Emerging Financial Products: Harnessing Opportunity (Muncipal Bonds, REITs, InVITs etc.)
Emerging Financial Products: Harnessing Opportunity
(Muncipal Bonds,
REITs, InVITs etc.)
SHORT SUMMARY - Indian Financial Market Products:
Capital
market in any country plays a pivotal role in the growth of economy and meeting
the country’s socioeconomic goals. They are an important constituent of the
financial system given their role in the financial intermediation process and
capital formation of the country. The importance of financial products cannot
be under-emphasised for a developing economy like India which needs significant
sources of financing for development of strong infrastructure, to reduce the
gap of socio- economic standards between people of India and world and to meet
the fund requirements for smart cities developments in India.
Indian
households have traditionally preferred safety of bank deposits and government
saving schemes and much less than 10% of the their investments in financial
assets is in shares, debentures and mutual funds, which is very low as compared
to some of the developed economies. The need to mobilise savings into
productive channels and the opportunity for financial intermediation, emerging
financial products like; Municipal Bonds, REITs and InVITs etc. will be an
opportunity of a lifetime for Indian investors and a challenge to financial
market regulators. The Government, the Regulators and the financial
institutions have an important role to play in building a strong, robust
financial products that will be easy to invest and shall have no major red-
tapes of various clearances. It shall be in harmony with government vision of
less government maximum governance.
The
growth trajectory of a country’s financial products is significantly influenced
by the actions of these stakeholders. Concerted efforts of the Government and
the Regulators supported by a long- term vision and clarity in action can
significantly help in fostering a climate that is conducive to growth and
investments. Before diving deep into finance, it may be useful to pause and
better understand emerging financial products.
Few
emerging financial Products which can be major sources of funding for various
projects in future and in today’s scenario are as follows:
(a)
Municipal
Bonds,
(b)
REITs (
Real Estate Investment Trusts),
(c)
INVIT
(Infrastructure Investment Trust).
A. WHAT
IS MUNICIPAL BOND?
Example: A City
Corporation wants to construct a new Cricket Stadium. It can issue municipal
bonds to fund the project. Institutional investors as well as the public can
buy these bonds. Revenues from cricket stadium will then be used to repay the
interest and principal on these bonds.
TYPES
OF MUNICIPAL BONDS IN INDIA
(1) REVENUE
BONDS
Revenue bonds are bonds
supported by the revenue from a specific project, such as a water supply
project or a sewer systems project. Such bonds finance income-generating
projects and are secured by a specified revenue source. For example, if a
revenue bond is issued to upgrade a water supply network, the water charges
collected from users would be used to pay off the bond.
(2) GENERAL
OBLIGATION BONDS
General obligation bonds are issued
in the belief that a municipality will be able to repay its debt obligation
through taxation or revenue from projects. Unlike revenue bonds, general
obligation bonds can be paid through a variety of tax sources. These therefore
may not be for specific revenue-generating projects.
HISTORY OF MUNICIPAL
BONDS IN INDIA
Municipal
bonds have been in existence in India since 1997. Municipal corporations of
cities such as Ahmedabad, Bengaluru, Nashik and Madurai have issued them;
mostly privately placed with institutions and not tradable. As a result, the
municipal bond issues only touched Rs.1,353 crores and there have been no new
issues since 2010 till 2016 .
SEBI GUIDELINES FOR
ISSUE OF MUNICIPAL BONDS
In
March 2015, SEBI issued guidelines for the issue and listing of municipal bonds
and clarified their regulatory status. The new rules that will allow these
instruments to be offered to the public, listed and traded on stock exchanges
will hopefully rekindle the appetite for them. After notification of these
guidelines; Pune Municipal Corporation (PMC) first Municipal Corporation in the
country in recent years to raise funds through municipal bonds by raising Rs
200 crore in the first set of a proposed Rs. 2,264 crore offer, it is a ten-
year bond offer carrying a coupon of 7.59 per cent rate at the Bombay Stock
Exchange (BSE).
RISK INVOLVED IN
INVESTMENT IN MUNICIPAL BOND
As with any
investment, investing in municipal bonds entails risk. Investors in municipal
bonds face a number of risks, specifically including:
Ø Call risk. Call risk refers to the
potential for an issuer to repay a bond before its maturity date, something
that an issuer may do if interest rates decline -- much as a homeowner might
refinance a mortgage loan to benefit from lower interest rates. Bond calls are
less likely when interest rates are stable or moving higher. Many municipal
bonds are “callable,” so investors who want to hold a municipal bond to
maturity should research the bonds call provisions before making a purchase.
