Wednesday, December 26, 2012

Developing debt markets – Lessons to be learned from a India

I have recently come across some interesting transcripts from presentations by Harun R. Khan about the Indian debt markets. They not only describe very well the state of Indian debt markets today but also provide some useful insights into how debt markets work and why this is important. If you don’t have much time, you can read my summary below. Otherwise, you will find the transcripts at the end of this post.

What is the current shape of Indian debt markets?

Today, India’s financial markets are dominated by equities. The debt market is underdeveloped.

In addition, as regards corporate debt issues, 93 % of them are private placements, due to extensive disclosure requirements, higher cost, plain vanilla character, and lower speed in case of a public debt issue. Publicly traded debt is, therefore, still dominated by government bonds.

What is a developed debt market?

Four main criteria measure the efficiency of debt markets:

  • Diversity of financial instruments
  • Diversity of participants and the heterogeneity of their responses to new information (“Breadth”)
  • Capacity of the market to dissipate price fluctuations (“Resilience”)
  • Capacity of the market to handle large transactions without causing sharp price changes (“Depth”)

Why is it imperative to develop functioning debt markets?

Developing debt markets fosters economic growth and development:

  • Debt markets transfer capital from savers to borrowers. Thus, they attribute funds efficiently.
  • Debt markets help transferring, pooling, and sharing of risks.
  • Government debt markets shape a yield curve that is essential for pricing other financial assets.

In addition to the above general rationales, India has specific reasons to develop its debt markets:

  • The country has substantial future funding requirements that cannot be met by bank financing alone. This is especially true for long-term financing, which banks cannot stem alone, due to increasing asset liability mismatch dilemmas over longer periods of time. For example, infrastructure funding requirements currently amount to 10 % of India’s annual GDP.
  • Functioning debt markets promote financial inclusion for small and medium-sized enterprises and retail investors.
  • Healthy domestic debt markets will reduce the dependency of Indian firms on external commercial borrowings in foreign currency. This will ultimately lead to stronger corporate balance sheets as currency exchange risk and volatility decrease. As the Rupee exchange rate volatility has grown significantly in recent years, RBI considers this raison d’être for domestic debt markets as substantial.
  • Functioning debt markets are safeguards for financial stability in India. The argument is that external commercial funding can be, in case of severe external shocks, very quickly drawn off from the Indian financial system. This actually happened in 2008, when India’s capital account dropped substantially due to liquidity requirements in the lending countries.

Major initiatives for developing Indias debt markets

Major initiatives by RBI and the Indian government concern the following:

  • Promote transparency by developing an imperative bond reporting platform
  • Allow REPO transactions in corporate bonds to make investing in corporate bonds more attractive to institutional investors
  • Alleviate exposure norms for primary dealers, market makers, and central counterparties to enable them to play a larger role in the corporate bond market
  • Introduce credit default swaps and interest rate swaps to facilitate hedging credit risk and market risk associated with holding bonds
  • Reform India’s legal system (bankruptcy framework, enforcement of creditors’ rights, etc.)
  • Introduce suitable credit enhancement mechanisms to allow SMEs to issue high quality bonds
  • Open up investment regulation for pension funds and insurance companies to allow them more extensive investments in corporate bonds
  • Open local debt markets gradually to foreign investors and reduce withholding taxes on coupon payments
  • Stimulate wider participation of retail investors in the market through bond exchanges and mutual funds


  • Address by Harun R. Khan „Corporate Debt Market: Developments, Issues & Challenges“ dated October 12, 2012
  • Presentation by Harun R. Khan “Role of State in Developing Markets” dated September 18, 2012.

Tuesday, December 18, 2012

Accounting for Financial Derivatives under IFRS

IFRS rules differentiate 3 types of derivatives, e.g. hedge derivatives, non-hedge derivatives, and embedded derivatives.

Hedge derivatives

Hedge accounting rules apply under 4 cumulative conditions:

  • Upon inception, the entity assigns and documents the hedging relationship and its risk management objective.
  • It expects the hedge to be highly efficient (= capacity to offset changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designed + actual results of the hedge within the range of 80-125 % + assessment of the effectiveness at least at the time an entity prepares its annual or interim financial statements).
  • The company can measure the hedge's effectiveness reliably.
  • The firm assesses the hedge on an ongoing basis.

