The Strange Case of Zero-Coupon Par Re-Capitalisation Bonds
In a related party transaction on the last day of the financial year the government of India (GoI), as a principal shareholder, infused Rs14,500 crore of equity in four public sector banks—Central Bank of India, Bank of India, UCO Bank, and Indian Overseas Bank (IOB). Simultaneously the four banks invested in bonds issued by GoI. These bonds, of varying maturities between 10-15 years, were issued at a zero rate of interest. These bonds have been labelled zero coupon par re-capitalisation bonds. 
 
Economist Madan Sabnavis has called this an ‘innovative’ fund raising exercise by the GoI. To this bond market observer, it appears a case of too good to be true. It is indeed so, and hardly innovative. 
 
To understand what is going on here, first let us understand certain bond market expressions:
  • Par or Face Value: This refers to the principal amount exchanged when a bond or a debt security is issued.
     
  • Coupon: Interest rate payable on a bond. Right now, it varies between 3% to 7% and more, depending upon the issuer of the bond. For the GoI (sovereign issuer) this has been between 3.25% to 6.75% recently, depending on the maturity or tenor of the bond. The GoI 10-year bond is currently priced at a yield of 6.15%.
     
  • Yield: The market determined rate of return on bonds of like maturity which are traded in the secondary market for GoI debt. As market interest rates keep changing the yield is often different from the coupon on any given bond. When market yield is higher than the coupon the bond trades at a discount to face value. When market yield is lower than the coupon on the bond the bond trades at a premium to face value.
     
  • Off-Market Coupon: Interest rate offered on a bond which is lower than the secondary market yield of similar maturity. Bonds can be issued at an off-market coupon provided on maturity redemption is at a premium to the par or face value.
     
  • Bond Total Return: This is total cash flow received by the investor if the bond is held to maturity. A bond is priced at inception (date of issuance) such that the net present value of the bond is zero. Which is another way of saying that the yield on the bond at issuance matches the yield for comparable maturity (of a like issuer, GoI) traded in the secondary government securities debt market on negotiated dealing system (NDS).
     
  • NDS-Negotiated Dealing System: Online screen-based trading platform for trading in government securities.
     
  • Zero Coupon Bonds (ZCB): Bonds issued at a discount to face value. This discount equal to the implied interest payment over the life of the bond till maturity when the bond is redeemed at face value or par. 
 
For ease of comprehension let us assume that all the re-capitalisation bonds issued by GoI are of 10-year maturity. The 10-year government security, trades in the secondary market, at a yield of 6.15%. Re-capitalisation bonds being issued to the investor banks have conditions attached to them which render them illiquid. 
 
As a result, re-capitalisation bonds are issued at a premium or higher coupon. This can be about 0.25% (25 basis points as it is called). Therefore, a re-capitalisation bonds issued on the 31 March 2021 ought to be issued at a coupon of around 6.40% for a 10-year maturity. 
 
Now herein lies the problem or the innovation. Instead of issuing these re-capitalisation bonds at 6.40%, the mandarins in the ministry of finance (MoF) (banking division) have determined that there is no need to pay any interest whatsoever on the bond.
 
Why? Before we answer that let us first establish the implication of this off-market transaction where a bond that would be issued at 6.40% for a 10-year maturity is issued at a zero-interest rate. Moreover, there is no premium payable by the issuer, GoI, on maturity, as explained above. 
 
The investor banks will have a mark-to-market loss at inception. How can this mark-to-market loss at inception be ascertained? This is the 6.40% interest rate loss to the investor banks (6.40%-0%=6.40%). 
 
The mark-to-market loss at inception means that the value of the bond issued at a face value (of say Rs100) bearing a zero-coupon is about Rs60. The Rs40 difference is the required depreciation in the price of a 10-year re-capitalisation bond issued at a zero coupon for the yield to be 6.40%.
 
