Maiden Century

The Reliance Industries 100 year bond issue is a classic example of the calculated risks and strategies all Indian corporates with a global vision would want to undertake.

A close look at the corporate philosophy, vision and constraints behind RILs latest milestone.

"Nobody can really guarantee the future. The best we can do is size up the chances, calculate the risk involved, estimate our ability to deal with them and then make our plans with confidence." When Henry Ford founder- chairman of Ford Motors came out with this general comment on risk-taking, little did he realise that it could turn out to be an apt prognosis on the fund-raising strategies of a leading Indian corporate decades later.

 

Reliance Industries Limited (RIL), the countrys largest private sector corporate, didnt exactly cause eyebrows to rise when it mopped up US $ 100 million through 100 year bonds in the US bond market. When RIL entered the 100 year bond market in Jan 1997, it seemed to most corporate analysts to be a logical step after its earlier bond issues of 10 year and 50 year tenures.

But this nonchalance was surprising. For, what RIL had actually done was create history in more ways than one with the successful launch of the 100 year bond issue. For one, it was the first Asian company and one among the 22 companies in the world to issue 100 year century bonds. Then, the success of the issue had proved that the international creditworthiness of a corporate could override country rating constraints in some ways. And this was in spite of the fact that, technically speaking, corporate rating is always notches below the sovereign rating of its country. Consider this: the IMF and World Bank loans to India have been for a period of 15 years at the most, as against RILs progressively increasing tenures.

Another significance of the 100 year bond issue was that it also marked the emergence of a company associated with the domestic equity boom over the past decade, as a major player in the world debt market.

But why, in the first place, did Reliance decide to tap the US market at all? The US market is perceived to be highly regulated and a rather expensive one at that. And thats established beyond doubt: RIL offered an issue spread of 335 basis points over the US treasury rate. Not only is this higher than what most other issuers had to pay in the 100 year bond market at that time, it was also high as compared to general standards. Also, could RIL establish a trend for other Indian companies to follow? To understand this, one has to look at the funding strategy of the company in the past.

Changing gear

In the early eighties, when the stock market was in a dormant state, Reliance Industries relied more on debt as source of funding. During 1979-80, the companys debt-equity ratio was 1.15:1, while its equity stood at Rs. 52 crore. When the Indian stock markets started throwing up opportunities in 1985, Reliance was quick to spot this and began tapping the market. It made a series of forays into the capital markets, and the next five years saw the equity increasing from Rs 52 crore to Rs 152 crore. The debt equity ratio fell from 1.66:1 to .055:1.

Cashing on the equity boom of the early nineties, Reliance raised funds from the domestic equity market. This was followed by GDR issues in 1992, ( it was then the first Indian company to do so) and once again in 1994. During this period, the equity of the company increased, and touched Rs 456 crore by 1995. As a result, the debt equity fell further to 0.35:1, one of the lowest in the history of the company. (see table : Funding strategy).

Why foreign debt ?

Over the past few years, Reliance had drawn up a Rs 10,000 crore investment plan in its various projects. But a large vision requires colossal amounts of funds. Meanwhile, the companys equations with its loyal investors had undergone some change. For the investors, the flash point came when Reliance, contrary to its claims in its GDR prospectus, privately placed equity shares worth Rs 586 crore with Unit Trust of India. This was in addition to the two GDR issues. After Reliance Polypropylene Limited and Reliance Polyethylene Limited were merged back into the parent company, the bloated equity and declining earning per share forced many foreign institutional investors to dump their holdings in Reliance. The message was now clear: the low debt- equity ratio and the bloated equity were all pointers to the fact that RILs reliance on equity would have to be brought down.

Commenting on this, Alok Agarwal, treasurer of the company and one of the key men behind the success of the issue says: " It is not that we have just raised funds. We have been equally active on the performance front, too. Also, our asset creation and profitability is one of the highest in the private sector. In fact, we are a major player in the global petrochemical business." (See chart: growth curve). Under such circumstances, debt was the natural choice for a company with a long-term global vision.

