Mix Bonds and Bank FDs for Best Returns

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Investors are betting big on tax-free bonds of longer tenures. The recent bond issues of National Highways Authority of India (NHAI) and Power Finance Corporation (PFC) were oversubscribed by almost three times, say merchant bankers. A similar issue from Indian Railway Finance Corporation (IRFC) is expected later this month.

With interest rates expected to fall soon, financial advisors are asking their clients to add long tenure bonds and long-term fixed deposits to their debt portfolio. A rate cut is round the corner. These long-tenure bonds could give you the added benefit of capital appreciation. Similarly, you can also lock into higher rates in fixed deposits and also enjoy the benefit of compounding. Build a ladder around bonds and fixed deposits to optimise your returns.

Bonds or non-convertible debentures give you the twin advantage of coupon, or interest, rate plus capital appreciation. This is because since they are listed and traded on the stock exchange, the price of a bond could move up or down depending on the interest rate. In a scenario when interest rates fall, bond prices go up and you will benefit from capital appreciation.

For example, Tata Capital - N2 bonds with a coupon of 11.25% (face value . 1,000) and a quarterly interest payment, issued in March 2009, still trade at a premium of 3.4% at . 1,034.

So if the current 10-year Benchmark G-Sec has a yield of 8.25% and due to falling interest rate the yield comes down to 7.75%, then the price of a bond you hold is bound to rise. The capital appreciation would depend on the duration of the bond. Prices of long tenure bonds rise more than short tenure bonds. On the other hand, if interest rates were to rise to 9%, then the price of the bond you hold is bound to fall.

A bank fixed deposit earns you only interest. However, you stand to benefit from the effect of compounding rate of interest in a fixed deposit. So the interest income you earn every year by default is reinvested at the same rate. Bonds have the benefit of capital appreciation while fixed deposits give you the advantage of compounding For example, suppose you invest . 10,000 in NHAI bond at 8.2% for 10 years where interest is paid out annually, and . 10,000 in an SBI FD at 9.25% for 10 years, where you get the benefit of compounding. In the case of NHAI, you will receive . 820 as interest every year, while in SBI FD it will be . 925. In the case of NHAI, you will have to reinvest it at the prevailing interest rates at that time. So you are not sure what you will end up with at the end of 10 years. However, in the case of SBI, the interest income of . 925 will get reinvested at 9.25%, and at the end of 10 years you are sure to get . 24,954. This eliminates reinvestment risk and gives you the benefit of compounding.

Drawing A Strategy

As you can see, the strategy is based on the theory that interest rates are going to fall soon. How realistic is the theory?

There is a case for a rate cut. However, the central bank may watch for some more time before taking any decision. Most analysts expect the central bank to start cutting rates from the first quarter of the next financial year. Even the RBI statements indicate the same: "The guidance given in the second quarter review was that, based on the projected inflation trajectory, further rate hikes might not be warranted. In view of the moderating growth momentum and higher downside risks to growth, this guidance is being reiterated. From this point on, monetary policy actions are likely to reverse the cycle, responding to the risks to growth".
The central bank has resorted to 13 rate hikes since early 2010, with an objective to rein in rising inflation. Food inflation was close to the 20% mark a year ago while the Whole Price Index (WPI) inflation crossed the 10% mark. While WPI inflation fell from 9.75% in October 2011 to 9.1% in November 2011, food inflation touched a 4-year low of -2.32%. However, growth is slowing down. India's GDP grew by 6.9% in the period July–September 2011, the slowest pace of expansion in the last nine quarters. It is this slowing growth which may make the central bank cut rates going forward.

Great Promises

For any drop in interest rates by 100 basis points, or 1%, very broadly you can see a capital appreciation of 5% on a 5-year bond, 7% on a 10-year bond and 10% on a 15-year bond. The higher the duration of the bond, the greater the capital appreciation. Since bonds like NHAI and SBI come from the government, they track benchmark 10-year Gsec rates. The 10-year yield now stands at 8.25%. Suppose this were to drop by 100 basis points over the next one year, then it is possible that the NHAI 10-year bonds with a face value of . 10,000 could gain . 700 per bond and trade at . 10,700 and the 15-year bonds will trade at . 11,000. Thus for a 15-year bond, an investor could make a capital gain of . 1,000, or 10%.

In addition, he earns an interest of 8.3%. So his total return could be as high as 18.3%.

Since it is very difficult to predict interest rates, experts are recommending the technique of laddering — a strategy to build debt portfolio with different maturities — to their clients. "Invest up to 75% of your corpus in a mixture of NCDs and fixed deposits. These products could have a maturity period between 3 and 15 years. If you are aggressive you could have a higher exposure to long tenure bonds. So your ladder could have NHAI/PFC bonds with a maturity of 15 years, SBI bonds with a maturity of 9 years and some fixed deposits with lesser and varying maturities. The advantage of such a ladder is that it frees up capital at various points of time, offering liquidity.

Lastly, financial advisors ask investors to buy these bonds with an objective of holding till their maturity, and not merely for capital gains. Bond markets are not well developed, with very little activity. So, exiting could be a problem. There are very few products with a maturity of 10 to 15 years, hence the market prices may not reflect the true price. For example, SBI - N6 bonds, with a 15-year maturity and a coupon rate of 9.45%, witness thin volumes with less than 100 bonds traded on most days. Also, some of these bonds have a call option. If the interest rates drop significantly, the issuer has the option to buy the bond back and return your money.

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