Why bonds issued by 'quasi-sovereign' firms aren’t risk-free

Swapnil Pawar

There is a class of issuers in Indian debt markets that is treated as being very safe in terms of credit risk – the quasi-sovereign companies. Generally, these include the so-called Public Sector Undertakings (PSUs) and their subsidiaries. There is, in fact, a whole category of bond mutual funds called ‘Banking and PSU Debt Funds’ that invests exclusively in debt issued by banks (public and private) and PSUs – under the broad assumption that banks and PSUs are safer that other issuers of debt.

This assumption is not entirely wrong. However, it is too general and can become dangerous in specific cases. This article explores why.

IL&FS was thought to be quasi-sovereign

After the event, many experts came forward to state that IL&FS was not a well-run institution and its default was only to be expected. Hindsight is 20-20 indeed; when the going was good, not many doubted IL&FS! Credit rating agencies gave it a full AAA status. The problems at IL&FS were largely ignored even by savvy institutional investors such as debt mutual funds. That was because a lot of investors considered IL&FS to be a quasi-sovereign company.

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Was IL&FS indeed a quasi-sovereign company? It started operations in 1987 as a company owned by Central Bank of India, Unit Trust of India and HDFC. In that sense, it was never directly owned by the government of India. Also, it was never a wholly owned (or majority owned) subsidiary of a single government-owned company/bank. Over time, its ownership passed to LIC, Abu Dhabi Investment Authority and ORIX Corporation. In this form, it hardly qualified to be called a quasi-sovereign company. Yet, most investors treated it as such.

‘Implicit’ guarantees mean nothing

When IL&FS defaulted on its obligations, it was widely believed that the government would intervene to bail it out and make good on its repayment obligations. The government did not. The important takeaway for investors was that unless the government explicitly guarantees some paper issued by a company, there is no real meaning to the term ‘implicit guarantee’ of the government. By virtue of a direct or indirect ownership in an entity, the government does not automatically become liable to pay that entity’s dues. Hence, although LIC owned part of IL&FS, it did not come forward to pay on its behalf.

The shades of ownership

As shown in the below graph, there are various possibilities when it comes to government ownership. Some companies are owned by the central government entirely – such as the National Highway Authorities of India. Some others are majority owned by the central government – PSU Banks, NTPC, Power Finance Corporation etc. There are wholly/majority owned subsidiaries of such wholly/majority owned companies – e.g., ONGC Mangalore Petrochemicals. Lastly, there are companies that were/are promoted by a government owned/controlled company but are no longer majority owned by them. LIC Housing Finance is an example of this – about 40 per cent of it is owned by LIC and the rest by the public.

Another possibility for government ownership is through state governments. State Electricity Boards are owned by respective state governments. Unlike the central government, the state government debt cannot be treated as sovereign debt since states do not issue currency.

In a nutshell, the government ownership of a company is a complex idea. Even if we assume that the government may intervene in the event of default by a supposedly quasi-sovereign issuer, it is likely to be quite dependent on the nature of government ownership. In cases of direct and majority/full ownership, an investor can be largely justified in her expectation that the government may not allow such a company to default. In the case of minority and/or indirect ownership (i.e., through another PSU), such an expectation is a stretch at best.

As the IL&FS default showed recently, it may be safer to assume that an entity with indirect government stake, especially if it not more than 50%, is as good as a non-government entity! LIC Housing Finance and PNB Housing Finance are not quite government-owned or government-backed in this sense.

What next? It is back to the basics!

Determining the creditworthiness of a supposed quasi-sovereign entity should still start with the assumption that it is a regular company with no government backing. This would give the investor a sense of inherent financial health of the company. For example, ONGC and NTPC are well-run companies with good financials. On the other hand, MTNL has a poor financial status. This tells us that the likelihood of a cash crunch and a need for government intervention is higher for MTNL than it is for NTPC.

After this, the ownership analysis described above enters the picture. In the specific case of MTNL, owing to the direct and majority ownership by the central government, one can have some degree of comfort. How much this improves the creditworthiness of MTNL is a matter of investor’s judgment. However, it would be counterintuitive to think that MTNL and ONGC both have the same credit risk because both are majority owned and controlled by the central government. Owing to the poor finances of MTNL, it is always going to be a poorer credit than NTPC or ONGC.

The following graph summarizes these axes of ownership and financial health.

Investing in PSU papers – directly or indirectly

Most investors have some exposure to quasi-sovereign issuers of debt – either through direct holdings or, more commonly, through debt mutual funds. It would be wise for investors in either case to evaluate the true relevance of government ownership. If the ownership is direct, by the central government and majority, it is good. Otherwise, one needs be on guard – best to treat minority and indirectly owned companies as effectively non-government-owned. Also, it pays to know the ‘raw’ creditworthiness of a company – without ownership boost – and stick to well-run companies. For these the need for bail-out itself is low, thus hopefully not invoking their ownership status!

(The writer is Founder, ASQI Advisors)