Targeting a distant financial goal is a scary prospect. Apart from the possibility of the instrument you choose not delivering, there is a real fear of the target itself changing due to either circumstance or inflation.
When targeting faraway goals, typically a child’s higher education or marriage or a retirement corpus, we use rough thumb rules. These are based more on what we can afford today rather than a theoretical number-crunching exercise of what it will cost us in the future.
Of course, those working with financial planners learn to save first, spend later and do manage to target wild-looking numbers with lots of zeros in them. But for the rest, it is more a “I can spare so much now, so what can I do to build a part of what I will need”, approach.
While using equity for a goal that is more than five years away is always a good idea, it helps to have some built-in certainty in the form of a guaranteed product that will give a base level to our future target.
One instrument that is useful in having a base level of certainty built into the future is an animal called the zero.
We’re used to bonds that pay out interest once or twice a year, but when this interest is not paid out periodically, but is paid out together with the amount invested, at the end of the investment period, you get a product called a zero coupon bond.
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Typically you will buy at a discount to the face value, or say one bond for Rs92, which will pay you Rs100 in a year’s time. The interest is embedded into the bond and does not come to you as a separate payment.
Retail zeros have had a shaky start in India and the two large retail issues have left the investors with a bad taste in their mouths.
The 20-year Sardar Sarovar Bond in 1993 promised to pay out Rs1.11 lakh for every Rs3,600 invested, giving a fat yield of 18.70%. Though the bond had no call option (the ability of the issuer to pay back investors before the term of the investment is over—this is usually done when the interest rates have fallen in the economy and by redeeming the bonds, the issuer will save on interest cost), the bonds were called back earlier this year, despite a Securities and Exchange Board of India attempt to get the investors a fair deal. To save on the ballooning interest burden, the Gujarat state government actually wrote a legislation to insert a call option. The bonds were redeemed earlier this year for Rs50,000 each.
The 1996 IDBI Flexibond issue promised to convert Rs5,300 into Rs2 lakh in 25 years, giving a yield of 15.63%. A friend’s eager dad lining up to buy five bonds for his yet-unborn grandkid is still fresh in the memory. The friend was just married, with no immediate intention of producing a baby. Sadly for the friend’s father (and the grandson who came along pretty soon), IDBI exercised a call option in the year 2000 and the bonds were redeemed, returning Rs10,000 to investors. Both Sardar Sarovar and IDBI had clearly got the product right.
Investors love a large number sitting at the end of the investment period, which is the reason they buy low-yielding money-back policies or endowment plans that typically offer between 3% and 4% returns. But both broke the investors’ trust by calling the bonds back.
The National Bank for Agriculture and Rural Development’s 2007 Bharat Nirman Bond issue got the product wrong. The zero promised to flip Rs8,250 into Rs20,000 in 10 years, but the bond issuer at this point made a key error by advertising a post-tax yield of 12.82%. Though technically correct, this was the simple interest on the bond, whereas the conventional way to list returns is a compounded annual growth rate, which worked out to a much smaller 9.26%, and the post-tax return was even lower at 8.51%. The issue did not do well due to an investor perception that something was not right with the bond.
Zeros have ended up as non-heroes in India, but there is merit in still trying to get the product right for they serve a key role in a long-term retail portfolio. But before the product, the issuers need to get their intent right.
Monika Halan works in the area of financial literacy and financial intermediation policy. She is consulting editor with Mint and adviser, Pension Fund Regulatory and Development Authority. Comments are welcome at firstname.lastname@example.org