iceberg and more steps may be required to be undertaken, particularly with respect to non-investment grade debt on the books of several mutual funds.

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