Banks find credit-linked notes a novel tool to ramp up returns

Indian banks have discovered a new product to generate higher returns on their loan portfolio but not without higher risk. Credit-linked notes (CLN) has found its way into almost every commercial bank's balance sheet.

The collective exposure of the banking system to the CLN could be $1 billion, said banks active in overseas loan syndication for Indian corporates.

CLN is a credit derivative linked to foreign currency convertible bonds (FCCBs) which has, of late, become the favourite with the mid and small corporates to raise overseas funds.

Subscribers to the FCCBs essentially invest in an equity instrument which is treated as debt till the time it is converted. CLN offers them protection from credit risk.

Normally Indian banks' overseas wings buy CLNs which are treated as unsecured loans in their books. If there is no default by the FCCB issuer, the banks make money on this.

On maturity, if an investor wants to convert an FCCB into equity, there is no cost to the company on the face of the product. There is no listing hassles and unlike the external commercial borrowing (ECB) which is capped at 200 basis point spread over the international interest rate benchmark London Interbank Bid and offer rate (LIBOR), there is no pricing ceiling for FCCB. Therefore, there is flexibility in pricing.

While most of the syndicating foreign banks exit after offloading the CLN in the secondary market, these have been lapped up by the Indian banks as they earn a coupon of 50-60 basis points more than other debt papers of the external commercial borrowing.

"The problem that has caught most of these banks unaware is the quality of the corporate that have raised these instruments and therefore the creditworthiness of these CLNs," said a banker.

These papers mature after 5-7 years and therefore the performance of the companies which has issued FCCBs has to be judged during the entire period.

"Even if once any corporate defaults in the payments of the coupon, it will have an adverse impact on the entire banking system as the credit linked note gets traded," said a banker.

A spiralling stock market and rising interest rates have made FCCBs the most favoured instrument for corporates to raise resources overseas.

Of the 25 overseas debt issues that raised an aggregate of $1.7 billion in the first half of 2005, 24 companies opted for the FCCB route.