In the past few months a number of corporate bond issues have hit the market. Among them, one from State Bank of India in February and another from Shriram Transport Finance Co. Ltd, which opened on Monday, targeted the retail investor with a minimum investment requirement of Rs10,000 and interest rates of 9.75% and 11.60%, respectively. In the last six months, there have been a few other privately placed bond issues with interest rates in the excess of 11%. A 10-11% return on investment per annum is meaningful for investors and one should be on the lookout for other such issues through the rest of this year. There are, however, some risks attached to bonds that one needs to understand before investing or trading.
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Why bonds now
When interest rates in the economy are high, investors begin to see higher returns from debt instruments. This usually coincides with a weak equity market. In such a scenario, bonds in particular make a return to investor portfolios. There are two reasons: firstly to generate higher regular income from one’s fixed-income investments, and secondly a falling equity market makes investors reallocate to other assets. Financial markets in India may be in the middle of this cycle, with a 200 basis points increase in the repo rate over the last one-year. Also, the S&P Nifty index has corrected 9.91% year-to-date.
One basis point is one-hundredth of a percentage point.
In addition to the retail issues mentioned above, recent months have seen some other attractive bond issues. For example, Tata group privately placed two series of perpetual bonds (from Tata Steel Ltd and Tata Power Ltd), offering 11.50% and 11.40%, respectively. According to Pawan Agrawal, director (corporate and government ratings), Crisil Ltd, “The recent launch of Tata Steel perpetual bonds came at a yield roughly 1 percentage point higher than other corporate bonds available today. Also, Crisil rated it AA/positive making it attractive.” If you manage to invest in such issues close to the peak of a rising interest rate cycle, there is a twofold benefit. Firstly, your investment is locked in at a higher rate even though rates may begin to fall. According to Atul Singh, managing director-global wealth and investment management (India), DSP Merrill Lynch Ltd, “We are seeing an increasing interest for bonds among our clients. As a firm too, we are interested in bonds.”
Also when rates fall, bond prices rise and trading the listed bonds on exchanges can result in gains. According to Ganti N. Murthy, senior vice-president and head-fixed income, Peerless Funds Management Co. Ltd, “The yield curve is nearly flat. Expect the Reserve Bank of India to be close to the peak of its interest rate hiking cycle. So, going forward we may see lower long-term yields. The yield on the benchmark 10-year government bond could be lower than 8% in six months to a year.”
When a company issues bonds, for institutions or individuals, it will get the issue rated by a credit rating agency. This rating gives you a sense of the issuer’s ability to service the loan obligations in terms of interest payment and repaying the principal. For example, a AAA rating by Crisil Ltd or CARE AAA by CARE Ltd means that the instruments with this rating are of the best credit quality offering the highest safety for timely servicing of debt obligations or minimal credit risk. A rating of AA from Crisil or CARE AA reflects high safety and low credit risk. So, you know that someone has done the required research to ascertain whether a company will be able to repay the loan from the individual investor in form of the bond.
According to Agrawal, “At Crisil we have a 250-member research team, who engage in industry research and talk to companies periodically.” Compare this to buying a stock, there is no official indicator as to whether the company you have bought is in good financial health or not. So the uncertainty attached to the price of a stock is much higher than the credit risk that a bond comes with.
Thus, the risk in holding a bond till maturity is limited. If you do decide to trade in bonds after listing, there are other risks to consider, such as liquidity risk and interest rate risk.
Should retail investors buy corporate bonds?
A favourable risk return tradeoff does make bonds a lucrative investment. However, you need to be careful, as there is a big gap in terms of accessibility, information and liquidity. Firstly, most of the large bond issues are privately placed and come with a minimum investment of Rs10 lakh. Chances are, you won’t find out about the issue on offer and even if you do, the minimum investment might make it beyond reach for retail investors. While, it’s true that the restriction of minimum investment is limited to the primary market, the trade sizes on the exchanges for secondary market trades are also fairly large and out of reach. Says Gaurav Mashruwala, a Mumbai-based financial planner, “It is a wholesale market, you may either not be able to buy the bond or may not be able to get the right price. I don’t recommend trading.”
Moreover, the trading volumes are extremely low and most of the secondary market deals are done over the counter at negotiated rates rather than at listed prices via exchanges. This exposes trading in bonds to liquidity risk, which you may not be able to bear. Singh says, “Liquidity in the bond market is a concern. We are seeing interest for bonds among clients who have the holding capacity and there is a sense that Direct Taxes Code might make taxation of this instrument more rational. Right now there is a tax arbitrage which makes funds and fixed maturity plans (FMPs) more favourable.” According to the World Wealth Report 2011, by Capgemini and Merrill Lynch Wealth Management, only 18% of high net worth individual’s assets in Asia-Pacific (ex-Japan) was invested in fixed income instruments in 2010.
The factors listed above complicate matters. Even though you have access to bond funds, matters such as bond pricing and interest rate risk need thorough understanding. For the retail investor bonds still remain a missed opportunity. “The investor today hasn’t seen the kind of great returns that bond funds delivered in 2001 and so stay away. Moreover, products like FMP’s offer a better tax arbitrage,” says Mashruwala.
For your bond allocation, look for specifically designed retail issues such as the one from State Bank of India or Shriram Transport Finance, and hold till maturity to take advantage of locking your investment at a high interest rate. For an investor in the highest tax bracket, an 11-11.50% interest from bonds will translate to a post-tax return of 7.60-7.95%. These rates are worth locking into for the next three-five years, provided the issue is from a company with stable credit rating.
Graphic by Ahmed Raza Khan; illustration by Jayachandran/Mint