The CFO's Need:
Diversification Of the Sources of Debt To Minimise the Interest Costs

In a capital-scarce, but accelerating, economy, the price of capital will be high. As the markets progressively move away from an era of controls and segmentation, financial deregulation will, inevitably, bump up interest rates. But that same process of liberalisation--which will, hopefully, culminate in convertibility--will also unleash forces that dampen interest rates. Equilibrating capital inflows will force a convergence of rates--provided macro-economic variables like inflation are not thrown out of kilter by a profligate government. Opines Anil Singhvi, 34, treasurer, Gujarat Ambuja Cement: "If the rupee becomes fully convertible, Indian interest rates will approximate international rates in the long run."

So much for the long run. In the interim, the Indian CFO will have to cope with dearer funds than his overseas counterpart. And, in the battleplace, that will translate into a competitive disadvantage. Points out Nitin Kanchan, 33, director, NatWest Group: "As technologies for large capital-intensive projects converge, the only critical difference between Indian and international companies in future will be the cost of funds."

Exacerbating the problem of the high cost of capital is the historically-predominant share of term-lending in long-term debt financing. The tap of subsidised funds via statutory pre-emptions has been squeezed shut for the Development Financial Institutions (DFIs), thereby forcing them to access the markets. Borrowing at market rates means on-lending at even higher rates. The higher the cost of capital, the higher must be the internal rate of return generated by the project; otherwise, the project will be financially unviable.

THE STRUCTURED SOLUTIONS: Obviously, the time has come to wean the CFO away from his dependence on term-lending. Sure, dealing with a single lender is simpler and less time-consuming than servicing a diffused mass of investors, but cutting out the middleman can shave basis points off your interest costs.

Such disintermediation--the next logical step in the process of resource diversification--has been hindered by a sclerotic secondary market for debt securities. But the current boom in the primary market for debt issues will spill over to the secondary market, galvanising trading activity. On the National Stock Exchange, volumes in the debt market have been climbing steadily to touch a record Rs 1,831 crore on August 12, 1997, from Rs 604 crore on January 30, 1997.

STRUCTURED DEBT INSTRUMENTS. The corporate NCD is an unfamiliar instrument to most retail investors. Innovative CFOs, however, can design multi-bond issues that cater to diverse investor segments. The package could include a mix of deep-discount bonds for investors seeking capital appreciation, and regular income bonds for investors who want a steady flow of returns. Liquidity can be grafted onto the instrument through put options that allow early redemption. The Industrial Credit & Investment Corporation of India has taken this process a step further by offering investors an on-tap encashment bond.

Given this flexibility in structuring, coupon rates need not be frozen over the life of the bond. The simplest way to allow refinancing at lower rates if interest rates move downwards is to add on call options. The price for such an option: a slightly higher coupon rate than that offered on a plain vanilla bond. Or, depending on the CFO's perception as to which way interest rates will move, coupon rates can be stepped up or down, ratcheting to their highest or lowest level in the terminal year.

The logical extension of step-up or step-down structures would be a floating rate bond, which would index rates to a reference rate. There used to be three constraints to the issue of such instruments: the lack of an appropriate reference rate, the absence of derivative products with which to hedge the interest rate risk, and the retail resistance to what is, arguably, a complex instrument. Successive credit policies have attempted to develop the bank rate as a reference rate, and have removed some of the restrictions that hampered the evolution of a rupee yield curve--steps that tackle the first two constraints.

The third is more difficult to overcome, but need not be a binding constraint. For, institutional investors constitute a natural clientele for variable-rate debt. Anyway, hefty issue expenses--which can go up to 8 per cent of the issue amount--raise the effective cost of capital, thus jacking up project costs and inflating depreciation charges. Since private placements are cheaper and quicker, as a general rule, unless the issue size is large, CFOs should opt for them.

In fact, such debt placements are fast emerging as the CFO's most preferred route for fund mobilisation. In 1996-97, the private placement of debt mopped up Rs 18,500 crore out of the Rs 34,300 crore raised from the capital markets. And, in 1997-98, estimates by the Delhi-based Praxis Consultancy suggest that private placements could easily surge past the Rs 25,000-crore mark.

NON-RECOURSE FINANCING. Diversification away from term-lending will force domestic lenders to experiment with the shape and structure of the basic loan. Traditionally, the debt component of the standard project finance package has been of the full-recourse variety. The DFIs have had full recourse to even non-project-related assets as finance is extended either on the basis of the overall strength of the balance-sheet of the company, or on the basis of the guarantees of other group companies. For instance, to obtain funding from the Industrial Development Bank of India, other companies in the Birla Group had to underwrite the Birla-AT&T telecom venture.

Sophisticated lenders have moved away from such inefficient modes of lending. Global best practices require the extension of project finance largely on a non-recourse basis. And much of the external commercial borrowings by Indian corporates is in this form. And the servicing, and repayment, of a non-recourse loan is solely dependant on the profitability of the underlying project--not on the other funds to which the borrower has access.

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