REC opts for currency risk to save on coupon

By Neha D'Silva and Manju Dalal

HONG KONG (IFR) - India's Rural Electrification Corp is choosing to take on currency exposure of around US$28m a year to save some 170bp on the coupon rate on a rupee bond. The state-run utility has issued a mandate for a local Rs15bn (US$304m) deal to be sold at a fixed rate, and then swapped into a spread over yen-Libor.

To old hands in India, the structure sounds almost too familiar. In 2006, the Reserve Bank of India had barred banks from swapping their rupee-denominated bonds into yen-Libor due to systemic risks.

The rule, however, was never extended to corporate issuers and REC is clearly aware of that. Granted, this time the issuer is at least mitigating the risk by only swapping the coupon, leaving the principal to be paid in rupees. Still, that alone means it will fall under the constant scrutiny of the Indian central bank.

In a circular issued on February 2, RBI advised banks to monitor and review on a monthly basis the unhedged portions of foreign currency exposures of companies with relatively large total foreign-currency exposures. In RBI terms, that means any deal above US$25m.

"In view of the importance of prudent management of foreign exchange risk, it has been decided that banks, while extending fund-based and non-fund-based credit facilities to corporates, should rigorously evaluate the risks arising out of unhedged foreign currency exposure of the corporates and price them in the credit risk premium," said the RBI circular.

That announcement came in the wake of a statement at the end of last year, when the central bank raised a red flag about banks' currency exposure to the Indian corporate sector. Specifically, the RBI concluded that only 40% of currency exposure had been hedged.

REC is looking beyond all that and training its sights on the cost saving that swapping to yen-Libor will provide. This structure reduces the coupon so significantly that bankers in India have said several other corporate issuers are asking for proposals on how to emulate REC.

All in all, REC will save some 200bp in swapping to yen-Libor. On February 9, the company mandated HSBC, ING, Axis, JP Morgan, Credit Suisse and ICICI Bank after they submitted a proposal that saw the bond coming out with a 9.28% coupon that would be swapped into 724.2bp over six-month yen-Libor.

With the Japanese base rate running at 0.34%, that means the cost of funding for REC will drop by 170bp. Even considering the 5bp fee for the swap, it is a great deal.

Still, it does not come without risk. The structure is based on the premise that the yen will weaken further. While the direction of the cross-currency rate between rupees and yen is currently favourable to REC, this may well change.

The rupee has been appreciating, while the yen has been depreciating. On February 9, the rate stood at Rs0.64 to the yen and around Christmas last year, it was at Rs0.67 to the yen. However, earlier in the year, it hit a low of Rs0.58 to the yen, 15.5% below the December peak.

In short, if markets suddenly turn, a steep depreciation of the rupee in tandem with a quick appreciation of the yen cannot be ruled out. That could trigger margin calls for REC.

"REC is taking straight currency risk from this transaction. As the company does not own assets in yen, the risk will get higher if the currency it is betting on moves in the opposite direction," said a Mumbai-based banker.

That risk could be mitigated if REC took up a reverse swap. However, in a recent controversial decision, RBI forbade anyone taking a derivative position on the rupee to do the counterswap. So, REC has no option but to go into this one naked.

(Reporting by Neha D'Silva and Manju Dalal)