A Date with Debt Market
With bank deposit rates plunging, investors look at corporate bonds, but there are some pitfalls
If you are an investor who wants to play it 'safe' or provide ballast to strengthen your volatile portfolio or get a regular income off the capital market, you may have already considered the 'hottest' option of the day - corporate bonds. The stock and bond markets in India have been booming for some time in spite of a slump in growth and weak incomes. But corporate bonds saw the best traction ever between January and July this year as overseas investors rushed to snap them up due to their relatively high yields and spent a whopping Rs 54,000 crore in the process. Several other factors also contributed to the huge inflow, including a hike on the investment cap for foreign investors and a favourable macro environment - low inflation, stable currency and high probability of rate cuts.
Post demonetisation, a paradigm shift in domestic investment has also led to a similar trend. "The banks' excess liquidity, coupled with low credit takeoff from industry, has hollowed returns from traditional asset classes," points out Dinesh Rohira, Founder and Chief Executive of 5nance.com, an online money management platform. Moreover, banks have remained hawkish on deposit rates, pushing them down to 6.5 per cent for a three-to-five-year term while 7 per cent is the maximum rate of interest on short-term deposits up to a year. Such subdued returns have compelled domestic investors to turn towards corporate bonds just like their global counterparts.
Know Your Bonds
Before you decide to invest in high-quality or high-yielding corporate bonds, let us take a look at these debt market instruments and how they work. Corporate bonds are issued by companies who require capital to finance their business activities. Those who buy the bonds are paid a certain amount as interest, and the entire loan amount (your principal) is repaid at the end of the term. Much like the government bonds, bonds or debentures issued by top companies are considered stable but a tad boring concerning returns. You will also find middle-tier firms and riskier enterprises, ready to offer higher interest rates. As a retail investor, you can spend as little as Rs 10,000 and start taking your pick.
One can invest in convertible or non-convertible bonds depending on the investment objective or holding period. "For instance, someone with a longer investment horizon than the bond's maturity period can invest in a convertible bond, which at a later period is converted into equity upon the agreed ratio and delivers better returns along with flexibility in a portfolio," explains Rohira. However, such bonds are prone to market risks, which may hinder one's portfolio value. If you are risk-averse, invest in non-convertible bonds (not backed by any physical asset or collateral), which would yield fixed returns upon maturity irrespective of market volatility. These bonds have gained in popularity as the interest they offer are often 1-2 per cent higher than bank fixed deposits, and the rates are typically determined by the duration of the term deposit and the risk they carry.
Bonds usually pay a fixed interest rate called the coupon rate, and you get the interest payments on a regular basis, usually twice a year. When the bond matures, you recoup the initial investment equal to the face value of the security. Those looking for bigger returns can reinvest the interest payments. There are also zero-coupon bonds sold much below their face value, and no interest is paid during the entire term. On maturity, one gets his/her initial investment plus the accumulated interest compounded over the life of the bond.
Finally, you must consider the rating of the bond for a sound quality assessment. To understand the details, let us look at the non-convertible debenture (NCD) recently issued by SREI Equipment Finance. The company offered interest rates of 9.25-9.55 per cent per annum for a period five years and three months or seven years or 10 years, which works out to be an effective rate of 9.30-9.92 per cent cumulatively. The NCD was rated 'AA+' by Brickwork Ratings and SMERA Ratings, which means it offers a high degree of safety regarding timely payment of interest and principal. The ratings indicate the likelihood of the instrument meeting payment obligations, which is based on the business performance of the company, among other things. Hence, it is important to understand the specifics of ratings before investing.
Such debentures work best for individuals who are in a lower tax bracket, considering the interest is taxed as per your tax slab. Do remember that the higher the rating, the lower the rate of interest considering it offers you a better safety net. However, the interest rate offered by such high-rated papers may seem unattractive if you are in the highest tax bracket or when you compare it to a long-term fixed-income mutual fund or even a public provident fund, which offers a tax-free interest of 7.8 per cent.
What Are Your Risks?
"If you want to invest in a corporate bond, make it a point to check why the company is raising money and how it is expected to be utilised," says Ajit Narasimhan, Category Head, Savings and Investments, at BankBazaar.com, an online marketplace for personal finance products. In the case of SREI, the company planned to use at least 75 per cent of the issue proceeds for its lending activities and also for refinancing its existing loans and up to 25 per cent of the proceeds for general corporate purposes. If such purposes are not clearly stated, the investor must try and ascertain whether the company really intends to create any value that could lead to stability and growth. According to Narasimhan, all companies are susceptible to sector risks and also gain from respective benefits, and it is up to the investors to decide what suits them best. However, the bond market is no longer the traditional safe haven, and the following pitfalls can easily trip you up.
Illiquidity: Most of the bonds are now listed on stock exchanges, but it is difficult to sell them in the open market. Unless there is a put option in place, you cannot seek early repayment before maturity. The call option, on the other hand, entitles the company to call in your bond any time.
Default: Even reputed companies defaulted on their interest commitments and principal repayments in the recent past. These include Elder Pharmaceuticals, Unitech, Jaiprakash Associates and Helios and Matheson, to name a few. Elder Pharma, for instance, defaulted on its interest and maturity repayments owing to liquidity crunch. So, it makes sense to look at a company's liquidity before investing. Capital market regulator Securities and Exchange Board of India has also come up with a new regulation on disclosure that requires all listed companies to specifically disclose any delay or default in the payment of interest or principal on debt securities within one working day. It may be a good idea to keep a tab on such listings. Also, credit ratings must be checked, and companies with AA or higher ratings should be selected.
Duration: All else being equal, a long-term bond usually pays a higher interest rate than a short-term security. For example, 30-year Treasury bonds often pay a full percentage point or two more in interest than five-year Treasury notes. The reason: A longer-term bond carries greater risks as higher inflation could reduce the value of payments, or a rising interest rate could affect its market value and hence, its liquidity.
Let us assume you have paid Rs 1,000 to buy a bond at par (its face value) and the coupon rate is 5 per cent. If interest rates rise, new bonds are bound to offer higher coupon rates and your bond will be trading at a discount due to lower interest receivable. The reverse happens when interest rates go down, and new bonds offer lower coupon rates. Your bond will now trade at a premium as the interest rate on offer is higher than the market. When Reserve Bank of India (RBI) cuts the repo rate, it lowers the banks' borrowing costs. As a result, both lending and fixed deposit rates come down and bonds paying higher interests have a field day. To avoid such market fluctuation, one should choose the duration carefully. Bonds with maturities of one to 10 years should be adequate for most long-term investors as they return more than shorter-term bonds and are less volatile than longer-term securities.
Are Corporate Bonds for You?
According to Narasimhan of BankBazaar, investing in corporate bonds comes with sector-specific and company-specific risks as retail investors put their money in a single instrument and not a portfolio of instruments or bond funds. "The best way to invest in fixed-income space is to invest in fixed-income mutual funds with medium-term duration. Such schemes buy into corporate bonds and deposits, and the volatility of interest rates are best played by the fund manager instead of individual investors," he adds.
Average returns from medium-term fixed-income schemes were 10 per cent over the past three years and 9 per cent for the past five years. Moreover, these returns qualify for long-term capital gains tax benefit after three years while such gains get taxed at 20 per cent with indexation. Also, with inflation under check, there are chances of more rate cuts by RBI, which could drive down bond yields and in turn, add to the returns of fixed-income funds.
Tanvi Varma is a Mumbai-based freelancer