We have been receiving queries from many of you on the series of covered bonds/market-linked debentures that are being issued by a platform. Many of you seem to derive comfort from the fact that the platform is backed by marquee investors. The interest in this new kind of bond appears palpable going by the number of YouTube videos plugging covered bonds as a high-return alternative to FDs.
Covered bonds have been popular in recent years among family office and ultra HNI investors. It is now being promoted to retail investors.
But can covered bonds really be compared to FDs? Where exactly do they get their high returns from, in a low-rate environment? We decided to add colour (or should we say black and white) to the existing information, through this FAQ.
#1 What are covered bonds?
Covered bonds are instruments of refinancing widely used in Europe and to some extent in the US. A bank or a financial institution lends to a variety of businesses or individuals. These loans are essentially assets for the bank/NBFC as it earns income from them.
A pool of such loans is created, against which a bond is issued to investors like you. The loan pool in some cases is ‘covered’ by collateral such as property, gold or business assets of the borrower. So, over and above the pool of assets that is generating income for you, there’s an additional layer of protection. Such a bond is called a covered bond.
- An NBFC lends to various companies. It has a loan book.
- Some of the loans from this loan book are pooled together and set aside.
- A covered bond is issued to you by the NBFC against this pool to raise cash for the NBFC for a fixed period.
- The pool is backed by property or gold or business assets of various borrowers to whom the NBFC has lent.
- So, the covered bond holder has the right to tap those mortgaged assets, if he/she is not paid interest or principal on time.
Does that sound like a regular secured NCD? It’s not. In a normal NCD, you’re lending money directly to a company. If the company defaults, you will need to sell that collateral to realize your money (well, not you, but perhaps the debenture trustee).
In a covered bond, an NBFC borrows money from you on a pool of loans it has already made. It is refinancing its loan book. That pool is in turn backed by collateral, which the NBFC can sell to raise the money.
The important point to note here is that the pool of loans against which it issues a bond remains in the NBFC’s books and it bears any risk of default in this pool.
As an investor, when you invest in a covered bond, you are thus said to have ‘dual recourse’. This means that you have a right to claim the money from the issuer (the NBFC) on maturity. If the NBFC defaults, you have a claim on the pool of loans that back such bonds. This is what the issuers claim is ‘bankruptcy protection’ in covered bonds. But more on this later.
#2 Why are these bonds claimed to be safer than regular secured instruments?
The issuers of these bonds and the platforms that enable it state that these bonds are better than regular secured bonds for the following reasons:
- One, you have full recourse (legal right to demand payment) to both the NBFC and its cover pool of secured loans.
- Two, If the NBFC fails to make the payment, you can recover your sum from the cover pool. When we say ‘you’ we mean the ‘SPV guarantor’ (custodian of the assets) and the debenture trust that is enabled by the platform to help you with this.
- Three, for an extra layer of protection, there is the collateral (the property or gold or business assets we mentioned). This is typically higher than the loan value. So, if the loan value is say Rs 20 crore than the collateral will typically be worth more than Rs 20 crore. It could be 1.2 or 1.3 times too. This means there is extra cover.
#3 Are the returns in these bonds fixed?
Yes, covered bonds assure a fixed interest rate, but some offer to ‘step up’ your rates if there is a ‘credit event’. To illustrate, an earlier covered bond series from Wint Wealth called Wint Bricks May 2021, offered an 9.5% IRR until the call option is exercised. If the call option on bond is exercised in November 2022, you would get Rs 1146 for every Rs 1000 invested. If there is a credit event (which includes not exercising the call option) then the return goes up to 13.5% XIRR, simply because your risk shoots up then.
#4 Why are the recent offerings then called ‘market-linked’ debentures?
That’s some product innovation for you from those offering it, to make the product more tax efficient. In the above Wint Bricks product for instance, the bond’s returns are linked to a reference index – the Sensex in this case. The illustration says if the Sensex drops to 10,127 or below, you will only get your principal back. But if it stays above this (unrealistically low) level, you will get your principal and stated IRR. Now, this ‘linking’ to a benchmark makes this a market-linked debenture. This is done to improve your tax status that you will read in the point below.
#5 How are covered bonds taxed?
In a normal covered bond or debenture, your interest income is taxed at your slab rate. But in a covered bond with a market linked debenture structure, you will enjoy 10% tax if you hold for over 12 months (it is treated as a capital gain). This makes the tax significantly lower than regular tax on interest income. Interest is taxed at your slab rate for holdings less than 12 months. Therefore, you will see that most covered bonds come with call options that go beyond 12 months.
#6 Are these covered bonds/market-linked debentures listed?