Ø Credit risk. This is the risk that the
bond issuer may experience financial problems that make it difficult or
impossible to pay interest and principal in full (the failure to pay interest
or principal is referred to as “default”). Credit ratings are available for
many bonds. Credit ratings seek to estimate the relative credit risk of a bond
as compared with other bonds, although a high rating does not reflect a
prediction that the bond has no chance of defaulting.
Ø Interest rate risk. Bonds have a fixed face
value, known as the “par” value. If bonds are held to maturity, the investor
will receive the face value amount back, plus interest that may be set at a
fixed or floating rate. The bond’s market price will move up as interest rates
move down and it will decline as interest rates rise, so that the market value
of the bond may be more or less than the par value. If they move higher,
investors who hold a low fixed-rate municipal bond and try to sell it before it
matures could lose money because of the lower market value of the bond.
Ø Inflation risk. Inflation is a general upward movement in
prices. Inflation reduces purchasing power, which is a risk for investors
receiving a fixed rate of interest. It also can lead to higher interest rates
and, in turn, lower market value for existing bonds.
Ø Liquidity risk. This refers to the risk that investors won’t
find an active market for the municipal bond, potentially preventing them from
buying or selling when they want and obtaining a certain price for the bond.
Many investors buy municipal bonds to hold them rather than to trade them, so
the market for a particular bond may not be especially liquid and quoted prices
for the same bond may differ.
EXPERT COMMENTS FROM
ADVISORS AND INSTITUTION
Ø According
to an advisor associated with ministry reported that to convince investors
in giving money to these municipalities would
be difficult. Therefore, many of the smaller municipalities are
going for total Greenfield projects inviting private parties. In normal course,
it would be a public private partnership.
Ø According
to the National Institute of Securities Market (NISM), SEBI’S Investor
Education Arm, raising capital from a domestic municipal bond market can start
as a supplement to funding from central and state governments, borrowings from
financial institutions such as LIC, HUDCO and commercial banks.
The revenue generated from various sources would be cost-effective and
reasonably equitable form of infrastructure financing.
Ø “As
the market develops, there is enormous potential to scale up the level of
investment much more rapidly than that can be achieved by the traditional
sources of financing alone,” NISM said in a paper.
Ø
Going forward, India
needs a well-developed Municipal bond market for numerous reasons. Municipal
bonds help the urban bodies to bridge funding gap. With implementation of GST,
the revenues of various states are likely to take a hit. For example, BMC
secures nearly 33% of its revenues through the octroi tax. In such an event,
Municipal bonds will prove to be an alternative source of funding. As per the
estimates of the Rating agency CARE, large municipalities could raise Rs. 1,000
to Rs. 1,500 crores every year through such bonds. Besides offering tax saving
advantage, they also come up as safe positions to invest in for low risk
appetite members of the public looking for products beyond the conventional
fixed deposits. The demand side is constrained by the conservative sentiment of
institutional investors. However, the supply side faces the heat due to a few
municipal bodies with good creditworthiness and reliance on old and established
methods of project financing by government entities. The urban bodies issuing
municipal bonds can be incentivized through additional grants based on their
creditworthiness to enable more and more issuance of such bonds.
Ø
Safeguarding the
municipal bonds market, plugging the existing loopholes and increasing their
penetration will go a long way in improving the efficiency of this market and
thus help the government fulfill massive investment requirements for improving
urban infrastructure.
B. WHAT IS REITs ?
REITs
(Real Estate Investment Trusts) are similar to mutual funds. While mutual funds
provide for an opportunity to invest in equity stocks, REITs allow one to
invest in income- generating real estate assets.
HOW REITs DOES
WORKS?
REITs
is a process to generate funds from a lot of investors to directly invest in
profitable real estate properties like offices, residential units, hotels,
shopping centers, warehouses and more. All trusts with REIT will be listed with
stock exchanges as they would be structured like trusts. Consequently, REIT
assets will be held with independent trustees for unit holders.
WHAT IS THE OBJECTIVE OF REITs?
A REIT’s objective is to provide the
investors with dividends that are generated from the capital gains accruing
from the sale of the commercial assets. The trust distributes 90% of the income
among its investors via dividends. Apart from minimum entry level, a REIT is
supposed to provide diversified and safe investment opportunities with reduced
risks, and under a professional management to ensure the maximum return on
investments.
ROLE OF TRUSTEES?