In addition, the hedge of an overall net position, rather than of a specific item, does not qualify for hedge accounting.

Once the hedging nature of a financial instrument established, the accountant differentiates 3 hedging relationships:

  • A fair value hedge counters an exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment. The fair value hedge might also target a portion of such asset, liability or commitment if the company runs a particular risk that could affect its profit or loss.
  • A cash flow hedge matches the exposure to variability in cash flows that is linked to a particular risk of a recognized asset, liability, or highly probable forecast transaction.
  • Hedge of a net investment in a foreign operation

Accounting for a fair value hedge

The gain or loss from remeasuring the hedging instrument at fair value is recognized in profit or loss, thereby adjusting the carrying amount of the hedged item.

Accounting for a cash flow hedge

The portion of the gain or loss on the hedging instrument that constitutes an effective hedge shall be recognized on the company's balance sheet as other comprehensive income. The ineffective portion of the gain or loss on the hedging instrument shall be recognized in profit or loss.

Accounting for the hedge of a net investment in a foreign operation

Again, the portion of the gain or loss on the hedging instrument that constitutes an effective hedge shall be recognized in other comprehensive income. The ineffective portion of the gain or loss on the hedging instrument shall be recognized in profit or loss.

Non-hedge Derivatives

Non-hedge derivatives are always recognized at fair value.

Embedded Derivatives

An embedded derivative is a component of a hybrid contract that combines a derivative with a non-derivative host. In this context, “embedded” means that the derivative part is not independently transferable by way of contract.

Accounting for embedded derivatives is subject to the following rules:

The above mentioned derivative accounting rules shall apply to the hybrid contract as a whole if the underlying is an IFRS financial asset (See my December 15, 2012 post).

By contrast, if the host is not an IFRS financial asset, the embedded derivative is separated from the host. It is then recognized as a derivative if

  • the embedded derivative's economic and risk characteristics are not closely related to those of the host; or
  • the company has chosen to account the entire hybrid contract at fair value through profit or loss.


  • IFRS 9 – Financial Instruments
  • IFRS 32 – Financial Instruments: Presentation
  • IAS 39 – Financial Instruments: Recognition and Measurement

Saturday, December 15, 2012

Accounting for Financial Instruments under IFRS – When numbers meet words

My today’s assignment is to explain 152 pages of IFRS language in a few lucid paragraphs. If you have ever tried to read IFRS 9 and 32 and IAS 39, you will recognize that this is not an easy task.

You might think that this post is an oversimplification of the above rules, and I will probably agree with you to some extend. However, I prefer some oversimplification to the obscurity inherent in IFRS’ language.

Recognition of financial instruments

To pinpoint financial instruments, you need a contract. Conversely, in absence of a contract, there is no financial instrument.

At this stage, legal and accounting definitions require each-other. Let’s, therefore, stick to the very basic civil law rules, e.g. the Roman corpus iuris civilis. In the Second Book, Title XIV, No. 1, § 2, you can read “Et est pactio, duorum pluriumve in idem placitum consensus.” (= A contract is the consent of two or more persons on the same subject.).

Classification of financial instruments

IFRS accounting rules differentiate assets, liabilities, and equity. Derivatives represent a specific category of financial instruments and will be subject of a later post.

Every discipline defines the above categories in another way. From an IFRS perspective,

  • A financial asset is cash; a contractual right to receive a financial asset; a contractual right to exchange financial assets, liabilities, or equity; or equity of a third party.
  • A financial liability is a contractual obligation to deliver or exchange a financial asset.
  • Equity is a residual interest in the assets of the entity, after deducting liabilities.

Classifying financial instruments means considering the substance of the contract. In other words, a contract will not become a financial asset just because you label it as such.

In case of a compound financial instrument, asset and liability components are separated first and the residual is recognized as equity.

A reclassification of financial assets is possible if the entity changes its business model for managing financial assets; financial liabilities and equity shall not be reclassified.

Measurement of financial instruments

Financial assets

Financial assets shall be recorded at amortized costs, if the company holds them to collect its cash flows (= payments of principal and interest). Amortized costs refer to the value of the asset’s future cash flows, discounted at the effective interest rate and net of any adjustment for impairment and uncollectibility. Additional gains or losses can only be recognized upon derecognition of the asset.