The information memorandum of the bond will mention whether these bonds are listed. The recent issuances are listed. However, the enabler of these issues has clearly stated that the liquidity is poor in the exchanges and that you may not be able to actually sell your bond on the exchange. Platforms like Wint Wealth enable you to sell the covered bonds they offered to you, to any other willing party who wants to buy them through their platform. They also state that they will maintain some cash reserve for any small portion that you want redeemed. However, there is no guarantee that you will be able to sell them prematurely. These are products that are ideally held till maturity.
#7 So this is a product that delivers better than FD?
Yes, it does. But the risks – specifically the credit risks – are far higher than those attached to an FD. If you are a bank FD investor and want to treat this as a substitute for your FD, it is a bad idea. When you invest in an FD you are lending to an RBI-regulated bank. In covered bonds, you are lending to an NBFC, whose income depends on repayments from its borrowers. This is the primary reason why you enjoy a higher return from covered bonds. Lesson 101 on risk – higher returns in debt cannot come without taking on higher risk to capital.
Covered bonds do not have deposit insurance, unlike scheduled banks whose deposits are covered upto Rs 5 lakh per account holder. You will not also have the RBI coming to your rescue if an NBFC that has issued a covered bond goes bust. A bank and its depositors are often bailed out in the Indian context by the banking regulator brokering mergers. In an NBFC, usual bankruptcy proceedings will apply (remember DHFL?).
Covered bonds are complex structures, meant for people who can take high risk. In the ensuing points we will cover what’s complex about them and what are the risks.
The complexities and risks in covered bonds
The earlier part of this article discussed the features of the product. We will now discuss the less obvious aspects.
# 1 What’s the real maturity of these bonds?
When you see the snapshot provided in the platform selling covered bonds, you will see ‘asset maturity’ mentioned. However, when you get into the information memorandum or the rating rationale for the bond you will see that the actual ‘tenure’ (maturity) of the bond is higher. This is because what is mentioned as’ asset maturity’ in the snapshot is the call option date.
A call option gives the bond issuer a right to buy your bonds back on a specified date. In a recent issue (called Wint Bricks May 21 and hereinafter called Wint Bricks by us) you would have seen a call option after 18 months. The actual maturity of the bond is however, 96 months.
So, if your money is repaid and within the call option date, all is well. However, if the call option is not honoured for any reason, then it is considered as a ‘credit event’ as if it is a default. The trust, which is created to help you, is then expected to take control of the cash flows from the pool of underlying loans to start repaying you. If need be, they can also use the mortgaged asset – property or gold – to repay you. So, what happens when the call option is missed? The trust will seek to repay you through a process called ‘accelerated redemption’.
In the case of Wint Bricks, this must be before 96 months since that is the tenure of the bond and the tenure of the last loan in the pool. However, to provide some comfort to you, the bond issue enabler says that since the underlying loan pool value is more than 1X, the repayment will happen earlier than the 96 months stated. In this case, a period of 50 months is stated to be enough to repay you. What does this assume? It assumes all the interest or principal from the pool is received on time without default. And any liquidation of assets if required will happen smoothly. Neither are certainties.
Bottom line: You should be willing to lock your money for a longer period than the call date suggests. To know what that period is, you should read the information memorandum and rating rationale carefully. What is stated upfront may not be the whole truth.
#2 Who is the issuer of these bonds and who is backing it?
The bond/MLD is not issued by players like Wint Wealth nor are they directly liable to pay you. Wint Wealth is an enabler/distributor who gets commission from NBFCs to issue these bonds.
The bonds are also not ‘backed’ (as in guaranteed) by Zerodha’s RainMatters or Cred’s founder or by Paytm Money’s ex-CEO, like some of you asked us. These are the equity investors in a seed-capital funding round raised by the platform – Wint Wealth. They are there as equity investors in Wint Wealth, willing to take risks in a fintech start-up.
Each tranche of bonds/MLDs is issued by different NBFCs that are not large and mostly do not enjoy top-notch credit ratings (they’re usually AA or below). Players like Wint Wealth are enablers/distributors for such NBFCs to offer these bonds. They also play a role in creating the SPV guarantor and debenture trustee to handle disposal of underlying assets. “Guarantors” in this context ensure that the cashflows from the underlying loans reach you in the event of a credit risk. It does not mean they will make good your principal or interest from their pocket if there’s a shortfall.
The NBFCs who issue these bonds remain the principal borrowers/ and the pool of loan assets and the property/gold mortgaged remain the only backing.
#3 What exactly is the credit risk here?
