Understanding the interest rate difference that a lender offers to the companies in Solar Home Systems (SHS) and Commercial and Industrial (C&I) sectors requires an understanding of the industry and the first principal of economics i.e. return is directly proportional to the level of risk involved.

This relationship explains why government bonds offer the lowest interest rates, while stock market investments have the potential for the highest returns.

The interest rate offered to the borrowers has several components. But to simplify it, let’s break it into three components = Risk free return (minimum return expectations from any investment) + Default Risk Premium (Extra return for taking the risk) + Transaction Costs.

What exactly is the Default Risk Premium?

A Premium refers to the extra return required to compensate for specific risks or uncertainties associated with an investment. The Default Risk Premium is therefore the sum of all the risks involved with the transaction, including but not limited to the industry risk, company risk, currency risk, and country risk.

To comprehend the interest rate difference between SHS and C&I, let's delve deeper into the subject and consider an example to better understand the specifics:

For both the sectors, risk free rate is the same i.e. the government bond yield which stands at 3.35% (as of Aug 11, 2023), but let’s deduct that and focus on Default Risk Premium:

If the default doesn’t occur, this premium looks attractive for SHS, doesn’t it? Although, this is not always the case.

According to a World Bank report, the default rate for SHS in 2022 was approximately 4% per annum, which essentially means that on average, investments in SHS lost 4% on the capital. If we remove that from the Default Risk Premium, our safety margin (essentially means that the income we will make if the defaults are at historical average) is 7.65% - 4% = 3.65%.

It's important to note that the default rate in the SHS sector has been increasing over the past three years, which means the safety margin of 3.65% will shrink, thereby impacting the returns. Furthermore, the SHS sector is highly sensitive to macroeconomic factors, such as inflation. If inflation rises, the default rate might increase at a higher rate compared to other sectors, including C&I. However, in favourable conditions, investing in SHS could yield a decent return. Just imagine converting that 4% default rate into cash in your pocket.

Now let's shift our focus to C&I companies and apply the same concept.

On average, losses on capital for C&I projects amount to less than 0.8% per year (a very conservative estimate). With that, our safety margin comes out to be approximately 5.15% - 0.8% = 4.35%. This figure is relatively conservative, especially considering that default rates in the C&I sector are not increasing as significantly as in the SHS sector. That’s 0.7% higher than SHS with better security.

While the returns in the SHS sector may appear higher, it's crucial to recognize that one or two bad investments can significantly impact profits. The intention here is not to undermine the SHS industry, but rather to understand why an investment may seem more lucrative on paper while presenting potential challenges in practice. Investors need to choose which type of companies to fund based on their risk appetite.