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Fine Tuning Your Bonding With Bonds

Investors are chasing direct debt when much of the rate cut is behind. Hence, don’t expect too much capital gains

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With the interest rate at a low, it might appear a moment too late to invest in direct debt offerings. However, a raft of investors is doing precisely that. Non-convertible debentures (NCD) and secondary market debt purchases of perpetual and tax-free bonds are still attracting much investor attention. Primary market debt offerings are being lapped up all too quickly.

DHFL came out with an offering of bonds that was over subscribed nearly 19 times showing a demand of Rs 19,000 crore. The housing finance company followed it with another offering that was again oversubscribed, which has garnered in another Rs 10,000 crore. Indiabulls Housing also raised Rs 7,000 crore through NCDs since July. From the looks of it, debt is clearly the flavour of the season.

A host of debt instruments are finding favour with retail and high-networth investors (HNI). Says Jiju Vidyadharan, director, CRISIL Research: “Corporate bonds, including plain vanilla and tax-free, are available for investment for retail/HNI investors. Tax-free bond is the most preferred option, especially during the tax season.”

However, at a time when interest rates are falling, investors are increasingly turning their attention to the fixed-income market. The 10-year G-Sec yield, which is the barometer of market-based interest rates, has come down in the last six months. The yield hovered around 7.9 in February 2016 and dropped to 7.08 last month.

Lately though, this major economic yardstick is showing signs of tightening. The 10-year G-Sec has risen from 7.08 to 7.14 per cent in the past fortnight ending 29 August, 2016. And higher interest rates do not augur well for prices of debt paper. Higher debt yields lead to a loss in bond values in the secondary market, and therefore, impact the net asset value of bond-holders.

An inverse relationship exists between bond yields and prices. When bond yields fall, gains follow on bond prices through rising net-asset values. Over the last six months or so, investors have been seeking capital gains through debt investing, marking a sea-change from the yester-years when debt investing comprised only just the humble bank or corporate fixed-deposit.

“Investors have been going in for direct investment because there are obvious capital gains to be made. In developed economies, debt investing through markets is a routine part of a portfolio and that’s why debentures are actively traded in Europe and America,” says Killol Pandya, head, fixed income, Peerless Mutual Fund.

“In India, in the last four years, we have started looking at debentures — direct investing in debentures — as a fruitful alternative to fixed deposits.The easiest way of getting people hooked to the asset class is to show them obvious capital gains,” continues Pandya.

And that’s exactly what has been happening in the bond markets lately. Prices of bonds have surged, landing investors, who had invested in debt directly through the market just about six months ago, decent returns in capital gains.

But will these gains continue in coming months and years? Pandya believes that while there has been a significant rate reduction in market yields, further rate cuts are still not off the table. The Reserve Bank of India (RBI) has cut the repo rate by 150 basis points in the last one and a half years. “There is not too much left by way of capital gains, but there could be about 25-50 basis points still left as far as rates go.”

Pandya reckons that, as some of these bonds have about five or 10 years of maturity, investors may see a long-period of lull in rates before another rising-rate cycle kicks in. “There’s still some time before this rate cycle changes, and that should give investors a long time to see if their bonds or debt investments are in the money. I believe that India is headed towards a lower interest-rate regime structurally,” says Pandya.

Hence, debt investing may prove profitable in the next one or two years. However, investors may have to reign in their expectations of returns. While nominal returns from debt investing are sliding as interest rates adjust structurally, real returns in the hands of investors are getting better. CPI inflation has slipped from around 9-10 per cent earlier to 6.07 per cent lately. So, even as fixed-income returns have dipped to 9 per cent, investors are still making a 3 per cent real return, as opposed to negative real returns in the past.

If the Indian inflation scenario is headed structurally lower and if the inflation target of 4 per cent is met over the next two-three years, real returns in the hands of investors will only get better. Hence, while Indian investors will get lower nominal returns, the final yield in their hands is still quite significant. “We are now wealthier with bonds even if your nominal return rate is coming down on the back of lower inflation.”