But domestic debt was out; interest rates were too high, specially to lock into. Besides, there was a total lack of investor appetite for long-term corporate paper. Reliance was therefore, forced to look beyond the domestic markets. It headed west.

What gave RIL a headstart was that it had already established its presence in the Euro market. Each segment of the Euro bond market, somehow or the other, says Naina Lal Kidwai, executive director, Morgan Stanley ( which was one of the lead managers for the 100 year bond issue) is made up of a few categories of investors. Thus, the investor base lacks diversity. If a company wants to raise funds at regular intervals, it becomes necessary to tap new pools of investors. The presence of big, long-term players like the pension funds, insurance companies etc., in the US bond market provides one such opportunity, as was the case with RILs 100 year bond issue.

Says G Shiva, head, fixed income and money markets at Citibank: The US market, apart from being deep in terms of investor base, also has high liquidity. One can expect fair pricing. " He further adds: "If the amount to be raised is large, then US would be a favoured market." As the fund requirement of Reliance was large, Yankee Bonds were the natural choice.

The journey

The first step that the company took towards the 100 year issue was getting itself rated by international rating agencies. Says Agarwal, "Standard & Poor (S&P) assigned a BB+ indicating long term rating with a positive outlook. Moody gave a Baa 3 rating." According to the press release of S&P "this reflects the sovereign credit risk of the Republic of India for foreign currency obligation, which was also rated BB+ with a positive outlook." The rating was constrained by the fact the international rating agencies generally do not rate a company higher than the country in which the company is domiciled. Adds a leading merchant banker: Reliance, on its own, could have got an even better rating.

The positive ratings were given largely on the strength of three factors: a solid financial profile and strong cash flows, good track record of plant commissioning and an anticipated competitive cost composition, as the Standard & Poors news release pointed out. The other positive factors that weighed in RILs favour were an effective and sales and distribution system ( that enabled it to maintain operating rates well above industry standards ) and international standards of its plants ( that could enable it to switch over in a larger way to exports with ease).

Once the ratings were obtained, says Agarwal "we could aggressively market the bonds to potential investors. This is because ratings are crucial for US investors. The journey to US first began with a 10 years bond aggregating $ 150 million in September 1995, which was the first and the largest international bond offering by an Indian private sector corporate then. This proved to be the stepping stone for the company's future offerings. In June 1996, Reliance issued two offerings of 20 and 30 year bonds of $ 100 million each. Once it established its presence it took further advantage of its familiarity with US investors by coming out with a 50 years bond issue of US $ 100 million. This established yet another record: these were the longest maturity bonds issued by a corporate issuer in Asia Pacific. RIL also set a precedent of being the only Baa3 rated company in the world to issue 50 year bonds successfully.

These issues were all precursors to the 100-year bond issue of US $ 100 million in Jan 1997, says Agarwal. The bond issue received a favorable response and was oversubscribed seven times. During the same month, Reliance also raised $ 214 million through yet another 30 year bond. So, within a span of 14 months Reliance had raised $ 914 million. Says Naina Lal Kidwai, This is another characteristic of the US market. Once a company establishes its presence and a good yield curve, it can raise funds in quick succession as demonstrated by Reliance. And that could well be a pointer to other Indian corporates with a global vision.

Why 100 years ?

But why did Reliance prefer to take such a long term view on interest rates at a time when few borrowers would like to get locked in at long maturities? Says Agarwal: "The petrochemical industry is a long gestation and capital intensive industry, and the economic life of the plant is thirty years. Raising long term funds, therefore, makes more sense."

Moreover, the cost difference between the twenty year maturity bonds and those with longer maturities is negligible when compared to its advantages. According to sources at Morgan Stanley ( which lead managed the first ever 100 year bond issue and is a leading player in the international investment banking scene), the spread premium required to extend from 30 years to 100 years has narrowed considerably since Walt Disney (the first issuer of 100 year paper) paid 43 basis points over US treasury.. It currently stands at 10-15 basis points, its tightest level ever.

