Debt instruments on the exchanges

A close look at fixed-income products suitable for retail investors, that are available on the BSE and the NSE

Those who invest in the equity market have to brace themselves for volatility this year, as the general elections, tightening liquidity conditions, slowing corporate earnings and uncertainty surrounding Brexit and other global events are likely to make stock prices whipsaw. In this scenario, debt instruments may be a reasonably sound alternative. While retail investors might be tempted to reach out to plain vanilla bank and corporate FD options, these are not as attractive on a post-tax basis compared to many listed debt products.

A broker’s trading and demat accounts are mandatory in order to buy and sell these bonds in the secondary market. The orders have to be placed through the broker’s terminal, the bond units are held in the demat account and the interest and redemption amounts are credited to the investor’s bank account.

Most investors consider just the coupon rate and the market price of the bonds while buying in the secondary market. But there are three other parameters that need to be factored in — yield-to-maturity (YTM), credit rating and liquidity.

When a bond is issued, the coupon rate is the annual rate of return. But this rate does not matter in the secondary market as bonds trade below or above their issue price. Investors need to focus on the YTM, which is the internal rate of return earned by an investor, who buys the bond today at the market price, holds till maturity, and enjoys all coupon and principal payments that are made on schedule.

Those who like to play it safe should pay attention to credit ratings. Bonds with AAA rating are considered to have the highest degree of safety in timely payment of principal and interest. Liquidity in a bond ensures that you get a good price while buying or selling.

Here’s a closer look at some of the fixed-income products suitable for retail investors, that are available on the BSE and the NSE.

Tax-free bonds

Tax-free bonds that were issued by 14 state-run infrastructure financial companies between FY12 and FY16 are listed on the BSE and NSE and traded in the cash segment, along with the equity shares.

Interest on these instruments is paid annually. The interest income from the tax-free bonds is exempt from tax. There is no upper limit for investing in these bonds.

 

 

Key points

Yield: There are 10 bonds series trading with YTM of around 6.4 per cent with good liquidity. Since the interest paid by tax-free bonds is exempt from income tax, the average yield of 6.4 per cent translates to 9.2 per cent of pre-tax yield for investors in the 30 per cent bracket. This makes it a more viable option than bank fixed deposits. Currently, public and private sector banks offer 6-8 per cent pre-tax interest rate for five-year FDs.

Suitability: Conservative investors in the highest tax bracket and wanting regular income can consider buying these bonds.

Quasi sovereign guarantee: Since these entities are backed by the government, the investments in tax-free bonds enjoy capital safety. Further, the bonds issued by most of these companies are rated ‘AAA’ currently, including NHAI, PFC, IRFC, HUDCO, REC, IIFCL, JNPT, NHPC, NTPC, NHB and Nabard.

Liquidity: Data compiled by HDFC Securities shows that out of the 193 series of listed tax-free bonds, around 30 series are traded at least 15 days in a month (of 20-22 sessions).

These bonds are available with a residual maturity of three to 12 years. Investors can buy the bonds that match their time horizon.

Taxation: Selling tax-free bonds in the secondary market attracts capital gain tax. If you sell them within 12 months from the purchase date, you will have to pay tax on the gains as per your tax slab. If you sell after 12 months, the tax is a flat 10 per cent. Tax experts differ on the availability of indexation benefit for the listed bonds.

Taxable bonds

Non-convertible debentures (NCDs) are taxable bonds issued by companies to raise long-term funds through a public issue. They are issued for a specified tenure — normally one to seven years. The holders of the NCDs receive interests periodically or at the end of the tenure. Normally, they carry higher credit risk than bank FD.

The NCDs that were issued for retail investors by Dewan Housing Finance, NTPC, Tata Capital Financial, M&M Financial Services, Shriram Transport Finance, Aadhar Housing Finance, IndiaInfoline Housing Finance, JM Fin Credit Solutions and Reliance Home Finance are traded actively in the secondary market.

