Even as the equity market had a dream run over the past year, the dull debt market is in for interesting times too. Investors, who hitherto had to be content with traditional debt options such as fixed deposits and provident fund, now have a wider universe of investible options; thanks to the country`s slowly deepening debt market. Besides an array of debt products that mutual funds offer, zero-coupon bonds, non-convertible debentures, corporate bonds and infrastructure bonds - instruments that were often not accessible to retail investors - are the new debt options to hit the market since 2009.
What makes the recent set of options different from the traditional `deposits`? For one, most of the instruments are keenly watched by regulators, thanks to a good number of them being traded on the bourses. Two, being mostly tradable securities, they offer investors greater liquidity.
However, they are not free from the interest rate and credit risks typical of debt offers. For this reason investors may have to survey their options based on four key criteria - safety, liquidity, returns and taxation; the last two going hand-in-hand. Here`s a look at how to evaluate the universe of debt options against the above criteria.
Safety
Thanks to the liquidity crisis in 2008, companies and even financial institutions strapped for funding decided to tap retail investors more actively. For individual investors this means exercising more caution while investing in debt.
While small savings schemes come with a government guarantee and bank deposits are protected by insurance, the credit quality of the borrower may vary significantly in other debt options. Given that companies are from myriad backgrounds, it has become imperative for investors to know the business profile and financial soundness of the borrower.
High safety: On the safety parameter, therefore, the traditional government Post Office Schemes, PPF, NSC and even zero-coupon bonds offered by government-backed apex institutions such as the Nabard come with an almost nil credit risk and offer fixed returns. Bank fixed deposits too can be termed relatively safe, given the guarantee on deposits (including savings account) up to Rs 1 lakh.
Medium safety: Fixed Maturity Plans (FMPs) of mutual funds and secured non-convertible debentures come under the medium-safety category. While FMPs too are subject to credit and interest rate risk, with their close ended nature (locked for a fixed period) and portfolios that are held to maturity, investors can be reasonably sure of receiving the indicative yields of the instruments these schemes take exposure to.
However, investors have to understand the nature of instruments that these schemes invest in. While commercial paper or gilts may be less risky, higher exposure to corporate bonds may carry credit risk.
For instance, FMPs that invested in debt securities of real estate companies in 2007 had a tough time post the realty meltdown, restructuring the debt and getting back the money.
What makes the recent set of options different from the traditional `deposits`? For one, most of the instruments are keenly watched by regulators, thanks to a good number of them being traded on the bourses. Two, being mostly tradable securities, they offer investors greater liquidity.
However, they are not free from the interest rate and credit risks typical of debt offers. For this reason investors may have to survey their options based on four key criteria - safety, liquidity, returns and taxation; the last two going hand-in-hand. Here`s a look at how to evaluate the universe of debt options against the above criteria.
Safety
Thanks to the liquidity crisis in 2008, companies and even financial institutions strapped for funding decided to tap retail investors more actively. For individual investors this means exercising more caution while investing in debt.
While small savings schemes come with a government guarantee and bank deposits are protected by insurance, the credit quality of the borrower may vary significantly in other debt options. Given that companies are from myriad backgrounds, it has become imperative for investors to know the business profile and financial soundness of the borrower.
High safety: On the safety parameter, therefore, the traditional government Post Office Schemes, PPF, NSC and even zero-coupon bonds offered by government-backed apex institutions such as the Nabard come with an almost nil credit risk and offer fixed returns. Bank fixed deposits too can be termed relatively safe, given the guarantee on deposits (including savings account) up to Rs 1 lakh.
Medium safety: Fixed Maturity Plans (FMPs) of mutual funds and secured non-convertible debentures come under the medium-safety category. While FMPs too are subject to credit and interest rate risk, with their close ended nature (locked for a fixed period) and portfolios that are held to maturity, investors can be reasonably sure of receiving the indicative yields of the instruments these schemes take exposure to.
However, investors have to understand the nature of instruments that these schemes invest in. While commercial paper or gilts may be less risky, higher exposure to corporate bonds may carry credit risk.
For instance, FMPs that invested in debt securities of real estate companies in 2007 had a tough time post the realty meltdown, restructuring the debt and getting back the money.
Non-convertible debentures and infrastructure bonds that carry a fixed coupon rate and are secured by the assets of the issuer are also not too risky, provided investors attempt to understand their credit rating and hold them until maturity. However, for those who wish to sell the debentures in the market before their expiry, interest rate risk and liquidity risk are key factors to watch out for.
As bond prices will decline during periods of rising interest rates, a wrong decision to sell bonds in such a scenario may provide lower returns or sometimes even result in capital losses. Besides, given that the bond market in India lacks liquidity, it is possible that investors wanting to sell may be unable to find takers for the entire lot on the stock exchange.
Credit risks in debentures can, to some extent, be understood from reading credit rating reports. All debentures are rated by credit agencies (such as Crisil, ICRA) based on various criteria such as nature and track record of the business, debt-equity levels and capital adequacy. Higher the rating, lower the risk. Debentures of Tata Capital or L&T Finance issued last year are instruments with a high rating.
An instrument below investment grade (as defined by the rater) carries higher risk of default - a clear sign for investors to stay away. Investors holding long-term debentures must update themselves occasionally on the latest credit rating to know if the view on the issuer has changed.