Anil R Bhatia, head-debt group, JM Shares and stockbrokers, sums up: "It makes more sense to go in for long duration funds as it is as good as quasi equity." After its last bond offering, the average maturity of RILs debt has gone up to 20 years and the rupee to foreign debt ratio to 1:1. The average debt cost on foreign funds is around 9.5 per cent.

Further, as Reliance is exposed to the global market, it is important that it also looks at what its peers are doing in terms of cost of capital and the average maturity of debt. Says Agarwal: The average debt period of other petrochemical majors are in the range of 10 to 30 years. As Reliance is a global player in the petrochemical business it has to match the other big players and thus the 100 years maturity bond.

A long maturity also means that the redemption is pushed back to that extent. Thus, the strain on the cash flow in the initial years is less. Incidentally, the companys Hazira plant took more then five years to come up.

Another issue which needs to be looked at is the timing of the issue. In the case of Reliance, the timing was perfect, says Naina Lal Kidwai. The interest rates were among the lowest for last 25 years (see table on US treasury rates ) and paper from emerging markets was in demand. As Reliance had already established its yield curve for all tenures of bonds, it had no difficulty in selling the issue.

The risk

But all good things come at a cost so what are the calculated risks associated with such long maturity foreign funds? Of course the foreign exchange and interest rate risk, says Lester Pereira, director-treasury, Barclays Bank PLC. Taking a view on forex risk for such long durations is impossible, concedes Agarwal. Despite global competitiveness, only one per cent of the Reliance turnover comes from export.

With such a huge forex exposure, will it now make a major thrust into the export market? Says Agarwal: The domestic demand is high enough to absorb our production. So, why should we allow others to sell into the domestic market. Further, our products are pegged against the dollar, so any fluctuation in the rupee will be reflected in the landed price of our product.

Another comforting factor to the RIL management is the fact that their plants are comparable with international standardsas pointed out by the S&P news releasewhich could make the switchover to exports easier, if the need arose.

The cost

One major consideration underlying all borrowingwhether through the external commercial borrowing route or by the launch of debt instruments is the coupon rate. How did Reliance fare against other issuers in matters of pricing? A look at the table on US treasury rates shows that Reliance paid 355 basis points over the US treasury rate, which is one of the highest paid by 100 year bond issuers (the lowest was paid by MIT, which had a rating of Aaa/AAA and issued in November 1996, paid only 60 basis points above US treasury rate).

As far as other issuers (which came out with bond issues at around the same time) are concerned, Cork & Seal (Baa2/BBB+) had an issue spread of +100 bp, while US West Cap Funding (Baa1\BBB+ ) offered a coupon of +120 bp. Endesb (Baa/A-) offered +127 bp. Caterpillar Inc. paid an issue spread of only +75 as it had a rating of A2/A (see box on treasury rates for details on other companies).

A leading investment banker with an FII says that there are three basic reasons why Reliance had to pay a higher coupon. One was that it was constrained by its country rating.

The other reason is the liberal approach of the company itself in matters of pricingits priority has always been to familiarise itself with overseas investors, during that time the interest rate in US were low so the Reliance offer looked attractive to the US investors.

Investment banking divisions of foreign banks which are active in the syndicated loan market comment on the aggressive pricing demanded by other Indian corporates. RIL is the only Indian company to have its priorities right, says one investment banker, in any case, domestic interest rates are higher, so this is a better alternative.

John McNiven, managing director of Merrill Lynch (Asia Pacific) has gone on record as saying that while LIBOR based borrowings are exposed to a rise in short term interest rates, Reliance which has secured long-term fixed rate funds, is well shielded against such fluctuations. If at the same time in future the outlook of Reliance changes, it could use the swap market to switch into floating rate funds.

Says Naina Lal Kidwai: " If you compare the 100 year bond coupon rate with other debt paper, it is expensive. But as compared to equity, it works cheaper, specially if the company is a high dividend paying one, and intends to remain on the higher side of long term debt. This is like quasi equity, and works out cheaper." Reliance paid 60 per cent as dividend in 1996, which is costlier then 9.5 per cent cost of funds.

