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Photo: iStock
Photo: iStock

Understand the hidden risks before you get lured into investing in high-yielding PSU bonds

Default in PSU bonds is not unheard of, so do your homework on its ratings and financial health before investing

In an environment where bank fixed deposits (FDs) are offering interest rates of 4-5%, the lure of certain state PSU bonds giving 8-10% is compelling. These bonds are marketed by brokers and wealth management outfits to their clients.

We explain how they work and whether there is a catch to this investment product.

How do they work?

Brokerages buy bonds from institutions like banks, mutual funds and pension funds in the secondary market. They then sell the bonds to you at a higher price. For example, the broker might buy a bond at 100 and sell it to you at 102.

Another way of saying this is that they sell bonds to you at a “lower yield" than the yield at which they buy. Yield is interest divided by the price.

Note that this kind of transaction (called over-the-counter or OTC) is completely opaque. The broker does not tell you exactly how much it has earned on the transaction. This is unlike, say, the expense ratio of a debt fund which is transparently disclosed.

Logic of high yields

Yields on many of these bonds are far higher than the market rates. For example, UP Power Corporation Bonds (maturing in 2025) are trading at 10-11%, while Rajasthan State Road Transport Corporation Bonds (maturing in 2022) at 9%.

So what justifies the high yields? The PSU in question might have a weak balance sheet or may be making losses.

Another category of high-yielding PSU debt is perpetual bonds by PSU banks. These are highly risky as they can be written down when the capital of the bank falls below certain thresholds. The bank does not have to be bankrupt for the bonds to be written down. The bank can be bailed out, as happened with Yes Bank.

The tax bite

The interest (coupon) on the bonds is taxed at your slab rate. However, if you buy the bond at a price more than its face value (called buying at a premium) and hold it till maturity, you make long-term capital loss (LTCL). This can be set off against long-term capital gains (LTCG) from any other asset.

Similarly, if you buy the bond at a price lower than its face value (buying at a discount) and hold it to maturity, you will make LTCG, which can be set off against short-term capital loss (STCL) or LTCL on another asset. You would make this kind of purchase at a premium because the bond’s interest rate might be higher than the market rate.

Note that while the coupon is taxed at your slab rate, the principal corpus may be taxed as capital gain or loss.

In case of listed bonds, the holding period for LTCG is one year and for unlisted bonds three years. LTCG on bonds is levied at 20% and you get the benefit of indexation. However, short-term capital gains (STCG) tax is levied as per your slab rate.

Can they default?

Yes, this is not unheard of. In September 2019, Bengaluru Metropolitan Transport Corp. (BMTC), a state government PSU, was downgraded by ICRA to D (default) on account of delays and irregular payment. At the time, BMTC had only bank loan facilities and not bonds. A downgrade equally affects both kinds of borrowings.

“With regard to PSU debt, typically state government PSUs trade at higher yields to central government PSUs, especially in the case of state discoms. Defaults in state PSUs are not unheard of so you should check the credit rating and financial parameters before investing," said R. Sivakumar, head, fixed income, Axis Mutual Fund.

Fund managers also warn against investing in perpetual bonds of PSU banks (typically, classified as additional tier 1 or AT1 bonds). “I would not recommend state government-guaranteed or bank AT1 bonds for retail investors. Similarly, I would not recommend state government-guaranteed PSU bonds directly to be sold to retail investors. If anything, they can look at state development loans (state government bonds)," said Rajeev Radhakrishnan, head, fixed income, SBI Mutual Fund.

Mint take

Do your homework on the rating and financial health of the PSU in question. “I do not recommend direct purchase of high-yielding bonds, even if they are PSU bonds. You often cannot tell what’s wrong with the paper in question. Instead go through a mutual fund where the fund manager has done some diligence on these bonds," said Kalpesh Ashar, founder, Full Circle Financial Planners and Advisors.

“State government PSUs have defaulted in the past. There is no iron-clad guarantee behind them," said Prateek Pant, co-founder and head, products and solutions, Sanctum Wealth Management.

Be cautious when such bonds are pitched to you.

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