Trustees with REIT have defined duties
which typically involve ensuring compliance and adherence to all applicable
laws that protect the rights of the investors.
NOW IN INDIA
REITs,
as a concept, have been on the horizon for a while now. India’s regulations in
2014 for the sector have not been able to attract investor interest. REITs
obtained exemption from dividend distribution tax in the Budget, a step towards
making them attractive for the investors. A report by real estate consultancy
firm Cushman and Wakefield estimates that Indian commercial real estate (like
office, retail assets) offers investment opportunities for REITs worth $43
billion – $54 billion (Rs, 2.88 lakh crore – Rs. 3.60 lakh crore) across top
cities.
India’s
REIT market is just about opening up with a number of developer-investors
partners acquiring and consolidating rental assets and firming up plans.
DLF,
which is in the last leg of selling a 40% stake in its rental portfolio to
Singapore sovereign fund GIC Pte, has said it will list its office and retail
properties in the form of REIT.
Global
private equity firm Blackstone Group LP, the largest owner of office real
estate in the country, may list two separate REITs for its office assets with
developer partners. One of them is with Bengaluru-based Embassy Property
Developments Pvt. Ltd, which is valued at around Rs22,000 crore with more than
22 million sq. ft of space.
“While
this will increase the number of institutional investors like banks coming in,
we would also like to engage with retail investors and assure them good returns
on the basis of rent income and appreciation,” said Embassy chairman Jitu
Virwani. Embassy filed an application seeking approval for its REIT offering
from Sebi in October and is expecting a go-ahead soon.
Other
companies acquiring and consolidating their office assets and moving towards a
REIT structure are RMZ Corp. and K. Raheja Corp.
The
Competition Commission of India (CCI) in March approved Blackstone’s plan to
acquire a stake in K. Raheja Corp’s commercial office portfolio.
SEBI INITIATIVE TOWARDS
REITs
SEBI
introduced its draft REIT regulations in 2007. Over the years, the regulator
has done a commendable job of structuring these regulations by closely
partnering with important stakeholders, government bodies, investors and real
estate developers in the country, and bringing them in sync with globally
recognised norms. After considerable modifications, REIT regulations were
finally enacted in India on 26 September 2014.
SEBI
has devised detailed guidelines governing the markets for investments, covering
the following:
·
Eligibility of the sponsor (the person
who sets up the REIT or InvIT), the manager of the trust and the trustee
·
Investment conditions such as the ratio
of the value of income-generating assets as well as other assets.
·
Policies and requirements with respect
to distribution of dividends, minimum capital required for an initial public
offer (IPO), listing requirements, key responsibilities of the parties to the
trust, etc.
POTENTIAL INVESTMENT
RISK
·
REITs units are listed on, and are
subject to the vagaries of the stock exchanges, resulting in negative or lower
returns than expected. The MSCI US REIT index crashed from over 1300 points in
2007 to under 350 points in 2009. As in mutual funds, retail investors in REITs
have no control over investments and exits being made by the trust.
·
Investing in real estate may be a big
winner for an Indian in India (in nominal
terms), but with the repeated de-valuations of the rupee, for an NRI, the returns
[at best] work out to a compounded yield of 7% per annum , more than which
could be earned even through index investing in countries like the USA. If India
needs to attract more FDI in the right sectors, then it needs to manage its
finances in a way that it does not have to repeatedly de-value the rupee.
terms), but with the repeated de-valuations of the rupee, for an NRI, the returns
[at best] work out to a compounded yield of 7% per annum , more than which
could be earned even through index investing in countries like the USA. If India
needs to attract more FDI in the right sectors, then it needs to manage its
finances in a way that it does not have to repeatedly de-value the rupee.
COMMENTS BY EXPERTS
PWC
in its report stated that In the near future, we expect REITs to increase the
depth of the Indian property market through a sound regulatory framework which
ensures transparency and high governance standards, and promotes regular monitoring
of their performance.
According
to Forbes Asia Real Estate advisor Mr. Alex Frew McMillan, it looks set to
be a bumper year for India in 2017 when it comes to real estate and the economy
as a whole. That makes a marked turnaround for a persistent underperformer in
Asia – India. The nation has shot to the top of the list of preferred
destinations for real-estate investment in the eyes of major institutional
investors.
C.
WHAT
IS InVITs?
InvITs
are similar to mutual funds. While mutual funds provide an opportunity to
invest in equity stocks, an InvIT allows one to invest in infrastructure
projects such as road and power.
