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Wait, The Government Can Default Too?


More rating craziness, with CARE downgrading what seems to be an ultra-safe instrument.They have cut the rating for a 100 cr. bond issued by Hindustan Organic Chemicals Limited, a PSU. The interesting thing: the bonds were guaranteed by the government.

HOCL had issued Rs. 100 cr. worth bonds in 2013, which are unsecured but are explicitly backed by the government (both principal and interest). These bonds carried a coupon of 10.57% per annum, payable annually, on 28th of August every year till maturity, which is on 28th August, 2017.

The government guaranteed carried a caveat, though: That the borrowing cost of the funds should be benchmarked to a Government Security of the similar maturity with a small spread of 0.5% to 0.7%.


That was August 2013, when the rupee was in turmoil and short term rates had spiked to 12%. So the coupon of 10.57% made sense. Today, when the two year (which is the remaining term to maturity) is probably trading around the 7.8% range, it feels expensive. The above guarantee is clearly not guaranteeing the bond itself; it provides a guarantee that the government will pay Rs. 100 crore and an interest rate that is upto 0.7% above the relevant G-Sec on each year (that’s what benchmarking should mean).

Apparently, this wasn’t read like that – it was believed that the government would guarantee the whole amount of interest regardless of how much the interest rate was.

So How Did It Happen?

The government apparently only paid Rs. 8 crore (Ignore the rest of the article, it gets all the other details wrong). Which would make sense according to my reading of the guarantee, but not according to CARE, the rating agency.

On August 28, there wasn’t enough money to pay the interest. So CARE put the bond on credit watch.

On September 10, the government has funded the account, but we don’t really know if interest has been paid. But CARE moved the bond to “Default” anyhow. This probably means that the government hasn’t really funded it fully? It could also mean that a delay in interest payment means a default, even if it was just 10 days. I don’t know which it is.

This Spirals Into A Complex Situation

Think about it. A bond that isn’t due for maturity for another two years, and for whom the government has paid at least 8 cr. out of the Rs. 10.57 cr. due as interest, is now a “defaulted bond”. It’s even likely that that government has made up the shortfall by now.

But the drop in rating to D means the bond is no longer investment grade.  Certain types of funds, like pension funds, mutual funds and insurance companies will have to mark it down or sell it because their mandates don’t allow them to hold non investment grade bonds.

And the drop in rating seems to be on a bond whose interest payment is nearly all funded. Can a buyer say I’ll accept the lower rate, just pay me whatever the government has funded? It’s not easy, because you have to get all the bondholders to agree and that can take, uhm, a while.

HOCL isn’t doing well at all, so there’s no real hope it can pay back the money if the government doesn’t. And the bonds are unsecured, so the bondholders can’t even demand that assets be sold to pay them off. (The assets are probably pledged to others)

One tiny little detail, and you have the unthinkable: A bond that was (sort of) guaranteed by the government, defaults. And the devil is in the (sort of).


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