The development of the variable bond market would help developers tap an alternate source of funding and help reduce lending pressure on banks, explains VIJAY AGRAWAL.Under the Hybrid Annuity Model (HAM) concession agreement, NHAI has agreed to pay interest on developers’ capital at the bank rate plus 3 per cent. Developers’ capital includes equity and debt amount infused in a project by the developer. Under the HAM concession agreement, typically, 40 per cent of the project cost is financed by NHAI and 60 per cent by the developer. This was evolved in view of the financial crunch faced by developers and the reluctance of banks to fund the entire project cost. Banks have borne the brunt of non-performing assets (NPAs) owing to default by concessionaires on non-completion of projects because of right of way (RoW) and other contractual issues. Hence, banks have represented NHAI to partly fund project costs to reduce their risk. Forward-looking concept In the earlier PPP model of annuity/toll roads, the developer used to fund the entire project cost. In case of the annuity model, NHAI used to pay a fixed half-yearly installment over the period of concession. Such projects ran into trouble in view of change in bank rates. Hence, NHAI came up with the new concept of variable interest rate linked to bank rate. This concept of variable interest rate was a forward-looking one where NHAI payment was linked to the bank rate. It was based on the presumption that interest rates are decided by banks in a transparent and fair manner. In case the bank rate is reduced by RBI, banks would reduce the interest rate; in case the bank rate is increased by RBI, banks would increase the interest rate. However, owing to increased NPA and higher fixed deposit interest payout, the lending cost of banks has increased substantially. Hence, they have not reduced their interest rate on lending to borrowers in the same quantum of bank rate reduction by RBI. See table on the next page for the movement of RBI repo rates and SBI MCLR and HDFC MCLR rates.It is evident from the aforesaid table that in the past two years, RBI has reduced the bank rate by 2.25 per cent. However, SBI has reduced its interest rate by only 1.25 per cent and HDFC has reduced its interest rate by 0.75 per cent. Variable interest rate loan and bondsA new lending product can be introduced by banks for HAM projects that could charge interest rate based on the RBI repo rate. This clause can be included in the loan agreement. Thus, for HAM projects, the lending rate would be linked to the RBI repo rate instead of MCLR. This can be done for projects that achieved rating above a minimum criterion. NHAI enjoys AAA rating, which is the highest. Owing to NHAI as a counter party, HAM projects would also enjoy AAA or AA rating based on their capital structure and equity infused by the developer. This would incentivise developers to infuse fair equity to achieve AAA rating for their projects and insulate them from adverse interest rate movements. Similarly, the bond market could also be developed where variable interest rate bonds are floated for HAM projects with higher ratings like AAA or AA. This would help developers to tap an alternate source of funding in addition to bank financing. The development of the variable bond market would also help reduce lending pressure on banks. RBI issues floating rate notes (FRN) on a regular basis. For example, it has issued a notification for issue of FRN for Rs.30 billion on May 22, 2017. The interest rate payout was proposed as follows: The variable coupon rate for payment of interest on subsequent semi-annual period shall be the average rate rounded off up to two decimal places, of the implicit yields at the cut-off prices of the last three auctions of Government of India 182 day Treasury Bills, held up to the commencement of the respective semi-annual coupon period. The implicit yields will be computed by reckoning 365 days in a year.Thus, floating rate bonds or loans are not a new phenomenon in the market. They have been used by RBI regularly to raise funds from the market. The same principle could be applied for bonds issued or loan given to HAM projects. This will mitigate interest rate risk for HAM project developers and save such projects from becoming NPAs or facing bankruptcy proceedings.  About the author: Vijay Agarwal, Executive Director, Equirus Capital, heads the firm’s real-estate practice. He advises clients on fundraising by way of private equity, structured finance and debt and capital markets like IPO, QIP and PIPE. He is active in the M&A space and is working with clients in real estate, infrastructure, e-commerce, pharma, retail, Source: Equirus Capital manufacturing and other sector.