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A closer look at NCDs - Is it worth perching high on the capital structure ladder?

Indian non-banking financial companies (NBFCs) have been rather busy of late. July and August witnessed a slew of non-convertible debentures (NCDs) being offered to investors with a few on the way. It has helped that August was a washout for equities. Investors, repulsed by the downturn, have gleefully accepted the prospect of high yields offered on newly minted NCDs. 

This post casts a bird's eye view on the NCD space, without treating any particular issuer specifically. The discourse is devoted to NCD investment appraisal and to ascertain the suitability of positioning in the senior pieces of the capital structure. 

Central Hypothesis
Most primary issues, at offered yields, are unattractive on an after-tax basis relative to other available fixed-income options. Bank fixed-deposit rates over a 3-5 year tenor (the typical NCD maturity profile) compare well on risk-adjusted return. The other rationale for ignoring these issues in the primary market is the prospect of purchasing them at a discount to par, once they begin trading on the exchanges. This is predicated on a view on near-term future interest rates. The RBI is likely to bump key interest rates up in the forthcoming September meeting. As a consequence, many of these NCDs are likely to trade below par, offering the investor the opportunity of purchasing some of the higher-quality securities at a meaningful yield.  

Disclosure: Apart from opportunistic interest in some of the issuers' common stock, no NCD holdings as of this writing.

NBFC Business model
Broadly, NBFCs are engaged in the business of providing capital to various sectors (auto, gold, capital market margin funding, small-and-medium enterprise financing, infrastructure financing etc.). NBFCs borrow from a combination of sources and lend onward at a higher rate (hopefully), making a spread in the process.  In recent times, with regulatory changes making bank funding harder to come by, NBFCs have had to resort to alternative areas such as private equity and NCDs.  

Key diligence factors to consider range from known knowns (company operating history, structure of loan book, non-performing loans, net interest margin and the rate of profit on invested capital relative to cost of funding), to the relative dangerous territory of known unknowns (how big are true bad loans?), to the most dangerous of them all, unknown unknowns (prospective regulatory environment, future macro-credit situation).

Factors contributing to business moat include promoter pedigree, long history of operations, size, clean credit history, access to low-cost funding, geographical presence and range of sectors serviced. Barriers to entry, in general, are low and NBFCs compete with banks that have access to lower cost capital and greater geographical penetration. As a result, NBFCs seek to differentiate themselves by offering better terms (speedy processing, rate of interest charged and other loan terms) to borrowers. Overarching these factors is the 'R' word. The prevailing Regulatory environment has a significant bearing on business and earnings power. 

Recent NCDs

$1 = INR 45.7

A few things stand out. Bid-to-covers (a measure of investor demand) have been strong but investor appetite seems to be waning gradually. Yields to Maturity are inching higher with a corresponding descent in issuer credit rating, in a pattern reminiscent of credit issuance cycles in the past. Of the recent issues, Manappuram Finance pre-closed its NCD issue prior to scheduled close date after mopping up INR 470 Cr ($103MM). Its larger rival Muthoot Finance's ongoing NCD could possibly have been one reason. Other factors prompting the early close are India Infoline Investment Services' NCD, which promptly dropped below par on listing and broker routs in the grey market. 

Key operating metrics

The table lists prominent operating metrics of NBFC issuers (by no means an exhaustive list). The ROIC - WACC spread is a measure of the excess return earned by an NBFC on its total capital funds (debt + equity funding). The Implied Growth Rate has been arrived at using the Price/Book model for financial institutions.

Bond investing is a negative art, as Ben Graham called it, and it is sound practise to follow a process of exclusion in security selection.  

Past growth for the group has been extremely strong, especially for the gold loan companies. The high debt-to-equity ratios reflect the nature of the NBFC business. Persistent growth is a function of continued and cheap access to external capital. Turning to the interest coverage ratio, a high number is preferable but there are no quantitative axioms with respect to what this ratio ought to be in order to be considered 'reasonable'. I prefer using 2x as a starting point, with a lower limit of 1.7x. 

An NBFC's loan book often is the largest component in current assets. Provisions for stale loans are made but almost always pander to 'provisioning norms' set out in the rule Bible. One way to think about this is to imagine a scenario if 10% of the loan book goes 'bad'. This could well be an outlier event but a remote probability, nevertheless, worthy of consideration. In a liquidation scenario (for e.g., all loans called in), only a fraction of book value is what is likely to be realised and hence, a cover of over 1x total debt is a reasonable standard to work with. Lower cover warrants close attention and needn't necessarily be the cause of complete exclusion.

