Since, with returns, their credit risk also gets compounded
ZERO-COUPON bonds, which were considered unsafe investments for banks by their regulator, are now being pushed on to retirement funds by bond brokers. The Reserve Bank of India (RBI) had asked banks to stay away from these bonds because, along with returns, their credit risk also gets compounded.
Zero-coupon bonds are debt instruments where the interest, instead of being paid out in regular half-yearly installments, is ploughed back and the compounded return is paid out on maturity.
The central bank had recently said that since the issuers do not pay any interest regularly, the credit risk of such bonds goes unrecognised till the maturity. In case of banks, if a borrower does not pay his loan installment within 90 days of the due date, banks have to make provisions for bad loans.
A similar debate on zero-coupon bonds had engaged the financial sector a decade back and some of the concerns highlighted then persist. According to the RBI, since a quarterly review does not take place in zero-coupon bonds, such issuances and investments, if done on a large-scale, could pose systemic problems.
Investment banking sources say that bond brokers who play the role of arrangers are now selling these papers to retirement funds such as exempted provident funds, gratuity funds and superannuation funds.
Market players believe that the RBI should do more to protect the end-users of such instruments, which plagued the investors earlier through deep discount bonds of weak issuers. It is finding its way into PF investors' portfolio via cooperative banks. Recently, a financial institution with the lowest investment grade with no guarantee launched such an instrument a few months ago. These securities are lying in the books of the cooperative bank and waiting to be dumped in the books of pension funds.
The RBI has said that banks can henceforth invest in zero-coupon bonds only if the issuer builds up a sinking fund for all accrued interest and keeps it invested in liquid investments/securities (government bonds). Banks have also been asked to put in place conservative limits for their investments in such bonds. The move is in line with corporate debenture redemption fund but the RBI did not specify any amount that banks may invest in such bonds.
However, for retirement funds, no such restrictions exist. For instance, the manager of a provident PF can invest in any bonds issued by PSU even if the bonds are not rated. But, most PF investors insist on a rating even in case of PSU issuances. There is a requirement for an issuance by a private company to be rated by two agencies.
While many institutions have been raising bond issuances, in case of zero-coupon bonds, there is a systemic risk in the absence of a provision of interest. For instance, in 2003, IIBI issued a 25-year deep-discount bonds worth 150 crore. The bonds with a purchase price of 16,000 had a face value of 1,00,000. An interesting aspect of this bond was that the interest for the first four years, which worked out to be 1,430 per annum, were stripped from the bonds and given to investors as separate zero-coupon securities. Interest from the fifth year onwards was cumulative and compounded to yield the redemption amount of 1 lakh at the end of 25 years. Taken together with the strips, the yield on IIBI's bonds worked out to 9.06%. The peculiar structuring of IIBI's deep-discount bonds has resulted in some brokers raking it in by selling the instrument in the secondary market.
A zero-coupon bond (also called a discount bond or deep-discount bond) is always bought at a price lower than its face value with the face value repaid at the time of maturity. These investments are extremely popular. Examples of zero coupon bonds include the US T-Bills among others.