 

 

Key points

Yield: HDFC Securities data shows that the NCDs with highest rating of ‘AAA’ offer yield in the 8.5-9.5 per cent range while bonds with ‘AA+’ and ‘AA-’ offer yields of around 9-12 per cent.

Suitability: Retail investors with a medium-risk profile looking for options other than fixed deposits and debt MFs can consider investing in the taxable NCDs.

Rating: The NCDs issued by Dewan Housing Finance, SBI (lower tier-II bonds), Indiabulls Housing Finance, Indiabulls Commercial Credit and NTPC are rated ‘AAA’ currently. Aadhar Housing Finance, M&M Financial Services and Shriram Transport Finance bonds hold ‘AA+’ status, while IndiaInfoline Housing Finance and Reliance home finance have ‘AA’ rating. One can get relatively higher yields in bonds with a lower rating as they are more prone to default risk.

Liquidity: Out of the 296 series of listed NCDs, only 25 bond series have traded with daily average volume of at least 300 units in the last one month.

Taxation: The interest received from NCDs are taxed, based on the investor’s tax bracket. If you sell after 12 months, tax has to be paid at a flat 10 per cent rate. There is no indexation benefit available. If sold within 12 months, gain is taxed as per tax slab.

Government securities

Recently, the BSE and the NSE launched online platforms — ‘BSE-Direct’ and ‘NSE goBID’ — that have made retail participation easy in the primary issuance of the treasury bills (T-Bills) and government securities (G-Secs).

T-Bills and G-Secs are issued by the government on behalf of the Centre to meet their debt obligation. T-Bills are short-term securities issued with a maturity of 91, 182 and 364 days, while G-Secs are issued with long maturities ranging from one year to 40 years.

G-Secs offer the maximum safety and carry almost nil credit risk as they are backed by sovereign commitment.

Since only big ticket transactions are done in the G-Secs market, institutional investors like banks, insurance companies and mutual funds are the major participants here.

 

 

To encourage retail participation, the RBI introduced non-competitive bidding facility in 2001 in the auction in which 5 per cent of the notified amount is allotted for small investors. Investors had to buy through banks.

Now, retail investors can invest in G-Secs using demat and broker accounts. The procedure is similar to applying for IPO in equity shares. The minimum investment is ₹10,000 and multiples thereof up to ₹2 crore.

Key points

More options in tenure: The RBI conducts G-Sec and T-Bills auctions every week. Currently, the notified amount for the G-Secs auction in a week is ₹12,000 crore. Of this, the RBI allocates around ₹2,000 crore each for the securities with varying maturity bands of 1-4 years, 5-9 years, 10-14 years, 15-19 years and 20 years and above.

The auction for G-Secs with 1-4 years maturities is conducted on alternate weeks. Hence, investors can get in touch with the broker and buy G-Secs that suit their time horizon.

Yields unknown: During the G-Sec auction, the price and yield are determined by the RBI based on the bids quoted by the institutional investors. The retail investors have to apply prior to the auction and accept the yield determined by the RBI. The yield would be closer to that of the securities with similar or same maturities available in the market.

Limited exit route: Currently, active secondary market access is not available for retail investors. So there is liquidity risk while selling G-Secs. Few brokers, including Zerodha, facilitate buybacks if investors wish to sell. Hence, investors who want to hold till maturity can buy the G-Secs.

No cumulative option: G-Secs pay interest semi-annually and no cumulative option is available. This may not be a suitable instrument in a portfolio with long-term goal.

Cost-effective: The brokerage for buying G-Secs is around ₹6 per ₹10,000, which is far lower than the expenses incurred in the other alternative investments, including gilt mutual funds and gilt ETFs.

Taxation: The interest income from G-Secs and the gain made in T-Bills are taxed as per investors’ slab. If you sell after 12 months, tax has to be paid at a flat 10 per cent rate. If sold within 12 months, gain is taxed as per tax slab.