Shriram Transport Finance (Bloomberg: SHTF IN) and Manappuram Finance (Bloomberg: MGFL IN) look good on these standards. Their comfortable Capital Adequacy Ratios and positive return spreads (ROIC - WACC) are other attractions. Macro drivers for the latter in the form of low gold loan penetration and a gradual shift in attitudes towards gold pledging should be supportive of prospective growth.

The recent NCDs are secured obligations ranking on par with other existing secured obligations. "Security" usually takes the form of a charge on receivables and/or immovable property. An asset cover might also be insisted upon, in some instances. (Whether the security is enforceable is another matter...).

Interest-rate cycle: A case for extending Duration 
The RBI seems to be heading towards hitting the pause button on broad interest rate hikes. The frenetic pace of hikes over the past year in a bid to tame inflation could possibly be close to plateauing (at least, temporarily). The September meeting could see a rate hike but the prognostications for the remainder of 2011 and early 2012 lean towards the 'pause' camp. Renewed global economic slowdown lies at the crux of this view.

The near-term hike could likely lead to a few NCDs trading below par (recently listed ones are already below par). However, craning the eyes out over a 3-year horizon, the path of least resistance for future interest rates is likely to be flattish-to-down; the latter gaining in probability should the slowdown persist through 2013. In such a scenario, extending duration by purchasing longer-dated bonds could be attractive.

Risks: Explicit (and Implicit) Issuer Call Option
A word of caution deserves mention. SHTF's 5-year NCD carries a Call Option at the end of 4 years. Were interest rates to follow the path posited above, it is likely that the issuer would Call the bonds and refinance it with lower rate debt. Capital appreciation on this bond will be capped due to the Call feature.

The other NCDs do not have an explicit Call Option but the indenture allows the issuer to call the bonds in, under certain circumstances. Sardar Sarovar's deep-discount bond story in 2004/5 is a good example from history that highlights the risks faced by investors holding bonds issued at high interest rates. When interest rates fall subsequently, it is in the issuer's interest to replace high-cost debt with low-cost debt. 

From my enlightening experience investing in convertible bonds (junior, unsecured debt in the capital structure), I have learned to make an allowance for wilful defaults. This refers to the situation when an issuer has the ability but not the willingness to honour debt obligations. The NCD's security acts as a reasonable mitigant but in my experience, enforcing the security is often a harbinger of a wild goose ride.

High yields are sometimes no compensation for deficient safety.

Risks: The 'R' Word
NBFCs are subject to close regulatory scrutiny. Over the past few years, capital adequacy norms have been tightened and so is a realignment in non-performing loan classifications. Any clampdown on bank lending to NBFCs is a significant source of risk and could dent earnings power. The Gold Loan financing companies, additionally, are subject to state laws that could cap interest rates charged to customers. Any imposition of rate caps by RBI could further erode earnings power.

The Tax Angle
Unlike infrastructure bonds which allow tax benefits to the investor, NBFC NCDs offer no such moolah candy. The interest income is taxed at an investor's normal income-tax rate and so are short-term capital gains (gains realised within 1 year). Long-term capital gains (realised after 1 year) are taxed at 10% without cost indexation. 

As an illustrative example, a 3-year annual-pay NCD carrying a 12% coupon would return the investor an after-tax yield of 8.4%, if held through maturity and sold at par value. IRRs increase if the investor's exit price is at premium to par.

These after-tax IRRs lose their sheen on a risk-adjusted basis, when compared to bank fixed-deposit rates over similar tenors (I am not particularly keen on interest income). After-tax interest rates on fixed-deposits, while lower, carry little default risk and come attached with a (near) assurance on principal repayment. 

Past NCD issue price behaviour: L&T Finance, 8.4% semi-annual pay, 2013 maturity
The security's 52-week low price of 78% of par value afforded an investor an after-tax yield in the 20%s. A decent return for secured senior debt, on a reasonably well-capitalised, pedigreed name. I am keeping an eye on high-quality issues when they are available at meaningful discounts to par value, ideally close to maturity.

Perhaps my history with issuer debt behaviour impels me to seek a wider-than-normal margin-of-safety. But I have learnt the hard way that in bond investing - as with recreational fornication - it is better to be safe than to be sorry!

The above write-up is not a solicitation to invest in the securities discussed. It is meant for a readership that is interested in the practise of investing. Comments/counter-views are welcome. 


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