Structured Obligation———— Made easy
Asst. Prof. Bikram Ghosh
Basics
In this segment we will discuss structured obligation or “SO”. It is a hybrid version or a complex weapon of increasing returns of a Bond or Debenture without attracting default risk, deferment risk, credit risk or currency risk. This note or composite instrument has become quite a famed object for investment banks in India from late 1990s. An easy example will be a Ten year bond tied together with an option contract. In fact by introducing SO, the credit risk comes down further. So it can be termed as a “Credit Enhancing Mechanism”.
Say suppose, a company has a CRISIL rating of AA, but the normal demand of AA, securities in the market can fetch a maximum of 300 Crores to that company, where it needs 450 Crores; it needs to enhance the demand. By clubbing the Bond with a long option will limit the downward risk further, thus enhancing the demand. So, XYZ (AA) will witness always a lower demand from buyers when compared to ABCD (AA-SO).
Central Bank Links
According to RBI circular No RBI/2009-10/335 of 2010, domestic Rupee denominated structured obligations has been permitted to be credit enhanced by non-resident entities under the approval route.[1]Callable Bonds issued by the central bank has been an apt example of Structured Obligation. Say suppose GOI has launched a new series of Bonds on December 2013 as 9.25 %GS 2023with an option of calling it back if interest rate/ inflation goes down by 2% on CPI base. Then RBI observes on 2015 March, that Interest Rates as well as Inflation are around 7.15%. Then GOI is virtually paying 2.1% from its reserves. Hence forth that Bond will be called off. Proceeds will be paid up to the day of calling off. By doing this the issuer in this case GOI has saved 2.1% additional outflow per year on 25,000 Crore. ICRA, has made several categories of SO, for better understanding and rating. They are ABS or Asset Backed Securities, MBS or Mortgage Backed Securities, FFT or Future Flow Transactions, CDO or Collateralized Debt Obligation and PGS or Partial Guarantee Structures. . Traditionally in the US, these were used to finance large scale Oil & Gas business in the 1970s. Most of these projects used to be turnkey in nature. Multi-lateral agencies, insurance companies & Banks of different stature used to participate in forming the entire deal comprising of various securities under one refinancing basket to form a special structured obligation or in other words CDO.
Case Let on Financial Engineering with “SO”
One small case of financial engineering will make it appear simple. One NBFC has 100 Crore Loan Base. Against which the amount receivable in coming 3-4 years will be to the tune of 150 Crores. Now traditionally the NBFC will approach a large Bank, it will hypothecate the receivables and raise money. But this borrowing will appear in the liability side of the balance sheet thus changing the Debt equity ratio quite uncomfortably. Second method will be something like this. The NBFC will float an SPV or Special Purpose Vehicle and will sell this Loan Book to that Company. So, this Loan Book goes out of Balance sheet from that NBFC. Now in order to buy this 100 Crore Loan Book, that SPV will create many Pass through Certificates or PTCs to raise the funds. But this transaction will not come in the Balance sheet of that NBFC at all. These PTCs are called “SO” and they will be asset backed too, so could also be called as “ABS”. Since the credit enhancement will happen so it will enjoy a higher demand, also, as it is basically a part of a Loan Book so it will enjoy a relatively higher interest rate for the buyers of that PTC or SO.
So, Buyers are happy as they have higher returns without extra risk, SPV is happy as they have got public money to buy that entire loan book and NBFC is happy as it all goes of the liability side of its Balance sheet
. Now if this loan book is across multiple credit related products such as credit cards, auto loans & mortgages then this ABS will be called as CDO, which we discussed earlier. In that said CDO, since that loan book of 100 Crores has three parts so they will be treated separately, based on the recovery chances. So, say suppose 70 Crore of 100 Crore is from Mortgage based securities, 25 Crores from Auto and 5 Crores from Credit Cards. So, lower Interest rates will be tagged along the first category say 9% and it will be called Senior. Mid Interest Rate will be tagged with the second say 9.75% and will be called Mezzanine and high interest say 11% will be tagged along with the third one and it will be called as non-rated or Equity. A CDO becomes even more interesting when a cross border aspect is associated with it. Then to cover currency fluctuations with the help of currency derivatives, such instruments are attached inside that security basket.
. Now if this loan book is across multiple credit related products such as credit cards, auto loans & mortgages then this ABS will be called as CDO, which we discussed earlier. In that said CDO, since that loan book of 100 Crores has three parts so they will be treated separately, based on the recovery chances. So, say suppose 70 Crore of 100 Crore is from Mortgage based securities, 25 Crores from Auto and 5 Crores from Credit Cards. So, lower Interest rates will be tagged along the first category say 9% and it will be called Senior. Mid Interest Rate will be tagged with the second say 9.75% and will be called Mezzanine and high interest say 11% will be tagged along with the third one and it will be called as non-rated or Equity. A CDO becomes even more interesting when a cross border aspect is associated with it. Then to cover currency fluctuations with the help of currency derivatives, such instruments are attached inside that security basket.
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Important information on “SO”
Reliance Broadcast Network Limited has recently got an SO approval from CARE or Credit Analysis & Research for their 12 Cr Debt as it has been assigned AAA (SO). In fact the proposed NCD or Non-Convertible Debenture by Lanco has also been assigned A (SO). DBS Corporate Banking used “SO” to good effect while refinancing Silver Oak’s 645 Million USD project in 2011.
Conclusion
This entire blog majorly throws light into demand scaling of debentures, structured product ideas for safety aspect, different types of asset backed securities along with their usage and lastly on the real life cases.
So, we hereby understand from an investor perspective that if we want to take mid risk and earn high return we can invest in PTC with SO from the middle segment. Also, “SO” limits the downside risk of those PTCs, so the default factor is virtually taken out of question. It will enable an investor more gain than any other fixed income vehicle on a standalone basis, without adding additional risk to his portfolio. So, say if there are two Corporate Bonds or NCDs are on offer namely 12%BGFD2029 with AA (SO) and 12%HGFD2029 with AA, the first one will raise more funds.