Covered bonds entirely rely on the financial health of the issuing NBFC or bank and its loan-appraisal capability. Here’s why:
First, covered bonds are unlikely to be used as a fund-raising avenue by top-rated NBFCs, which can easily tap banking or market sources. Usually, NBFCs that are unable to source funding through the regular banking channels or find that route more expensive are likely to raise covered bonds. This is evident from their credit rating. Let’s take Wint Bricks. The NBFC issuing these MLDs is Ugro Capital. Its long-term rating for bank loans is A (which is 5 notches below the highest rating). Its’ short-term commercial paper rating is an A1 and not A1 plus.
Let’s take another issuer (gold loan NBFC) that came up with covered bonds in December 20 – Kanakadurga Finance. This NBFC’s rating (March 21) is BBB stable by Care Ratings, this is barely investment grade. A mutual fund holding a BBB rated issuer will receive brickbats.
Second, it is true that the MLDs issued by NBFCs enjoy a higher credit rating (called enhanced credit) than the issuers, because the bond is backed by additional security. For example, Wint Bricks’ Ugro Capital bonds have a rating of Acuite PP-MLD AA+ (CE) even though its own rating is only a ‘A’. But a lower-rated NBFC’s loan pool is unlikely to be made up of prime borrowers.
Wint Brick’s loan pool is made of loans given to MSMEs across sectors such as food processing, light engineering, auto components and chemicals. While Wint Wealth tries to get the best of the lot into its loan pool to reduce risks, the very nature of these borrowing segments spell risk. Similarly, gold loans (such as those backing covered bonds from gold finance player Kanakadurga) typically cater to borrowers in fairly dire need of money. The risk profile of the loans may therefore be high.
Third, the existence of collateral backing bonds, in the Indian context, does not offer certainty of repayment. The assumption here is that the assets can be liquidated. As most of us are aware, assets such as properties cannot be liquidated easily. Banks do this for a living and in India, struggle to enforce collateral even from large companies, in the case of default. In the case of collateral like gold, liquidity may be a given but the realizable value may not.
Yes, the difficulty of enforcing collateral exists even in the case of banks or marquee NBFCs. But banks or marquee NBFCs usually have to the financial strength to borrow quickly from markets to tide over a cash flow mismatch. For a low credit rated NBFC, access to such funding may be limited.
Fourth, the use of terms such as ‘bankruptcy protected’ mentioned in the marketing material and emphasized in videos by influencers may be misleading. Just read this disclaimer from the Information document of Wint Bricks:
‘In the event that bankruptcy proceedings or composition, scheme of arrangement or similar proceedings to avert bankruptcy are instituted by or against the Issuer, the payment of sums due on the Debentures may not be made or may be substantially reduced or delayed.’
Having a pool of assets or being secured does not make a lending ‘safe’ when bankruptcy kicks in. Remember IL&FS? Some of the toll roads of this bust company had healthy cash flows that were not allowed to be paid to the lenders because bankruptcy procedure did not allow it. Similarly, DHFL’s loans were secured against property but that did not mean fast recovery of the dues when it went bust! Therefore, the above risk statement in the Information memorandum is important. There is no extra ‘protection.’ The liability will rank ‘pari passu’ with all senior secured creditors.
#4 Are these risks too high for me to take?
Let’s list down the factors that make these bond issues attractive, before discussing whether you can handle the product.
- One, the attractive interest rate. This is not debatable but it needs to be understood that it comes with credit risk that we discussed above.
- Two, the attractive taxation – The tax loophole arising from linking a product to an unrealistic (and somewhat irrelevant) benchmark may not go down well with the taxman.
- Three, the comfort from the bond being asset-backed. We have explained that being secured by collateral does not make this a safe product.
- Four bankruptcy protected – we think this is a fallacy. Unless something is sovereign guaranteed (even then there is no zero risk), you cannot not suffer if your issuer is bankrupt. The suffering may come either through delayed repayment or lower repayment.
- Five, the simplicity to the whole product – This is the most dangerous part. You go to a platform. You read what is stated in a few lines; click a few buttons and invest. In fact you may not even know the true maturity date if the call option is not honoured! A complex product that is oversimplified to reach the retail investor does not become a simple product. It becomes a complex product that is guised as a simple one.
In our view, in covered bonds, only one thing matters: the quality of the issuer. If you have a high-quality issuer then you will have no reason not to invest. However, then the interest offered may not be high.
Else the risk is not something that everyone can take as the attractions mentioned above come with risks. If the payment is made on due date, you can pocket it happily. But the complication if the amount is not repaid on call date is not something you may be comfortable handling as a retail investor.
Overall, covered bonds can be a small allocation for investors with deep pockets who can take on risk to their principal for high yields. This is not a product for a regular income earner or someone looking to hedge their equity risks with debt. This is why these products were earlier only meant for ultra HNIs and family estates.
Democratizing fixed-income assets should not come at the cost of giving retail investors products whose risks are underplayed.