The International Finance Corporation, the World Bank affiliate charged with investing in private enterprise, broke new ground last month when it provided a partial guarantee for 10-year rupee-denominated bonds issued by Ballarpur Industries (BILT) of New Delhi, India. The Rs1.5 billion ($32 million) private placement was a milestone of sorts in efforts by the Washington-based lender to ramp up a guarantee programme that it had seldom used before. The IFC had never used a guarantee to enhance the credit quality of local-currency-denominated bonds.
The BILT bonds carry a coupon of 11.7%, yielding 120 basis points over 10-year government securities. The deal found acceptance with investors that had expected it to pay about 100bp more, after the IFC spent time presenting a theoretical evaluation. The issue was oversubscribed by one-third. DSP Merrill Lynch served as sole adviser and lead arranger for the issue. The cost of the IFC guarantee was not disclosed.
“The BILT issue will establish a benchmark in the Indian domestic capital markets for high-quality, long-maturity corporate assets that have the potential for secondary trading,” says Bernard Pasquier, the IFC’s director for South Asia.
BILT, the largest producer of writing and printing paper in India, will use the proceeds to help finance a $126 million modernization and expansion programme. “This investment will create a strong, internationally-competitive paper company that can provide a steady stream of business to local wood-pulp producers,” says Pasquier. “It reflects IFC’s strategy for reducing poverty in rural areas.”
CRISIL, the Indian affiliate of Standard&Poor’s, gave the issue a rating of AA+, four notches above BILT’s stand-alone rating of single A. Public sector corporates have occasionally appeared in the 10-year maturity sector, but there was no precedent for a private-sector issue below the AAA level.
“Long-term local currency funds for non-AAA corporations often are not available in developing countries and this new product responds to that need,” says IFC treasurer Nina Shapiro. “It’s our hope that this is going to pave the way for similar deals.”
IFC mobilized additional funds with its partial guarantee. It stands behind two semi-annual payments of interest and principal on a rolling basis during the first four-and-a-half years, and all debt service payments for the remaining five-and-a-half years. Bondholders absorb the credit risk involved with the remaining funds.
The World Bank Group extended a similar partial credit guarantee for bonds issued by the Electricity Generating Authority of Thailand (EGAT) at one of the worst moments in the 1997-98 Asian crisis. The World Bank provided back-up for one interest payment on a roll-over basis plus the bullet payment at maturity in the EGAT deal. The World Bank also guaranteed, on a springing basis, the first zero-coupon bond in the recent Republic of Argentina series of zeros. The World Bank guarantee springs to the next zero after Argentina repays the currently guaranteed bond.
“The IFC is offering greater protection to investors against liquidity risk in the BILT deal by extending the rolling guarantee to two interest payments,” says Mahesh Kotecha, president of Structured Credit International Corporation in New York. “It also helped bring in investors who otherwise might not go as long as 10 years, by guaranteeing debt service payments at the back end until maturity.”
IFC has not used guarantees much before because it treated them as complete substitutes for loans. “They were 100% guarantees and didn’t offer all that many advantages,” says Shapiro. “We’re emphasizing partial guarantees that will catalyze the market and provide a route to local currency financing. That’s a critical contribution that the IFC can make.”
The IFC successfully urged CRISIL to relax its previous standard by moving to an expected-loss approach for rating the issue. The new method estimates the probability of default and then the expected loss from default. S&P’s previous weak-link approach evaluated the quality of each payment from the security and then assigned a rating based on the weakest one.
“It doesn’t make sense to give a B rating, if 90% of a bond’s payments is guaranteed by a high AAA,” says Lee Meddin, a structured finance expert at IFC. “We think that this is very important for capital market development because it means that other guarantors eventually can come in and participate in this market.”
Structured Credit’s Kotecha, however, distinguishes the IFC guarantee from partial credit guarantees provided by private sector players, for example to cover the credit risk on the entire pool of loans supporting a mortgage-backed security issue. “There, a 10% pool insurance policy might cover the expected worst-case losses in the US,” he says, “and it may be sufficient to achieve AAA ratings on the entire issue, but the IFC partial credit guarantee leaves investors completely open to the corporate risk for payments that are currently not guaranteed. The weak-link rating theory, therefore, should apply as long as the rating agency uses the first dollar loss definition of a rating.”
Kotecha concedes that some “notching up” might be justified even when using the weak-link approach because BILT’s willingness to pay is presumably greater because of the need to maintain its relationship with IFC. The alternative expected loss approach could prove difficult in India because the ratings-based history of defaults in India is short and the approach itself is better suited to structured financings.
Kotecha also noted that CRISIL is providing a national-scale rating where the notching-up effect is magnified, rather than global-scale ratings. Indian sovereigns rate AAA on the national scale, but not on the global scale. “In the end,” Kotecha concludes, “one must make a subjective assessment of both the borrower’s willingness to pay debt service on time and its ability to do so.”
Professor Franklin Edwards, an expert on capital and money markets at Columbia University’s Business School in New York, is sympathetic to the expected-loss approach as a general concept. But he sees a potential conflict that can lead to undue influence over the rating agency. “The problem stems from the fact that the people who paid for the rating are the people being rated,” he says. “That makes all ratings suspect. There’s always a question of whether rated firms have gone beyond providing the relevant information. Investors need to look at this aspect carefully.”
IFC also persuaded the Reserve Bank of India to grant the bond an initial 20% risk weighting, making the issue attractive to banks. That gives the paper some potential for secondary trading, a factor with appeal for mutual funds as well. Only government issues are actively traded in India’s secondary market.
The BILT issue is also the first-ever private placement denominated in Indian rupees with documentation that approaches US Securities&Exchange Commission standards. The deal was the first of its sort to use a red herring and also discussed potential risks to investors in a special section of the prospectus. “It takes a lot of work to put the essentials in place at the country level,” says the IFC’s Meddin.
The IFC’s Shapiro adds that the IFC plans to offer partial credit guarantees on a global basis to clients in the emerging markets for bond and loan transactions. US dollar lending has traditionally been the IFC’s bread-and-butter business. She also does not rule out using partial guarantees for cross-border deals. Shapiro expects other multilateral agencies to enter this arena as well.