Suitability: Conservative investors with focus on capital safety, wanting regular income from investments with tenure of more than five years, can invest in the G-Secs.

Sovereign Gold Bond

Sovereign Gold Bond (SGB), a substitute for holding physical gold, has been gaining attention among retail investors, thanks to the frequent issuances by the RBI. Retail investors can also consider the 24 series of SGBs issued in the last three years, that are now traded on both the BSE and the NSE.

The minimum lot size in the exchange is one gram (one unit) and the maximum limit is 4 kg for individuals in a fiscal year. The first five tranches of SBGs offer coupon rate of 2.75 per cent while the SGBs issued later offer 2.5 per cent.

SGBs mature in eight years. However, the RBI facilitates buyback at the end of fifth, sixth and seventh years.

 

Key points

Liquidity: Of the 24 listed SGBs, 8-10 bonds are actively traded on the NSE with relatively higher liquidity (see the table). For instance, bonds such as SGBAUG24, SGBNOV24, SGBSEP24 and SGBJUL25 are traded on the NSE with the daily average volume of 473, 372, 189 and 154 bonds in the last one year period respectively.

Discounted price: In the secondary market, most series are available at lower prices — ₹200-300 lower than the current spot price and the prices of the latest bonds in the primary issue, even after adjusting for the ₹50 online subscription discount.

For instance, the closing price of SGBNOV24 on the NSE on January 15, 2019 was ₹2,970. This implies 7-8 per cent discount to the spot price of ₹3,239 (IBJA rate) on the same day and the offer price of the gold bond that opened for subscription last week (₹3,164).

Inter-depository settlement issue: The difference in the prices of SGBs and spot price seems to occur due to the absence of ample liquidity and as compensation for holding the bond till maturity (opportunity cost). The main problem is that most brokers do not allow buying of these bonds in the secondary market owing to operational challenges in the inter-depository settlement mechanism with depositories. However, brokers like HDFC securities allows both buying and selling in SGBs.

The latest industry news is that the depositories — NSDL and CDSL — have sorted out the issue and are waiting for the exchanges to offer seamless service to the investors. Once done, we can expect increased liquidity in these bonds.

Medium-term strategy: Investors with medium-term time horizon of, say, three to five years can buy SGBs and exit through the buyback option provided by the RBI. It is worth noting that the first buyback date of earlier issued bonds is just two to three years away (see Table).

The buyback price will be equivalent to the spot price. Hence, buying SGBs at a discount to the spot price from the secondary market and exiting at the prevailing spot rates during buyback seems to be an ideal investment strategy.

No short-term opportunity: Traders cannot use SGBs to capitalise on any short-term movements in gold price. Our analysis shows that the short-term appreciation or depreciation in the spot gold price were not factored in the market price of SGBs.

Taxation: Interest income is taxed as per the tax slab. No capital gains tax on redemption. Indexation benefit will be provided to long-term capital gains.

Redeemable NCPs

The redeemable non-convertible preference shares (NCP) of four companies — Zee Entertainment Enterprises, JSW Steel, Mukand and IL&FS Financial Services — are actively traded on Indian exchanges.

Preference shares are securities issued by a company with fixed dividend and set tenure. The market lot is one unit. Most of the NCP shares are redeemed in instalments after certain years. For instance, Zee Entertainment redeems one-fifth of the nominal value of its preference shares every year from the 4th anniversary of the date of allotment (from 2018). Investors with medium-risk appetite can consider these NCPs based on rating, liquidity and YTM.

However, only Zee’s NCP shares are liquid; they traded with daily average volume of ₹3 crore on the BSE over the last month.

At the price of ₹7.6 (on January 15, 2019), the YTM works out to approximately 8.6 per cent. Brickwork Ratings has reaffirmed with BWR AAA (Outlook: Stable) for this NCP shares on November 2018.

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