The Hindu Business Line : Scare for REC bond investors

Investment World - Insight
Industry & Economy - Investments
Money & Banking - Financial Institutions
Columns - Taking count

Scare for REC bond investors

Suresh Krishnamurthy

THE hunt for higher yields in 2002-03 took investors' money to destinations not seen so far. One such parking slot was the Rural Electrification Corporation bond. It now turns out that the risk involved in these bonds may have been significantly higher than perceived by investors. At least, a recent report of the Disinvestment Commission says so.

The implications are obvious for investors: Avoid REC Bonds in 2003-04 at all costs. ICICI and IDBI bonds appear better investment options for tax-saving purposes. If investors are spooked by ICICI and IDBI bonds too, because of the level of their non-performing assets, it would be better to avoid tax-saving bonds altogether.

Highly risky: In 2002-03, the REC tax saving bonds offered better yields than IDBI and ICICI Bonds. In addition, for some months, REC bonds were the only option available to investors. With nominal yields of 7-8 per cent, REC bonds would have attracted higher inflows. These funds may have been chasing a mirage, if REC defaults. The Disinvestment Commission's April 2003 report lays bare the precarious financial position of REC.

The report observes "... a delay in payments by even a couple of SEBs (state electricity boards) has the potential to create a significant cash flow problem for REC... "

The Commission has made other significant observations, including:

REC has a high level of outstanding dues, at 12 per cent of total assets, whereas provisions are only .01 per cent.

If provisions had been made REC's net worth would have been eroded;

Non-provision is due to guarantees by State governments but those governments are themselves in poor financial position;

REC's disbursements to SEBs are higher than the repayments. If the disbursements decline due to defaults it can create serious problems for REC;

REC's business plan is unsustainable, based as it is on continuation of the status quo;

These observations highlight the serious risks involved in investing in REC. Investors must, therefore, pull their funds out of REC at the earliest. The earliest chance available is when a put option is exercisable three years from the date of investment.

Default unlikely: Are these factors new? Where they not known earlier? These are legitimate questions. It is true that the financial position has not deteriorated in the last year alone. However, detailed information, as contained in the Disinvestment Commission report, was not known earlier.

Investments in REC bonds were not made based on the disclosures contained in any offer document. Barring sketchy details of financial performance over the last few years, two factors influenced the investment decision-making:

REC is a wholly-owned government undertaking;

It enjoys a triple-A credit rating;

In fact, the Disinvestment Commission report makes the point that "ratings appear to have been influenced basically by the implicit Government of India guarantees to the borrowings of REC". However, the detailed information contained in the April report is enough to scare the wits out of any REC bond investor.

Is the probability of default high? Defaults are unlikely. First, the power sector is itself being restructured.

All the States have now migrated to a system of cost-based pricing of power. Further steps are also being taken. These can at least ensure that the financial health of SEBs does not deteriorate further.

With some luck, it might even improve. In addition, the Government will step in if the REC's cash flows are constrained.

However, investors cannot afford to rest on such assumptions. Some might even dismiss them as fanciful. Also, any bailouts in the event of a default may assume the form of a restructuring package.

Such packages may also require the investor to make some sacrifices. As such, fresh investments in REC bonds need to be avoided. The put option on existing investments also needs to be exercised at the earliest.

Article E-Mail :: Comment :: Syndication

Stories in this Section
Vickers Systems: Accept

Carbon Specialities: Accept

Alpha Drug: Accept

Beware! High coupons do not mean high returns

Smart money heads for mid-cap stocks

Tap profits at the right time

Scare for REC bond investors

From unsustainable jumps...
Market on new path of consolidation

Honda CR-V: Sedan in an SUV

It's all war in telecom fare

National Commission: Principles, procedures