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Why are NBFCs suddenly using Zero Coupon Bonds to raise Debt?

One of the most significant lessons in the Indian Banking literature is that firms should never borrow for a short term when their asset’s cash has a long time horizon. 

Or to put it more simply, you don’t buy your house with credit card debt.

Thus, it is vital for firms to ensure that their debt repayment horizon is longer than the time taken for the firm’s assets to generate revenue. 

Indian Banking Environment

IL&FS is the prime example for this cautionary tale. The infrastructure lender was financing itself with short term credit to construct infrastructure projects that pay out several years down the line. When the short term creditors came knocking at IL&FS doors but IL&FS had all the money locked up in construction projects that would pay back several years later. This inevitably led to IL&FS downfall.

Dominant NBFCs like Bajaj Finance, Aavas Financiers and Cholamandalam etc have always kept this principle as a priority when taking strategic decisions. These NBFCs have always borrowed using long term debt instruments while negligible proportions of borrowing that relies on short term debt instruments to finance their projects which have a much shorter time horizon.

This obsession with Asset Liability management (ALM) has rewarded them quite handsomely. 

Economic Environment

The pandemic had brought the global economy to its knees. To stave off recession, all major economies provided economic stimulus in one form or the other. The stimulus did do its job but in return, introduced inflationary pressures on the economy. Furthermore, the Ukraine – Russia conflict also brought its own problems. As the breadbasket of Europe turned into a war zone and economic sanctions on Russia made things even worse from an inflationary standpoint. Along with that, oil prices soared reflecting the current economic climate. All these factors combined, brought inflation to a higher than desired levels in many economies including India. RBI responded with increased interest rates with the hope of curbing inflation.
*To understand the global macroeconomic scenario better, check out this report.

The Zero Coupon Bond Trend

In the situation of high interest rates, domestic NBFCs kept the mantra of Asset Liability Management (ALM) in mind and pivoted to Zero Coupon Bonds to raise debt. The reason behind this trend is that with zero coupon bonds do not have to pay coupon payments at regular intervals. The absence of coupon payments in a high interest environment benefits NBFCs. Zero Coupons Bonds are given at a discount amount and at maturity, they are repaid at the principal amount. As an NBFC, to rely on a non-coupon paying long term debt instrument is an intelligent move keeping in mind their ALM agenda especially in a high interest rate environment. Additionally, zero coupon bonds take away the reinvestment risk for investors and gives the borrower more time to repay the loan.

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