If the company does not intend to hold the financial asset until maturity (= held for trading), it is measured at fair value. Fair value means transaction costs. If, however, the transaction costs differ from the market price, the asset is accounted at the amount of the transaction costs plus or minus the difference with the market price, the latter being recognized as a profit or loss, either immediately or differed. Subsequently, fair value is the asset's market price at measurement date.
The movements of the market price are normally recognized as a profit or loss. However, the firm can opt for presenting a gain or loss on equity, not held for trading, outside the company’s income statement, as other comprehensive income.

Financial liabilities

In principle, financial liabilities are measured at amortized cost.

Per contra, the following liabilities are measured at fair value:

  • financial liabilities held for trading;
  • residual liabilities after imperfect derecognition of financial liabilities;
  • guarantees;
  • loan commitments at below market interest rates;
  • Financial liabilities subject to fair value accounting upon option of the company (Such option is only available in specific cases such as embedded derivatives and accounting mismatch.)

Amortized cost and fair value definitions are the essentially the same as for financial assets. Similar to the above, the firm can present subsequent gains or losses on liabilities, measured at fair value, outside its regular earnings, as other comprehensive income.


The initial value of equity consists of par value plus additional paid-in capital minus transaction costs.

Changes in the fair value of equity are not recognized in the financial statements.

Derecognition of financial instruments

Financial assets and liabilities can be derecognized upon

  • discharge, cancellation, or expiry of contractual rights to the cash flows; or
  • transfer of the financial instrument, either directly, or indirectly by committing oneself to forward the cash flows received.

A partial derecognition for specifically identified cash flows is possible.

Upon derecognition, the difference between the carrying amount at the date of derecognition and the consideration received (if any) shall be recognized in profit or loss.


  • IFRS 9 – Financial Instruments
  • IFRS 32 – Financial Instruments: Presentation
  • IAS 39 – Financial Instruments: Recognition and Measurement

Monday, December 10, 2012

Project Bonds – Definition, purpose, concerns, and remedies

1. What are project bonds?

Project bonds are private debt issued by a project company to finance a specific off-balance-sheet project. Because the project company’s only purpose is the project, project bonds are an asset-based form of financing. Project bonds can be placed publicly or, most oftentimes, privately.

Today’s project bond market is concentrated in the US and Canada; issues in Europe and emerging markets are still seldom.

2. Who needs project bonds?

Project bonds are necessary from both the borrower’s and the investor’s point of view:

First, bank lending capacity has and will become ever more limited, due to increasing capital requirements and liquidity constraints for commercial banks as well as tight public budgets. This is especially true for long-term financing, which is, nevertheless, fundamental for an economy’s competitiveness, productivity, and long-term growth.

Second, from an institutional investor's (pension fund, insurance company, etc.) perspective, there is a strong demand for long-term investment opportunities. However, bond markets for very long maturities are oftentimes underdeveloped.

Project Desertec

3. Project bond concerns

Riskiness of project bonds

Project finance is characterized by the following factors:

  • off-balance-sheet financing (e.g. usually non-recourse vis-à-vis the sponsor);
  • longer maturity, compared to corporate loans;
  • higher leverage, compared to traditional corporate finance.

All of the above make the investment more risky for an institutional investor because they typically invest exclusively in high-quality assets.

Debt origination

A general remark is that bank loans are faster and cheaper to deliver than bonds. Indeed, bonds require a rating and the respect of a specific issuing procedure (namely marketing documentation), which increases time and transaction costs. The result is that project bond financing is often inefficient for small transactions.

Another challenge related to bond debt origination is the fact that deliverability and pricing of project bonds are unknown until actual issuance of the bond, As a matter of fact, this might counter the typical public bidding process (“Certain Funds Period”). In addition, public authorities can lack necessary project bond know-how which will enhance this issue even further.

Finally, bonds are settled upon issuance. This can contradict the financing needs of the project company that will usually need funding spread over the whole construction phase and, as a consequence, will cause cost of carry of early provided funds.

