(Updates to add background, quotes)
By Suvashree Dey Choudhury
MUMBAI, Feb 5 (Reuters) - The Reserve Bank of India has clamped down on bank purchases of low-coupon bonds by requiring them to invest in such debt only if the issuer has a back-up fund, widely known as a "sinking fund", to ensure payment in case of a default.
The central bank notified banks about the directive last week, two officials with direct knowledge of the matter said. A spokeswoman for the RBI confirmed the central bank had communicated the notice to lenders.
Dealers said the move could slow issuance of such bonds, which have been used to raise funds by Tata Steel Ltd and Indian Hotels Co Ltd , which is also part of the Tata conglomerate, and Hindustan Mittal Energy Ltd, among others.
Low-coupon bonds offer small interest payments but pay a premium at maturity.
Tata Steel and Indian Hotels issued bonds paying 2 percent annual interest, compared with roughly 10 percent coupon payouts for similarly-rated firms making traditional bond issues.
Indian companies issued around $735 million in bonds with coupon rates of 5 percent or below between the start of the fiscal year in April and early November, according to Thomson Reuters data, soon after dealers say the RBI began making queries to banks about their purchases of such bonds.
In the same period a year earlier, issuance of such bonds totalled just $58.6 million.
Banks account for nearly half of purchases of low-coupon bonds, according to dealers. The new rule does not apply to insurers, mutual funds, and provident funds, which also invest in low-coupon bonds.
"After this notification issuances will come down significantly," said Mohan Shenoi, head of treasury in Kotak Mahindra Bank.
The sinking fund would collect all accrued interest during the maturity of the debt, ensuring payout at redemption in case of default.
"There is credit risk associated with such low-coupon bond issuances in the absence of a sinking fund. All such low-coupon bonds should be treated in the same way as zero-coupon bonds," said one official, citing the notice to banks.
Dealers said the move would also squeeze liquidity in the low-coupon bond market, which could push up pricing.
In 2010, the RBI barred banks from investing in zero-coupon bonds, saying that such debt offered little information on the issuer's cash flow, making it hard for investors to gauge potential default risk.
Zero-coupon bonds offer no interest during the tenure of the bond, but promise a premium at redemption. The ban on zero-coupons led some companies to issue low-coupon bonds, which avoided meeting the technical definition of a zero-coupon bond despite carrying similar risks.
Zero- and low-coupon bonds are usually popular with issuers undertaking a project with limited cash flows in the initial period, or who want to replace high-interest bearing loans.
The RBI in November expressed its concern to banks about the shift to buying low-coupon bonds and sent emails to banks that had invested in such debt, seeking details of those deals. (Reporting by Suvashree Dey Choudhury; Editing by Ranjit Gangadharan and Tony Munroe)