With the hardening of yields becoming an issue in recent times, the Reserve Bank of India (RBI) has removed the restriction on Primary Dealers (PDs) to fix the coupon rate for Tier II and Tier III bonds.
At present, the coupon on instruments at the time of issue by Primary Dealers cannot exceed 200 basis points over the yield of comparable residual maturity on Government of India dated securities.
A PD is basically a securities firm that makes a market in government debt securities, acting as a principal in the trades. RBI has permitted them to deal in corporate bonds also. “On a review, it has been decided to remove the ceiling on the interest rate spreads at the time of issue of the subordinated instruments by the PDs under Tier II and Tier III capital requirements, with immediate effect,” RBI said in a notification.
The head of a public sector bond house said that the ceiling did not make sense as the interest rate for corporate and other papers has shot up substantially. The spread over the government bonds for Tier II bonds are at least 200 basis points. PDs can issue subordinated Tier II and Tier III bonds at coupon rates as decided by their Boards of Directors.
The ruling yields in the market have hardened. If investors pick up bonds (for capital) floated by PDs at lower yield in primary issuance, there is a greater risk that the market yield may be higher. This means that the price of bonds is less than the purchase value and investors would have to make provisions for this from profits, which amounts to taking a hit.
“Lifting of the cap would help us to offer better rates to attract investors,” said the head of dealing at a private sector bond house.
Since much of PDs’ activity involves trading, they are exposed to the market risk more than the credit risk. The government paper has zero credit risk, while exposure to corporate bonds comes with exposure both to market as well as credit risk.
The Tier II bonds are used to manage credit risk, while Tier III bonds are short-term subordinated bonds to provide for market risks. Usually, they have a residual maturity of between 3 and 5 years.
With the sharp rise in the borrowing programme, the load on the PDs for underwriting and trading in government bonds has gone up. They would have to raise more capital to support rise in business activity. At present, the capital adequacy ratio prescribed for PDs is 15 per cent.
Banks which undertake PD activities departmentally have to follow the guidelines applicable for banks while issuing subordinated debt instruments.
