The low interest rate environment and soaring equity market have nudged savvy and rich investors towards fixed-income investments that offer higher yields. Others are also looking at market-linked debentures for better tax-efficient returns. Though returns appear attractive, experts say that these instruments come with higher risks.
Nitin Rao, CEO, InCred Wealth says, “AAA-rated high-quality bond yields are low and in some cases the real rates (return less inflation) are negative. Investors looking for positive real rates are now going down the risk spectrum, looking for high interest paying AA and lower rated bonds in fundamentally sound companies.”
Going down the rating curve
There are three types of low-rated (AA and below rating) bonds being offered to investors looking for better yields.
Traditional bonds pay a fixed coupon in the range of 9-10.5 percent for tenures ranging from two to three years. These are mostly rated AA and A. These bonds pay regular interest. But there is one drawback from the point of view of high networth individuals. The interest is clubbed with their income and taxed at their slab rate.
That makes investors consider market-linked debentures (MLDs). There are two variants of these MLDs. The first variant offers payoffs in line with the movement in underlying security. The payoff could be linked to a benchmark, say the Nifty 50 index. So, a certain MLD may offer 110 percent of the move in Nifty over the next three years. If the Nifty delivers 50 percent absolute returns over next three years, then the investor will receive 55 percent returns. In case the Nifty gives negative returns, the issuer returns the principal to the investor. These are termed as principal protected MLDs. If the investor is willing to forego principal protection, then he can get higher participation in the benchmark’s return.
“Investors who wish to participate in the stock market rally, but want to protect their capital are going for principal-protected MLDs offering payoffs linked with the movement in benchmark indices such as the Nifty,” says Feroze Azeez, Deputy CEO, Anand Rathi Wealth Management.
The second variant of the MLD, however, is designed with the sole objective of taking advantage of the tax-efficiency (or the loophole in tax rules) these bonds offer. Some issuers bring in a seemingly-impossible condition attached with the payoff. It could be an 80 percent fall in Nifty over the tenure of the bond – say two years. So, the issuer pays interest at, say, 10 percent if the Nifty does not fall 80 percent or more in next two years. If it falls 80 percent or more, then there is no interest to be paid. Only the principal is paid back to the investor. In these cases the investors are fairly aware that they are going to pocket the coupon.
The payoff from most of the MLDs are decided on the date of maturity. Just before the maturity, these MLDs are sold by ascertaining the fair price in the secondary market. The issuer or the arranger of the issue makes necessary provisions for the same. Since they are sold in the secondary market, the money received by the investor is treated as capital gains. For a listed bond held for more than one year, profits are treated as long term capital gains and taxed at 10 percent without indexation.
This works the best for the high networth individuals who would otherwise be taxed at much higher rates.
The size of the trade
Most of these bonds are issued to large institutions and brokers. These brokers then sell it in the secondary market to the investors. The minimum ticket size is Rs 10 lakh in most cases. And the wealth management firm or the broker facilitating the deal may stipulate the minimum deal size between Rs 30 and 50 lakh. Since these are secondary market deals, it is difficult to estimate the correct size of the market. However, various estimates say that almost Rs 800-1000 crore worth of deals are done per month. If inflation remains sticky and the interest rates do not catch up, then the demand for such investments is expected to increase.
Not a risk-free investment
These investments come with high credit risk. The money so raised is utilized by the issuer for lending to businesses. And many times, they cater to that segment of the economy which is not funded by banks, thus involving high credit risk. The ratings are vocal about it – as they range between AA and BBB.
“Investors should not blindly pick up bonds offering high yields. They have to analyse the risks involved and take an informed decision,” says Rupesh Nagda, Founder and Managing Director, Family First Capital. Most of these bonds and MLDs mature in a maximum of four years. It is better to avoid long-term bonds involving high credit risk at a time when interest rates may rise. “We do not recommend low-rated bonds maturing beyond three years,” Nagda adds.
To offer the payoff linked to a volatile stock market index, the issuer has to create an option structure that pays off at the time of maturity. The issuer should carry out this option purchase transaction on the stock exchange to nullify counterparty risk. If the issuer enters into a private forward agreement, then there is a counterparty risk.
“Though low-rated bonds offer good returns, they suffer from low liquidity in the secondary market. It was observed in the past that in case there is a crisis, it is almost impossible to sell them in the secondary market,” says Vaibhav Porwal, Co-Founder, dezerv. He says investors must buy with the view of holding them till maturity, if they understand risks.
Though these bonds and MLDs look attractive, they cannot be your core fixed income holding. Retail investors should avoid these, given the ticket size and enhanced risks.
High networth individuals, whose core portfolios are well-diversified may consider them if they have a high risk appetite.