So, while there is money on the table for investors, direct debt investing in the markets still comes with plenty of caveats. In the debt market AAA space, the trading system is not designed for retail investors. The cost of a bond is in the range of Rs 10 lakh and over. Hence, pure retail investors with lower investment amounts are better off investing through debt mutual funds.

However, some HNIs are warming up to buying direct debt through their family offices, and wealth managers. Such investors can find decent bonds in the AA plus category, where some good companies and banks are listed. That said, investors should research well before zeroing in on a bond to buy and hold — which includes looking at financial parameters such as whether the company is covering its interest costs by generating sufficient profits. Financial advisors play a crucial role here in selecting suitable bonds for investors.

Debenture investors should also look at other parameters such as whether the bonds are secured or unsecured. Generally, secured bonds have a lower coupon than the unsecured ones. Besides, the ratings category has a bearing on bond yields. The lower the rating of a bond, the higher is the yield. You should not invest in a debenture if you are worried about the company going bankrupt or defaulting on its interest payments. Says Pandya: “Invest only in robust companies where you know that you are going to get your interest and principal.”

For direct fixed-income investing, investors must look at the debt servicing of a company, and not whether investors will ultimately be paid off. But when you look at debt investments, you look at its debt-servicing and interest-coverage ratios; and these data are easily available on bond literature and on company websites.

The interest-cover ratio will vary between industries. A non-banking financial company may seem to have a poor interest-cover ratio, because the nature of the business is highly leveraged. On the other hand, if you are looking at a manufacturing entity, you will need to watch for a better interest-coverage ratio.

Another factor investors have to watch for is liquidity. The retail bond market is extremely under-developed, while even the institutional bond market is quite dwarfish compared to international markets. The RBI has recently come out with norms to strengthen the bond market and to add a dollop of liquidity, but that is still some time away.

Hence, most bond dealings are either through off-market transactions (the good old telephonic-negotiation route). Says Vishal Doshi, financial advisor and partner, Alpha Investment Services: “Negotiated off-market route is the only option and, depending on how much you want to invest, yields on debt paper differ to that extent. Currently, perpetual bonds are offering decent yields of around 10–10.5 per cent for retail investors.”

But the net yields for a retail investor are normally lower than those for an institutional investor. Common sense suggests that in such a market, where there is low liquidity, discovery is not easy. When you actually want to sell your bond, you may not get its true value. Says Vidyadharan: “Since bond market is dominated by institutional investors (daily trading by them is close to Rs 4,000 crore), the price discovery is superior in those segments. Retail/HNI investors due to low ticket size and odd lots may not be able to command similar price (yields) on their transactions and may have to pay higher premium on the price depending upon size, rating and liquidity of the instrument.”

But Doshi reckons that if you have small lots, selling the bonds is not that difficult, as deals involving a few bonds are easily conducted through the negotiated route.

Besides, there is no benchmark to tell you that this is the best price. As things stand now, there is a chance that a retail investor may be short-changed when making investments in the secondary market.

In the primary market, however, offerings are on par, which means investors are getting the best possible price. In the secondary market though, you will face the issue of whether the pricing given to you is right or wrong.

Experts reckon that if you are an investor in debt now, the next rate cut may be some time away. Hence, hold on to your debt investments and pocket the interest accrued. Investors buying from the secondary market have to look at the yields and lock-in to higher rated paper at better yields. But ride out the current tightness in interest rates till the next cut is due, which will probably happen only next year.

THE LURE OF DEBT

The rate cut cycle seems to be nearing its fag end, hence big gains on bonds may be elusive

Holding till maturity in many cases may give investors a decent coupon and accrual income

Real returns in the hands of investors have got better as consumer inflation has dipped

Secondary debt market are still illiquid, hence retail investors may not get the actual yield

HNIs and corporates will manage to get a better yield as they can invest in higher lots in debt

Investors should keep an eye on the ratings. Companies with lower ratings have higher yields

The critical thing to watch is the interest-coverage ratio, which should cover the interest payment

In the past, companies have known to default. Hence, it’s prudent to diversify in the debt basket


clifford.alvares@gmail.com