Low safety: Corporate deposits of the high yielding variety are typical examples of high-risk, high-return instruments within the debt category. They often come last in terms of safety. While all corporate deposits are not equally risky, given that a number of deposit-takers do not disclose their credit rating in the application made available, investors are often lured by the high interest rate offered. While choosing from various corporate deposits, investors should do some homework in understanding the business risk of the borrower, track record of financial performance, the debt position and whether the company`s profit can comfortably service interest, besides any history of default. Looking out for deposit schemes of companies whose stocks are also listed may be less of a hassle, as the financial statements and filings pertaining to such companies are available in the public domain. Investors can also look out for companies with consistency in earnings rather than flashy performances.
LiquidityWhile the traditional options are high on the safety radar, it is the new-age options that often top the liquidity list. Open-end debt-oriented mutual funds are the most liquid options, given the ease with which these schemes can be redeemed, especially when there is an emergency. However, most of them have a short period of compulsory holding, any redemption within such period being charged an exit fee.
The holding period, though, is negligible for liquid and short-term funds. For this reason, these are most suited for any temporary parking of funds, at the same time earning more than savings bank interest rate.
Debentures: Some debentures and bonds are listed in the market as soon as they are issued and can be sold in the bourses provided one holds it in demat form. Shriram Transport Finance or Tata Capital NCDs are examples.
In fact, even if one missed the initial issue, they can be bought in the market, provided the investor is well-informed on debt markets and can time the call based on yield movements. Liquidity in these instruments is not uniform and some may be traded more frequently than others.
For investors wishing to hold these the debentures/bonds for a while but not until its maturity there are other options as well. Sometimes debentures/bond come with a lock-in period before they can be traded.
As bond prices will decline during periods of rising interest rates, a wrong decision to sell bonds in such a scenario may provide lower returns or sometimes even result in capital losses. Besides, given that the bond market in India lacks liquidity, it is possible that investors wanting to sell may be unable to find takers for the entire lot on the stock exchange.
Credit risks in debentures can, to some extent, be understood from reading credit rating reports. All debentures are rated by credit agencies (such as Crisil, ICRA) based on various criteria such as nature and track record of the business, debt-equity levels and capital adequacy. Higher the rating, lower the risk. Debentures of Tata Capital or L&T Finance issued last year are instruments with a high rating.
An instrument below investment grade (as defined by the rater) carries higher risk of default - a clear sign for investors to stay away. Investors holding long-term debentures must update themselves occasionally on the latest credit rating to know if the view on the issuer has changed.
Low safety: Corporate deposits of the high yielding variety are typical examples of high-risk, high-return instruments within the debt category. They often come last in terms of safety. While all corporate deposits are not equally risky, given that a number of deposit-takers do not disclose their credit rating in the application made available, investors are often lured by the high interest rate offered. While choosing from various corporate deposits, investors should do some homework in understanding the business risk of the borrower, track record of financial performance, the debt position and whether the company`s profit can comfortably service interest, besides any history of default. Looking out for deposit schemes of companies whose stocks are also listed may be less of a hassle, as the financial statements and filings pertaining to such companies are available in the public domain. Investors can also look out for companies with consistency in earnings rather than flashy performances.
LiquidityWhile the traditional options are high on the safety radar, it is the new-age options that often top the liquidity list. Open-end debt-oriented mutual funds are the most liquid options, given the ease with which these schemes can be redeemed, especially when there is an emergency. However, most of them have a short period of compulsory holding, any redemption within such period being charged an exit fee.
The holding period, though, is negligible for liquid and short-term funds. For this reason, these are most suited for any temporary parking of funds, at the same time earning more than savings bank interest rate.
Debentures: Some debentures and bonds are listed in the market as soon as they are issued and can be sold in the bourses provided one holds it in demat form. Shriram Transport Finance or Tata Capital NCDs are examples.
In fact, even if one missed the initial issue, they can be bought in the market, provided the investor is well-informed on debt markets and can time the call based on yield movements. Liquidity in these instruments is not uniform and some may be traded more frequently than others.
For investors wishing to hold these the debentures/bonds for a while but not until its maturity there are other options as well. Sometimes debentures/bond come with a lock-in period before they can be traded.
This is typically for almost half the tenure of the bond. Investors may either sell it post such lock-in or alternatively go for a call/put option if such an option is available at the time of applying for the bonds. The recent SBI Bond offered a call option, where it may choose to buy back the securities after five years. If it fails to do so, the bond promises an additional interest rate as compensation. A few other debentures also come with put options, where the investor has the option of redeeming the money.
While the traditional deposits are not very liquid, an exit from them is still possible. Most bank and corporate deposits allow premature withdrawal subject to a minimum lock-in period. Some even allow part withdrawal without affecting the interest earned on the rest of the capital.
Illiquid: Public provident funds can be termed illiquid as even a part withdrawal is possible only in the seventh financial year from the year of starting the account. The sum too is restricted.
Others, such as the Post Office Senior Citizens` Scheme and Post Office Monthly Income Scheme can be withdrawn after one year but are subject to penalty. However, loans can be taken against products such as PPF (from third year) and post-office time deposits, subject to certain conditions on the amount available as loan.
While the traditional deposits are not very liquid, an exit from them is still possible. Most bank and corporate deposits allow premature withdrawal subject to a minimum lock-in period. Some even allow part withdrawal without affecting the interest earned on the rest of the capital.
Illiquid: Public provident funds can be termed illiquid as even a part withdrawal is possible only in the seventh financial year from the year of starting the account. The sum too is restricted.
Others, such as the Post Office Senior Citizens` Scheme and Post Office Monthly Income Scheme can be withdrawn after one year but are subject to penalty. However, loans can be taken against products such as PPF (from third year) and post-office time deposits, subject to certain conditions on the amount available as loan.
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