A rupee denominated bond is a bond issued by an Indian entity in foreign markets and the interest payments and principal reimbursements are denominated (expressed) in rupees.
The peculiarity of rupee denominated bond is that buying of bonds, interest payments and repayment all are expressed in rupees. All payments are converted into corresponding dollar values at the time of payment. The term ‘masala bond’ is also used to describe rupee denominated ever since the first issuer of rupee-denominated bonds used the name masala bonds in its first issue. RBI in its August 2016 regulations also used this name.
What is the case of conventional foreign currency denominated bonds?
In the case of a traditional foreign currency bond issued by an Indian entity, if $1000 bond is issued overseas, its 10% interest rate should be made in dollars ($100). Here, it is the responsibility of the issuer to give $100 (instead of in Rs in the case of rupee-denominated bonds). If the dollar’s exchange rate goes up, or rupee depreciates, the burden of repayment goes up for the bond issuer. If the Rupee depreciates from Rs 50/1$ to Rs 75/1$, the cost of bond issuer in terms of rupee goes up as he hast to pay more rupees to get dollar from the market.
Here, the exchange rate risk is with the Indian issuer.
How the masala bonds or rupee denominated bond works?
For example, if an Indian financial entity issues Rs 1000 rupee denominated bond overseas, the buyer in overseas can buy the bond, paying equivalent amount of dollar/sterling.
If the exchange rate was 1$ = Rs 50, the bond buyer will pay $20 (or Rs 1000) to buy the rupee denominated bond.
Suppose the interest rate is 10%. Here, the Indian entity has to pay Rs 100 annually and this can be paid (in dollars etc.) at the prevailing exchange rate at the payment time.
Now if the exchange rate depreciates to 1$ = Rs 75, the bond buyer’s interest revenue of Rs 100 equals just around $1.3. He actually incurs losses in terms of dollars (might have got $2 if the exchange rate was the same or in the case of dollar denominated bonds).
Here, if the rupee’ value has changed, the risk should be borne by the foreign investor. At the end of the time period, the issuer will give Rs 1000 and this can be converted into dollar at the prevailing exchange rate at that time.
Why the masala bonds are attractive for foreign investors?
For the foreign investor, the rupee denominated bonds is attractive as it will give him higher interest rate compared to the standard interest rate prevailing in their markets. On an average, the rupee denominated bonds have an interest rate of 2 to 3 % higher compared to the standard LIBOR (London Interbank Offer Rate).
An additional benefit of rupee denominated bonds is that it will encourage foreign buyers to deal more in rupees (and products that help them to reduce exchange rate risks). Hence, internationalization of rupee can be promoted by rupee denominated bonds.
The International Finance Corporation (IFC) – a World Bank affiliate is the first major issuer of rupee denominated bonds in the name tag of ‘masala bonds’. Later, in September 2015, the RBI came out with detailed regulatory guidelines for the issue of rupee denominated bonds. As per the RBI’s regulation on masala bonds, the money can be used only for infrastructure financing purposes. In August 2016, the RBI allowed banks to issue masala bonds to procure money to meet their capital needs and to collect fund to finance infrastructure projects. The overall guidelines for rupee denominated bonds will be same as that for External Commercial Borrowings