Opinion | Loans against shares not as bad as perceived
Advantage to the investor in LAS-secured bonds is the relatively higher returns
Debt mutual funds have various kinds of instruments in their portfolios. These are mostly bonds but there may be certain variants like commercial papers, certificates of deposit, government securities, overnight parking with CCIL, etc. All investments are within Sebi regulations. Talking of bonds, bonds may be ‘secured’ which psychologically sounds better (my fund invests in secured bonds) or unsecured (antennae goes up).
Now let’s see what this “security” is. This is a legal charge against assets of the bond-issuing company which, in case of default, the bondholder (the mutual fund in this case) can dispose of and realise the dues. The charge may be against fixed assets of the company (for example, land, building and machinery) or floating assets (working capital etc.). Unsecured bonds make your antennae go up because in case of default the investor does not have any assets assigned to sell and realise dues. But this is a textbook or academic approach. Now let’s look at the practical side.
Charge against assets of the bond issuing company does not have much of practical relevance. In case of default, though, on paper the investor can sell those, in reality, she has to go through the legal process. Till the Insolvency and Bankruptcy Code (IBC) came along in 2016, the charge against assets had no significance due to the time consuming and complicated legal process, which afforded enough time to the defaulting company to figure out something. Things have improved now, by virtue of the IBC and National Company Law Tribunal (NCLT) delivering judgments under IBC. However, it has nothing to do with charge against assets, but (a) day-to-day management being taken away from the defaulting promoter and given to an independent person called insolvency and resolution professional and (b) ownership being taken away from the promoter and given to the successful bidder or (c) in the absence of proper bids, the company going into liquidation. In case of unsecured bonds, timely payments are not a function of the security per se, but of (a) the ability of the issuer to service debt obligations and (b) intention of the issuer to service obligations. We saw an example of “intention” in the IBC/NCLT case of Essar, where promoters offered to pay at the end of the process, but the offer was rightfully rejected by the court.
We started by stating loan against share (LAS) exposures in your fund portfolios. The background discussed above was to get a perspective on this, to understand the import of conventional security on bonds. There are certain bonds that are secured, not by a charge against assets as discussed above, but by pledge of shares of the promoter. Of late, this security is being tarred by a negative brush by certain sections, but similar to other bonds, this is also secured against assets. Let’s see how this security works and how it is safe. The security cover, which is computed as number of times of the loan exposure, normally ranges from 2 to 2.5 times in LAS deals against 1 to 1.25 times in conventional bonds. For example, for a bond of ₹100, shares worth market value of ₹200-250 would be pledged with the bond investor, by way of marking a lien. The price of the share, for arriving at the cover of 2 or 2.5 times, is not as on the date of the transaction which can be manipulated, but an average of a reasonable period, say the last six months. In spite of the cover, if the share price in the markets drops steeply, there are clauses in the agreement that provide for top-up i.e. either provide more shares through pledge or provide some other security as per agreement.
Importantly, in case of default, the shares can be disposed by the investor without the intervention by court of law, which provides a lot of flexibility and instant liquidity of the security. The background for comparison of LAS deals with bonds is that both conventional bonds and LAS deals are bonds in nature, only that the nature of the security is different; the legal charge is against equity shares of the issuer/group company of the promoter, of which she would not like to give up control. The advantage to the investor in LAS-secured bonds is the relatively higher returns. These deals are not done in the regular course of business but by promoters otherwise pressed for money, hence they are forced to pledge their shares and offer a higher rate. Instead of simply pledging shares and taking a loan, sometimes it is done in the form of issuing a bond with a collateral of pledge of equity shares.
Net-net, we rely on the fund manager’s judgement on the investment portfolio. Sometimes there are accidents, but the accident may happen in an erstwhile AAA rated entity; for example, IL&FS. From a security point of view, LAS bonds are not as bad as perceived.
Joydeep Sen is founder, wiseinvestor.in
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