In Defense Of Equity-Backed Bonds - Brickwork Ratings

Brickwork Ratings is neither India’s oldest credit rating agency nor its largest. And yet, it leads one segment of the rating business. That of rating bonds backed by promoter equity. A financial instrument that one governance expert recently described as a “weapon of mass destruction”.

There are an estimated over Rs 40,000 crore worth of outstanding equity-backed-bonds that are rated and listed, as earlier reported by BloombergQuint. And Brickwork has rated over 86 percent of them.

But according to Brickwork, the total issuance of such instruments is much larger. The rating agency, one of seven in India, told BloombergQuint it has rated over Rs 30,000 crore of such bonds and has a 50 percent market share.

Around 75 percent of the equity-backed bonds BloombergQuint scrutinised were rated above ‘BBB’—most of them being ‘A’ and ‘AA’.

Brickwork’s leadership in this segment came under the spotlight when promoters of two large business groups - Zee/Essel Group and Reliance Anil Ambani Group - failed to honour the terms of equity-backed bonds issued by their promoter entities. And negotiated standstills with the bondholders - primarily non banking finance companies and mutual funds.

The standstills sparked off fears regarding the quality of assets held by MFs and NBFCs and whether the risks had been adequately ascertained by them as well as agencies rating these instruments.

All the equity-backed bonds issued by these two promoter groups, except one, were rated by Brickwork, and at above BBB and A, as of the last published rating release.

Brickwork says the events of the past two months are anomalies given that so far the overall rate of default for such instruments stands at 0.19 percent, in value terms, as of the year ended March 2018.

Challenges In Rating Equity-Backed Bonds

As in the case of loans against shares, a debt instrument or bond is issued by a company by providing a security cover in the form of listed equity shares to bondholders. If the equity cover for such a bond falls below a certain level, usually 1.5-2x, due to a decline in the stock price, the bond agreement ordinarily provides for the issuer to ‘top-up’ the equity collateral, or, if it doesn’t do so, permits the bond trustee to sell the underlying shares.

Often promoter entities in India hold shares in listed companies of the same group and pledge them to raise funds to finance other private investment activities of the promoter. Both, the Subhash Chandra-promoted Essel Group and Anil Ambani-promoted Realiance ADAG, did just that. But when the underlying equity shares witnessed a sudden sharp fall in price, the over-leveraged promoter entities that had issued the bonds were unable to top up the collateral and hence negotiated a standstill with bondholders to hold off on selling the shares for several months.

These recent events underscored the challenges in rating such instruments, namely...

• appraising the volatility of the underlying stock price
• cash-flows and operational performance of the issuing entity
• information gaps when it comes to pledged shares

Amit Tandon, co-founder and managing director of Institutional Investor Advisory Services believes these instruments are fundamentally ‘un-rateable’.

“Some of the most stable stocks have a 20 percent variation between high and low, while for others it is higher, so how do credit rating agencies factor this? What this means is an equity cover of about 1.5 times is not good enough,” he said.

Brickwork explained that the rating they assign to these structured obligations is based on the following parameters:

• Rating of the underlying company whose shares have been pledged
• Size of the security cover
• Volatility of the stock
• Cushion of shares with the promoter which is expected at around 40 percent
  

The rating agency stated that the final rating they assign is capped at the credit rating of the underlying company whose shares are pledged, regardless of the size of the cover given.

But often opaque, multi-layered promoter holding structures and information asymmetry in such situations may make it difficult to ascertain the extent of indebtedness of the promoter entities and the exact proportion of shares pledged.

“In many cases there is no visibility on the ultimate repayment of the debt raised from the cash-flows of the issuing company, so the rating factors-in the security cover against the debt without looking at the underlying company’s performance,” said a senior executive with a credit rating agency on the condition of anonymity.

Financial market expert Ananth Narayan in this column also pointed to the challenges in pricing the risk associated with such instruments.

“When the going is benign, they (bondholders/lenders) receive a fixed debt-type return. When the promoter is in trouble, however, they face adverse correlated equity market risks of a sharp fall in the value and liquidity of the underlying collateral. Lenders sell an implicit equity option in such transactions, and they would be relying on the kindness of markets and the goodwill of the promoter to not exercise the option,” wrote the associate professor of finance at the SP Jain Institute of Management And Research.