Don't chase only yields while investing in debt

Last Updated: Tue, Sep 17, 2013 03:32 hrs

Given the volatile equity markets, investors are seeking comfort in debt instruments. While bank fixed deposits (FDs) are the safest bet, the returns are not able to beat inflation. But should high yields be at the cost of credit quality? The recent rout in the debt market has shown that even in debt instruments there can be loss of capital.

In such a scenario, are secured non-convertible debentures (NCDs) a good option? Or should one look at tax-free bonds? What about tax-saving bank FDs? After Srei Infrastructure Finance and Muthoot Finance, the latest non-banking finance company to come out with secured NCDs is India Infoline Finance Limited (IIFL).

IIFL's NCD issue is opening on Tuesday. The interest rate offered on the monthly option is 12.68 per cent and in case of the annual option, it is 12 per cent. But the post-tax returns for someone in the 30 per cent tax bracket are 8-8.5 per cent. IIFL's NCD has a credit rating of AA'. So, if you get similar yields from another instrument with a credit rating, you should consider that.

Ashish Shanker, head, investment advisory, Motilal Oswal Private Wealth Management, says given the deteriorating credit environment, investors themselves are conservative and aware of the risks of investing in such instruments. That is why a lot of money is going to Fixed Maturity Plans (FMPs). "In this market, if you want to invest in debt, it does not make sense to take risk. We prefer companies which have a more diversified book. So, we are advising investors to look at bond issues of highly rated public sector companies, which will hit the market soon,"' Shanker says.

IIFL's NCD could be a good option for those in the lower tax bracket. For those in the higher tax bracket, tax-free bond issues work out better, says Raghvendra Nath, managing director, Ladderup Wealth Management.

For those in the highest tax bracket, returns from REC's recently launched tax-free bonds work out to be over 12 per cent. The issue, closing on September 23 is better in terms of risk profile, since it is rated AAA' and has sovereign backing.

Since IIFL is an NBFC and is in the lending business, the overall risk is higher as compared to, say, a manufacturing company. Therefore, investors should be aware there will always be credit risk associated with such NCDs, says Feroze Aziz, director and head, investment products, Anand Rathi Private Wealth Management. Of the other two recent NCD issues, Srei is offering 11.75 per cent and has a rating of AA' by one rating agency and AA-' by another. Muthoot is offering 12.55 per cent and has a rating of AA-'. In the case of Srei, credit quality is better due to a diversified loan book. With Muthoot, the risk is higher because its loan book is comprised largely of gold loans and gold prices have been extremely volatile.

Since more public sector units will be launching tax-free bonds, it is better to wait than rush to invest in NCDs. Given the tight liquidity conditions, there are chances that interest rates could go up. That could fetch you better yields if you wait. In case interest rates go up, the price of NCDs will go down, which means a loss of capital on your investment. But that will not be an issue if you remain invested till maturity.

One advantage of NCDs is that they are of shorter duration, up to five years, as compared to tax-free bonds' 10-20 years. But you can consider tax-saving five-year bank FDs, currently offering 8.75-9 per cent. One-year FMPs are also offering 9-10 per cent. For risk-averse investors, these are better options than NCDs.

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