One of the recent measures taken by the government to boost the fear-ridden bond market was the decision to do away with the requirement for all listed companies, non-banking financial companies (NBFC) and housing finance companies (HFCs) to create a Debenture Redemption Reserve (DRR) for their outstanding bonds. The move, the Centre said, would improve ease of doing business and deepen the bond markets. But it may not bode well for investors.
What is it?
Non-convertible debentures (NCDs) are debt instruments that companies issue to investors to raise money for their capital requirements. NCDs regularly pay interest at a fixed rate for a fixed tenure till maturity. However, there have been incidents where companies raising funds through NCDs at high rates of interest have failed to pay their dues. In order to protect the interests of retail investors in such cases, the Companies Act mandated that companies must maintain a redemption reserve. As per the Companies (Share Capital and Debentures) Rules 2014, all listed companies, NBFCs, HFCs and unlisted companies were to create a DRR with 25 per cent of the value of outstanding debentures from their profits. For example, if a company’s outstanding value of debentures was ₹1 crore, it was to create a DRR of ₹25 lakh.
In addition, companies/NBFCs/HFCs also had to deposit 15 per cent of the amount due on debentures in the next fiscal with scheduled banks or invest it in specified government securities, on or before April 30 of each year. The amount invested could only be used to repay outstanding debentures.
Why is it important?
A DRR ensures that a company sets aside a portion of its profits toward repayment of long-term NCDs out of its current profits. When a company that has issued NCDs goes bankrupt or faces a liquidity crunch, it usually defaults on its repayments to lenders. In such cases, the existence of the DRR reduces the investment risk for the buyer of the debentures. Though a few companies issue secured debentures (with the assets of the company as security), a DRR can help them as well, as recovery of dues by liquidating assets can take a considerable amount of time.
But on August 16, the Ministry of Corporate Affairs relaxed this DRR requirement. It said that listed companies, NBFCs registered with the Reserve Bank of India and HFCs registered with the National Housing Bank would no longer be required to maintain a DRR if they issue NCDs. The DRR requirement for unlisted companies (excluding unlisted NBFCs and HFCs) is still on, but at a lower rate of 10 per cent (against the earlier 25 per cent).
NBFCs and HFCs have been the most frequent issuers of NCDs in the market. With the DRR rule gone, the government expects more of these firms to come up with NCD issues that could ease their funding constraints. The extra money that the companies will now be left with due to no provisioning for the DRR is expected to flow into the economy by way of credit too.
Why should I care?
With no backing of DRR for the debenture issues from companies (except unlisted ones)/NBFCs or HFCs, your investment in NCDs are set to become riskier. The rule requiring NCD issuers to deposit 15 per cent of their maturing amounts for the next fiscal has not been changed and remains a protection for buyers.
Beyond this, the RBI and the Centre also plan to more closely monitor the liquidity positions of NBFCs/HFCs so that they have early warning of possible defaults. However, the lack of a DRR does make NCDs, particularly unsecured ones, more risky. Therefore, the move may have a negative impact on debt investors in the medium- to long-term.
This is one move that may trade off short-term gains for long-term pain.