Non-banking finance companies (NBFCs) are seeing higher credit growth than banks and a larger share of the lending pie. At 13% annual growth in 2017, credit from NBFCs grew around 4 times faster than banks. While their share of credit improved to 21% in 2017, compared to 17% in 2014, according to a latest report by Fitch Ratings.

“NBFCs are likely to continue to play an increasingly important role in India’s economy over the next few years, helping to compensate for weak bank lending, which is likely to be held back by state banks’ under-capitalisation, despite the government’s planned injections,” say Saswata Guha, director, and Jobin Jacob, associate director for Fitch’s financial institutions rating practice in India.

Both believe that NBFCs will continue to provide an alternative source of credit to the large proportion of Indian borrowers that are underserved by banks. But to support growth, NBFCs need funding. “We expect banks’ share of funding to fall, given banks’ capital constraints,” Guha and Jacob say.

Lately, NBFCs have shifted towards bond markets, as yields have fallen while bank lending rates have remained stubbornly high. Masala bonds - rupee-denominated bonds issued in offshore capital markets - potentially offer issuers a larger investment pool, while avoiding the currency mismatches associated with international bond issuances denominated in foreign currency.

And, masala bonds are getting attractive. Reserve Bank of India data on 62 masala-bond issuances, between September 2016 to January 2018, shows that bonds worth $6.14 billion (Rs 40,621 crore) were issued.

Guha and Jacob believe that NBFCs are likely to become more active issuers of masala bonds over the medium term reflecting their rising need for diversified funding to support growth. An analysis of the 62 masala-bond issuances reveals that bonds raised with the intent of on-lending or sub-lending account for $ 3.21 billion – 52.3% of the bonds issued in the 17 months.

Improving recognition of the masala bond market among international investors could help to improve relative pricing, but only larger on-bank financial institutions (NBFIs) with strong reputations are likely to find masala issuance viable. Although the pricing of masala bonds remains an obstacle as issuers have seen their bonds priced 20-50 basis points (100 basis point make a percent) more the domestic issuances. International investors’ risk aversion towards Indian issuers and concerns over currency risks could mean this remains the case, says the Fitch note.

While lenders account for over half of the masala bond issuances, leading financiers - Housing Development Finance Corporation (HDFC) and Shriram Transport Finance Company (STFC) together account for 38.4% of the total masala bonds offered in the 17 months. HDFC, with four issuances worth $ 1.26 billion accounts for 20.5% of the total. While STFC, with two issuances worth $ 1.10 billion accounts for 17.9% of the total.

Fitch’s Guha and Jacob believe that the pricing mismatch between masala and domestic bonds may fade as the masala market deepens and international investor recognition improves.

Yields on Shriram Transport Finance Company’s masala bonds issued in March 2018 were lower than those on its comparable domestic bonds, as per issuer feedback, the Fitch note highlights. Rising domestic interest rates may also serve to narrow the pricing gap if yields on domestic bonds respond more sensitively than masala yields, according to the Fitch note.

“The 10-year government bond yield has increased by more than 100 basis points in the last 12 months, and we expect the Reserve Bank of India to hike its policy rate by 75bp over the next two years,” Guha and Jacob say.

But, masala bonds’ improving market recognition will not make it less difficult for smaller unrated issuers. The Fitch note points out that some issuers have previously issued masala bonds on an unrated basis, but these have all been marquee names, and at tenors of less than three years. “Issuers are increasingly looking at longer tenor borrowing, for which reasonable standalone creditworthiness is likely to be a prerequisite,” say Guha and Jacob.

Like they have done so far, NBFCS could continue to dominate the masala bonds raisers’ list, with bigger players claiming the larger pieces of the pie.