Future cash flows

Cash flow is another area of concern in the case of a company with such a huge debt position. RIL will have regular outflows on account of redemption of non convertible debentures, repayment of loans and regular expansion programmes (which are an intrinsic part of the companys corporate philosophy How will it affect the companys profitability ? Predicting cash flows for such long duration is impossible.

However, Agarwal is confident about cash flows and says: Reliance is comfortably placed if one looks at the cash profit generated in the last two years, which was Rs 2984.8 crore.

Commenting on RILs cash flow, Suresh Iyer, analyst with PR Subramanyam & Sons says: The year 1997-98 will see a 300 per cent volume growth on account of new capacities going on stream and further enhancement of economies of scale, not to speak of higher cash inflows. Jardine Fleming has projected a total cash profit of Rs 3758 crore for next two years for RIL, which is almost equal to its total borrowing of Rs 3300 crore from the US market. Says Agarwal: "Considering the current levels of cash profit we will not face any problem at all in terms of repayment."

In spite of Agrawals confidence, the risk is there. But the strategy is well-planned and the risk very well-calculated. And that is what usually ensures success. Did Henry Ford have Reliance Industries in mind when he commented on risk taking?

Notable Achievements of RILs 100 years bond issue

The deal represents the first split-rated 100 year issue ever, representing a landmark transaction for Reliance and the Indian sovereign.

The first 100 year issue by an Asian private corporate entity and only the 22 issuers in the world have issued 100 year bonds in the last 4 years.

The deal achieved several important objectives for Reliance- lengthening the maturity profile of its debt, diversifying its investor base and establishing a visible benchmark for the company and the sovereign.

The transaction attracted high quality and diverse investor interest with over 50 investors participating.

Several purchasers were first time Indian and Reliance buyers and thereby the transaction significantly broadened the investor universe for Indian paper.

The transaction reaffirmed investor interest in India and established a large source of capital for future fund raising.

The legwork

The legwork basically involves creating an appetite and presence for your paper, says Naina Lal Kidwai. Adds Agarwal: " It was not a day-long or a month-long exercise; what worked was the performance put up by the company since its inception. Further, the success of the issue was also due to investor franchise value based on Reliance's track record.

The first three offerings were done through extensive roadshows in May-June 1996 to create awareness among the large investors in the USA. The issue met with good response specially in the secondary market and was traded at 312 basis points and 225 basis points over the US treasury rate. For the 50 and 100 year issues, what was commendable says Agarwal, "was that there were no road shows. This was at a time when RIL was competing with other sovereign borrowers who were in the market during the same time - Venezuela ($1.5 billion), Mexico ($1 billion) and Argentina ($2 billion). The deals were done through international conference calls.

Investor perspective on 100 -year structures

Extending the maturity of a corporate bond by 70 years results in relatively small duration extension while significantly increasing the convexity of the bond. For example:

Unlike other sectors of the bond market, an investor buying a 100-year bond receives extra yield while pickinng up convexity with minimal duration extension. This is one of the cheapest ways of buying convexity in the bond market. In other sectors of the market, increasing convexity usually entails giving up significant yield or extending duration significantly.

The higher yield and higher convexity combination works in the investors favour. Over a one year holding period, the 100 year bond outperforms the 30-year bond significantly if rates fall and underperforms the 30 year bond significantly if rates fall and underperforms less if rates rise.

Over a longer holding period, the convexity and yield advantage of the 100-year bond truly sow their impact. Over a five-year holding period, the return profile is fully in favour of the 100-year bond. Note that despite its slightly longer duration, the 100-year bond does not substantially underperform the 30-year bond even when rates rise 400 basis points due to its higher convexity.

Five-Year Total Return Performance (%)

The credit risk fro a 100-year bond is not significantly higher. The present value of the principal payment 100 years from the issue date is only 0.08 per cent of the total value. Moreover, the present value of all cash flows beyond 50 years, including coupon and principal payments, is insignificant.