Loan vs. bond administration

Compared to traditional bank financing, bonds carry a certain number of disadvantages:

  • The confidentiality of bank loans is higher: For one, possible restructuring negotiations are lead out only among a limited number of banks. In addition, bond markets need, even in the normal course of business, higher disclosure requirements to bridge the information asymmetry between investors and issuer and to compensate for the close monitoring that is common place in case of bank financing and lacks in case of bond financing.
  • Bond financing terms are usually less flexible than bank loan terms and conditions. Moreover, the administration (prepayments, waiver proceedings, etc.) of bonds is normally less flexible than the administration of bank loans. For example, in case of bank financing, an agent will coordinate voting processes within the banking pool. This function is usually missing in case of bond issues.

Liquidity of project bond markets

Oftentimes, project bond markets lack infrastructure and liquidity. This can lead not only to bond pricing dilemmas but also to a more difficult refinancing of bonds.

Dhukwan Project

4. Solution proposals

Riskiness of project bonds

The riskiness of project bonds can be moderated by two basic means, e.g. by modifying the structure of the debt itself or by providing credit enhancement.

The first method refers to debt tranching, thus cutting the overall debt burden of the project company into different pieces and conceiving a priority order of repayment. This solution, however, will necessarily make the financing structure more complex and, as a consequence, potentially shy away investors.

The idea of providing credit enhancement tries to alleviate the off-balance-sheet character of project bond financing. De facto, credit enhancement gives investors indirectly access to the balance sheet of third parties such as project sponsors, commercial banks, state-owned or supranational development banks, and debt service reserve funds. In legal terms, third-party support can be arranged particularly as a letter of credit, guarantee, stand-alone facility, or sub-participation. The EU/EIB 2020 project bond initiative might serve as an example here. The downside of this second solution is that is operates in the shadow banking area: Because credit enhancement usually constitutes, from a bank's perspective, an off-balance-sheet item, it runs against current attempts to reform the stability of financial system.

Debt origination

The administrative origination process can only be shortened through standardization. As far as possible, such standardization should apply to any stakeholder in the origination process. Examples include rating methodologies for project bonds and a legal framework for SPV issuers.

To promote project bonds, it will be necessary to amend public tender regulation. By way of explanation, it is essential that the bidding process specifically closes out the uncertainty linked to size and pricing of bond issues. What's more, firm underwriting by investment banks can also ensure a certain funds period for the project.

Excess funding at the outset of the project can potentially be avoided by deploying MTN programs. Obviously, the high costs for preparing a MTN program imply that this solution can only apply to large-size projects.

Loan vs. bond administration

If not already provided for in mandatory bond regulation, a legal structure for efficient bond administration should be put in place by way of contract. Standard forms for loan agreements should serve as a template here.

Creating conclusive incentives for investors may also help to enhance the administration of bonds. As a matter of fact, if investors can benefit from straightforward bond execution, they will also enhance their efforts to ensure efficient administration. Incentives could include

  • Link credit enhancement and the assigned rating to bond administration processes (Example: Reduction of credit enhancement in case a waiver is not treated during a specific time period.)
  • Link coupon rates to the efficiency of the bond administration
  • Extend simple majority decisions as much as possible

Liquidity of project bond markets

Liquidity of project bond markets can be built up by taking the following initiatives:

  • Create a capital market infrastructure for project bonds, allowing a more efficient placement, listing, trading, and settlement
  • Encourage private investment in project bonds by providing a supportive investor regulation
  • Attract foreign investors to domestic project bonds by setting tax incentives such as lower interest rates on interest income and by canceling withholding tax requirements on interest payments
  • Favor market making activities for project bond markets


  • Scannella – Project Finance in the Energy Industry: New Debt-based Financing Models, International Business Research 2012, pages 83 et seq.
  • S&P Rating Direct – How Europe’s New Credit Enhancements for Project Finance Bonds could affect Ratings, November 13, 2012
  • Sawant – Emerging Market Infrastructure Project Bonds: Their Risks and Returns, Journal of Structured Finance 2010, pages 75 et seq.
  • European PPP Expertise Centre – Financing PPPs with Project Bonds, October 2012
  • Lam, Chiang, Chan – Critical Success Factors for Bond Financing of Construction Projects in Asia, Journal of Management in Engineering 2011, pages 190 et seq.
  • European Commission – A Pilot for the Europe 2020 Project Bond Initiative, October 19, 2011
  • European Commission – Regulation Proposal Europe 2020 Project Bond Initiative, October 19, 2011