India central bank tightens rules on low-coupon bonds

MUMBAI: The Reserve Bank of India has plugged a loophole that banks were using to buy low-coupon bonds by requiring them to invest in such debt only if the issuer has a back-up fund widely known as a "sinking fund" to ensure payment in case of a default.

The central bank notified banks about the directive last week, two officials with direct knowledge of the matter said.

The sinking fund would collect all accrued interest during the maturity of the debt, ensuring payout at redemption in case of default.

"There is credit risk associated with such low-coupon bond issuances in the absence of a sinking fund. All such low-coupon bonds should be treated in the same way as zero-coupon bonds," said one official, citing the notice to banks.

A RBI spokeswoman confirmed the central bank has communicated the notice to lenders.

In 2010 the RBI barred banks from investing in zero-coupon bonds, saying that such debt offered little information on the issuer's cash flow, making it hard for investors to gauge potential default risk.

Zero-coupon bonds offer no interest during the tenure of the bond, but promise a premium at redemption.

The ban on zero-coupons led some companies to issue low-coupon bonds, which offer small interest payments but pay a premium at maturity. They thus avoid meeting the technical definition of a zero-coupon bond, even if the debt shares some of the same risks.

The RBI in November expressed its concern to banks about the shift to buying low-coupon bonds and sent emails to banks that had invested in such debt seeking details of those deals.