Real Returns. Myth of sovereign guarantee

Indian investors have an affinity for any and every kind of debt instrument that is believed to carry a sovereign backing. As long as an institution or bond is thought to be backed by the Government, it soars on the popularity charts. It is perceived ‘government backing’ that ensures that over 70 per cent of the bank deposits in India are still held by the public sector banks, despite their bad loan problems.

More than 20 years after insurance was privatised, the LIC commands a 70 per cent share of the market, thanks to its sovereign guarantee.

This penchant of Indian savers to ignore returns, liquidity and other aspects, extends to surrogate sovereign instruments, too. Public deposits from broke state government entities are invested in because they are ‘backed’ by the Government. Bonds from public sector entities are bought with barely a glance at their credit rating.

But with so many entities laying claim to the government’s coffers to stand guarantee for their liabilities, it is time to question if the sovereign backing can really stretch this far.

Cautionary tale The ongoing legal battle between bondholders and the Sardar Sarovar Narmada Nigam (SSNNL) offers a cautionary tale on sovereign guarantees.

The story goes like this. In 1994, when interest rates in the economy were sky-high, SSNNL issued deep discount bonds with a face value of ₹3,600, guaranteed by the Gujarat government. While they carried no interest, they were redeemable at fixed values of ₹12,500, ₹25,000 and ₹50,000 at the end of their 7{+t}{+h}, 11{+t}{+h} and 15{+t}{+h} years, respectively. For investors who held them until maturity (January 2014), the redemption value was promised at ₹1,11,000.

These bonds were quite popular, as the effective annual returns at the promised price translated to a compounded annual growth rate (CAGR) of 18.7 to 19 per cent. Everything went well until interest rates in the economy began to collapse dramatically. SSNNL initiated proceedings in 2004 to try and prematurely redeem its bonds, as it felt it would be unable to meet its obligations. Bondholders resisted this as the original prospectus for the bonds did not carry any call option. The State government (of the day) responded by enacting an Act conferring on itself special powers to redeem the bonds at ₹50,000 in January 2009.

This attracted the ire of investors who took the matter to SEBI and also dragged SSNNL and the Gujarat government to the Bombay and Gujarat High Courts. Recently in January 2016, the Gujarat High Court held the Gujarat government’s special Act unconstitutional. But this hasn’t clarified if investors who have surrendered their bonds early, can now enforce their original claim. Investors have now resolved to take the matter to the Supreme Court.

Some lessons In short, after betting on a State government-backed instrument and staying put with it for 20 years, investors in the SSNNL bonds even today have no idea of their eventual returns.

They may have no choice but to wait for the apex court ruling.

But others who place such blind faith in sovereign-backed instruments can take away some learnings from this case.

One, if the returns on a bond or deposit are out-of-sync with the rest of the economy, you can be sure the entity offering it will run into trouble. With interest rates in the Indian economy almost completely deregulated in the past decade, it is impossible for any entity — private, public or even Central government — to offer an island of exceptional returns. If anyone does, no matter how sovereign-backed they are, there is a credit risk.

Two, if pushed into a corner, governments too can renege on their commitments, especially as every bailout exposes the Government to public scrutiny and criticism.

Three, when it actually comes to a crunch, the letter of the law matters more than public perception. Depositors in public sector banks should note that, officially, public sector deposits don’t enjoy any superior insurance protection from DICGC, when compared to their private peers.

Going bust While most investors imagine that a sovereign bailout of a troubled instrument will happen seamlessly, the resolution process can be long and messy. Remember Unit Trust of India’s US 64 scheme which went bust in 2001-02?

When it fell short of cash to fulfil its obligations, there were long parleys before a government bailout. The bailout too was only partial with investors getting back only par value.

Finally, in this era of deregulated markets and fiscal discipline, don’t be surprised if the government backing to many entities is consciously withdrawn. There’s an ongoing debate about whether the LIC should continue to enjoy a sovereign guarantee in a liberalised era. There’s also a move to dilute government ownership in PSBs below 51 per cent, to privatise them.

In light of all this, investors cannot afford to completely skip their due diligence or brush aside prudent investment tenets, just because an instrument has the sovereign chaap. Even when you’re investing in a sovereign instrument, don’t get carried away by tall promises and don’t forget to diversify.