Saturday, June 11, 2011

Investors prefer Bonds

(This appeared in the recent issue of Moneylife)

Investors are facing a dilemma. The capital markets are perhaps going through a kind of ennui. Perhaps Rip Van Winkle will go to sleep, wake up, find the markets at the same level and carry on without even realising that a couple of decades have gone missing.
Investment in equities, according to all experts, would give an annualised fifteen percent return over the long term. This is on the premise that our economy would sustain a growth rate of eight to ten percent year on year and inflation would be under around five to six percent per annum. The unfortunate aspect of this is that timing matters. For each investor, what matters is the time he puts his money and the time he cashes in his chips. This can take your returns from zero to fifty, depending on your luck, and the timing of your investments. Of course, one can theoretically smoothen it out with regular investments etc., The fact of the matter is that each one of us wakes up at different times in our lives and money for investment gets ear marked, at different stages in each one’s lives. Someone may start at thirty and someone at fifty. And many never start.
Inflation continues to be a bugbear and will likely stay at near double digits in the foreseeable future. Much as our RBI tries, its policies make no dent in inflation. Perhaps RBI actions are adding to inflation. Whatever be the case, the fact is that inflation with economic growth is better than no inflation and no growth.
These monetary policy measures have thrown up an investment opportunity. We are bombarded with SMS and mails about bank FD’s that are offering ten to eleven percent annual interest. Most offer these for a year or two. The hope is that interest rates at some point would start cooling off. If they don’t then we are headed towards very interesting times (also called as ‘stagflation’ or stagnating growth with rising prices). I would like to believe the former.
In these times, we are seeing some companies raise money through long term bonds (five to ten years or more duration) and some very aggressive instruments. For instance, Tata Steel raised nearly Rs.1500 cr by way of ‘perpetual’ bonds. In essence, it means no repayment ever, unless the company is wound up. The bonds carry a ‘coupon’ interest rate of 11.80% p.a, payable every six months. Tata Steel has also put in a clause ( a ‘call’ option) which enables them to repay (at their instance alone) at the end of ten years the principal in full. In case they choose not to repay at the end of ten years, the interest rate gets automatically revised to 14.80% p.a!!
Alas, the company did not make a retail issue. It placed all the bonds with insurance companies, funds, banks and other wholesale merchants. The bond is listed on the exchanges and is ‘traded’ on the exchanges (BSE, I think). So, now one has to pay a price of anything between Rs.107 or thereabouts (a premium of Rs.7/-) to buy it. Even after paying this premium, it works out to a yield of 11% p.a. if one assumes a ten year repayment. If there is no repayment, the simple yield would be 11.80 on every 107 (or whatever price one pays) .
This compares very well with FD’s or FMP’s. In fact, if I am bullish on India, surely interest rates would come off. So, I am getting a great opportunity to lock in to a high yield for ten years! And I would sincerely pray that at the end of the tenth year, the company gets in to some problems which would make repayment impossible and the bond gets in to the 14.80% percent interest. Today, when I put money in FD or FMP, the duration is short (one to three years) and after that the returns may not be so attractive. Currently, the FMP enjoys a tax arbitrage, which would vanish post end June 2011.
I have give the example of Tata Steel bonds due to its attractive features. There are other instruments with varying yields available. The sad thing about these bonds are its lack of pricing transparency. Stocks have abandoned the concept of ‘market lots’, but bonds continue to have ‘minimum’ trade sizes. The Tata Steel bonds are traded in single deal sizes of five lakh rupee face value of bonds.
It is imperative that the regulators remove these stupid ‘ticket’ size considerations for the debt instruments. Only then will the debt markets expand. So would awareness. Today, the entire debt market is like a ‘black’ box.
The other interesting thing is that there is no TDS on the interest that would come to the investor in bonds. These are in demat form, so easier to manage also.
Once interest rates start to move up, the prices of these bonds would go up. So, after a year, if the interest rates go down by half a percent, the price of the bond would go up by nearly three rupees (in the Tata Steel example). So over a one year period, you would have got a return of nearly fourteen to fifteen percent! Of course, the risk is that the prices can go down further if the interest rates keep rising. In which case, one continues to enjoy the interest rate on the instrument.
The instrument like that of a Tata Steel would be a bad one if at the end of ten year (at the tenth anniversary of the bonds) the economy is in such a bad shape that interest rates go up to 18 or 20 percent per annum. So, best not to put everything in these kind of instruments, but a fair part of one’s portfolio that is earmarked for low risk, predictable return portfolio.


Sandeep said...

What is your view on longer term (10 year) Rupee vs US$ or S$?

Frustrations Amalgamated said...

Hi Sandeep,
Two things: Hi Sandeep
USA will recover and grow at its modest rate, with low inflation;
India will sputter, grow at average of maybe seven to eight with high inflation.
That would automatically weaken the rupee against the dollar.