Total re-capitalisation bonds issued to five government owned banks in the just concluded financial year of 2020-21 were Rs20,000 crore as budgeted equity capital infusion. Therefore, the loss to the investor banks by way of mark-to-market loss at inception is about Rs8,000 crore. 
 
Who will hold the MoF mandarins to account for this financial sleight of hand, which violates the cardinal principal in a related party (GoI owns the banks) transaction, namely, arms-length? 
 
Arms-length in this context plainly means arms-length pricing which is market related and not ad-hoc and arbitrary. This clumsy attempt to fix the challenge of high debt servicing cost, growing borrowings to finance large fiscal deficits is another brazen example of financial repression that this author spoke about in an earlier piece
 
The nation needs to know, as an accomplished anchor on prime-time television is so fond of pontificating, who is responsible for inflicting this loss on publicly-owned banks? 
 
To argue that this loss is only a notional loss, in the books of the investor banks is neither here or there. In fact, this defense is disingenuous as all valuation losses are notional till the asset is sold and value realised. A true and fair picture is revealed by an honest mark-to-market.
 
Now our questions and observations for the stakeholders:
 
Reserve Bank of India (RBI): Present governor is an experienced civil servant having worked in the MoF. How is it that the RBI failed in its responsibility to the banking institutions that it regulates? Why was the RBI not able to convince and prevail over the MoF to desist from this “adventurism”? What does this episode tell us about the financial markets and about the co-ordination between the RBI and the MoF? To suggest that the re-capitalisation bonds are held by the banks in the held-to-maturity category and therefore need not be marked to market to reflect the true and fair picture is mischievous.
 
Securities and Exchange Board of India (SEBI): All these banks are publicly listed on the stock exchanges. SEBI has a responsibility to the minority shareholders of these banks to protect their interest. SEBI needs to have a conversation with both the MoF and the RBI at the next Financial Stability Development Council (FSDC) meeting on this financial shenanigan of the MoF, which has been endorsed by the RBI. 
 
SEBI also ought to make a case for the cancellation of these re-capitalisation bonds as a custodian and guardian of minority shareholders. SEBI also needs to underline to the MOF that such financial shenanigans will only dilute further the value of the government owned banks some of which are candidates for privatization in 2021-22.
 
Comptroller & Auditor General (CAG): Should understand the underlying nature of this clumsy structured product transaction where the GoI as the principal shareholder claims to have injected equity capital to these five banks with a matching interest-free loan from the very banks which entails an actual annual loss of interest income to the tune of Rs1,280 crore (Rs20,000x6.4/100).
 
What does the MoF achieve by this financial chicanery? Nothing. In fact, GoI loses credibility. Especially so after the finance minister injected a refreshing dose of transparency to the budget process by stating the fiscal deficit the way it is actually rather than pretending the fiscal deficit is lower.
 
The MoF needs to understand that the local bond market is large enough to accommodate the growing needs to both the GoI and the state governments. Just let the market determine the price at which it is comfortable in financing this onerous requirement. Financial repression can never be a brahmastra to beat up the local banks, pension funds and mutual funds who channel large domestic savings. Domestic savings are the key to India’s atma-nirbharata. And RBI, you look silly, when you label our domestic investors bond vigilantes.
 
(Rajendra Gill-An ex-TAS (Tata Administrative Services) Officer with two decades experience in the financial markets. He is a whole-time director with VMS Consultants Pvt. Ltd, a expertise-based structural engineering design consulting practice in Mumbai.)
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    COMMENTS

    Ramesh Popat

    2 weeks ago

    superb!

    Kamal Garg

    2 weeks ago

    How this is only a "notional loss"?
    Banks got bonds at face/par value with no interest attached/accruing to it and therefore would write-off the equivalent value every year to have a fair price of the bonds (means M2M). At the end of the tenure, banks would get only the face/par value of the bonds and therefore, the M2M loss every year is not a "notional loss". It is a real loss. Banks cannot write-off the entire 10 years loss of "assumed accrued interest" in one go at the end of the tenure.

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