HOW DO INVITs WORK?
InvITs raise funds from a large number of investors
and directly invest in infrastructure projects or through a special purpose
vehicle.
TYPES
OF INVITs
Two types of InvITs have been allowed:
(1)
Which invests
in completed and revenue generation infrastructure projects; the other, which
has the flexibility to invest in completed or under-construction projects.
InvITs which invest in completed projects take the route of public offer of its
units.
(2)
Those investing in under construction projects
take the route of private placement of units.
NOTE: Both
forms are required to be listed on stock exchanges.
WHAT
IS THE STRUCTURE OF INVITs?
InvITs are registered as trusts with SEBI and there
are four parties — Trustee, Sponsors, Investment Manager and Project Manager. In
the case of IRB InvIT, IRB Infrastructure Developers Ltd. is the sponsor, IDBI
Trusteeship Services Ltd. is the trustee, IRB Infrastructure Pvt. Ltd. is the
investment manager and the project manager is Modern Road Makers Pvt. Ltd.
FOR
WHICH CLASS OF INVESTORS ARE INVITs SUITABLE?
As per present regulations, InvIT investments are
not open for small and retail investors. The minimum application size for InvIT
units is Rs.10 lakh. The main investors could be foreign institutional
investors, insurance and pension funds and domestic institutional investors
(like mutual funds, banks) and also super-rich individuals.
According to SEBI rules, at least 90% of funds
collected, after paying for expenses, taxes and repayment of external debt,
should be passed on to investors every six months. IRB InvIT is expected to pay
about 12% as returns to investors. Dividend income received by unit holders is
tax exempt. Short-term capital gain on sale of units is taxed at 15%, while
long-term capital gains are tax exempt. Interest distributed to unit holders is
taxed.
WHAT
ARE THE POTENTIAL INVESTMENT RISKS?
·
InvITs are
listed on and are subjected to the vagaries of the stock exchanges, resulting
in negative or lower returns than expected. An economic downturn or project
delays may hit infrastructure projects and result in lower returns. As in
mutual funds, investors in InvITs have no control over investments and exits
being made by the trust.
·
With more
domestic fund houses coming in, the demand for InvITs would drive yields lower
in the secondary market.
·
Risk free
interest rates have been declining for quite some time. This is why investors
keep on searching for new investment avenues to get better returns. "But
InvITs are not risk-free in any way.
ANALYSIS
OF INDUSTRY EXPERT
·
Many experts
feel conservative investors should play the waiting-game for InvITs.
"Despite the general dip in the interest rates in the market, the
incremental yield on InvITs is not commensurate with the incremental risk
involved in InvITs. Given this, the retail investors, on the look-out for
risk-free returns, may still not be completely inclined to invest in InvITs, of
PWC India.
·
InvITs are innovative new vehicles that can play a crucial role in
meeting India’s huge infrastructure requirements, estimated to be Rs 4.3 lakh
crore (Rs 43 trillion) over the next five years said CRISIL on 2/12/2016.
·
Ajay Saraf, Executive Director,
ICICI Securities, ICICI
Securities was lead managing an InvIT public offer in Feb 2017. Said, Infrastructure
is an emerging asset class in India that is garnering much attention among
investors worldwide and some describe it as the perfect asset for pension plans
seeking to match long-term liabilities, diversify portfolio holdings, lower the
risk of capital loss and, in some cases, hedge inflation as well.
·
Kranti Mohan, Partner, Cyril
Amarchand Mangaldas, said while you’re getting to
invest in a stable cash-generating asset, you’re also getting rights similar to
shareholders in a company. Other debt products won’t give an investor any say
in the way a company should run.
CONCLUSION
Just giving tax-free
status to municipal bonds may not be enough. Some policy innovations may be
needed till a proper market for bond insurance is in place. Municipal bonds
should thus be seen as only one part of a larger package to strengthen city
finances. Cities need to generate more revenue as well as get more untied funds
from the money collected through the new goods and services tax. And to pull
this all together will require city administrations that are empowered.In the near future, we expect the REIT vehicle to
increase the depth of the Indian property market through enhanced transparency
and governance standards along with monitoring of the REIT’s performance on a
regular basis by the financial media. The introduction of InvIT is a positive
move and we believe that this model of investment under InvIT mechanism will
have positive impact on the Infrastructure projects in India. However, it will
inter-alia depend on credibility of sponsor/investment manager and substance
and commercial income of underlying assets of InvIT to incite the investors to
invest in this new exciting product.
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