Bonds Part III: Cumulative Vs periodic interest payment

This is a 3 part of the series of post on bonds. I have designed this post as a water fall model:

1. The most common bonds in most portfolios are the infrastructure bonds and other bonds bought as part of 80 C, 80 CCF etc. These bonds usually give lower than market rate returns and have a stringent lock in period etc. If you intend to buy such bonds then ALWAYS GO FOR THE ONE WITH COUPON RATE. This way only your capital would be locked and interest (which is about 8-9% of your capital) would be returned back to you annually for reinvestment (probably in another tax planning instrument for next year) This way one can recycle the capital to ensure maximum tax benefit with least amount of capital being locked away.
2. Default risk: Simply put most companies irrespective of how harsh the times are somehow manage to pay the interest rate. However when the time comes to pay back the principal, the company faces issues. This is primarily because companies tend to prefer to roll their debt. i.e. issue fresh bonds (from retail or via banks/FI) and if their standing in the industry falls, this could become difficult. Looking at the recently open issue (10.75% interest over 15 years) 10,000/- has a maturity amount of 46,255/- So if I were you, I would prefer to get an annual coupon rate, reinvest it in another bond and diversify so that even in case of default I am able to capture back 36,255/- of the 46,255/- maturity value. However if you are subscribing to public sector bonds/bonds with explicit/implicit sovereign guarantee then move to point 3.
3. Interest rate trend: If you believe that interest rate are going to go up in the future then go for shorter duration bonds and in that one with most frequent interest payment (monthly/quarterly/semi-annually). More frequent the coupon payment, lesser would be Macaulay Duration and hence lesser sensitivity of your portfolio to interest rate hikes.
4. Trading: As mentioned in the previous point. If you don’t intent to hold the bond till maturity and sell it once the interest rate falls then probably you would make more money by going for the cumulative bonds.
5. Liquidity requirements: Pension holders prefer monthly income bonds which allow them to cover a part of their monthly expenses by bond income. On the other hand if you are young and intend to save money in bond so that you could buy property/car etc. then go for cumulative bonds that way your savings would be inflation proof (at least partly)
6. Your job/financial security: You won’t find this in any book, but for guys like me who are expected to bring food to the table but don’t have a secure government job, I prefer periodic interest payment. My logic is that these interest payments would ease my liquidity crunch which could arise due to sudden loss of job/income source. This way I don’t have to dip into my investments (which like selling gold ornaments could be very depressing) and if I don’t need the interest money, I could always reinvest and increase the diversification in my portfolio.
7. On the other hand if you are the secondly breadwinner (usually the wife) or have a secure govt. job, then all things equal I would go for cumulative bonds. Again based on your personal preference even a mix and match would not be something I would proscribe.

I hope you found this useful. Please feel free to add to this post or highlight the fault in my logic.


Bonds Explained: Part II: Bonds vs. Debt Funds

This is in continuation with the Bond vs FD post. Please refer to it for some technical jargons.

Contrary to popular perception, one can actually lose money in a guild fund. When the interest rate goes up, the bond becomes less valuable. (as bonds offering higher interest rate are available in the market) For more details please refer to Macaulay Duration ( Also fund managers are required by law to disclose their portfolio and they usually don’t churn their portfolio frequently enough. So if I were you, instead of investing in a guild fund, I would invest directly into the individuals bonds and save on the Fund Management fee, exit fees etc.

Why my financial planner never told me about them. Simple look at who is paying them…. Usually it is the firm selling the financial products. So if you invest in a 15 year bond then he/she can be assured that you won’t touch that money for the next 15 years. So there goes all the commission that could be made when you switched from one fund to another every 6 months.

PS: There is a slight difference in tax implication in various instruments, but since I don’t have an official degree in Tax, I would advise to consult your tax planner.

Bonds Explained: Part 1: FD Vs Bonds

SBI and Sriram motor finance bond issue was oversubscribed many times on the opening day itself would make one wonder why people go for the bond issues. After all Fixed Deposit has many advantages

1. Sovereign guarantee: RBI offers banks a lot of protection enabling them to raise capital from public and RBI itself at a very discounted rate (sometimes at a cost lower than then that of government borrowing) and in return RBI forces a lot of lending norms to ensure a healthy balance sheet and growth in the nation.

What it means: There is an explicit insurance that all customers who have deposited money with the RBI approved bank would get back at least a minimum assured amount. Also what has been seen is that generous bailout packages and doles are given to sick banks enabling them to not default.

1. Flexibility: You can walk into a bank (or order online/phone) anytime and open up a Fixed deposit of whatever tenure that suits you. Also after paying a nominal penalty, one can also close the deposit and withdraw the money back
2. Best interest rate: If the interest rate are up, no problems. You can close the fixed deposit and reopen it at the prevailing rate.

Benefit to senior citizens: I have never understood the financial logic of offering higher interest rate to senior citizens, but they do exist. Bonds make no such distinction.

Compared to that Bonds offer:

1. Higher interest rates: Remember the Risk Return Graph (CAPM )
2. Higher risk: The bonds of a firm are worth something only as long as the issuer is capable of paying you back (or as in case of Essar… willing to honor its debt). So watch out for shady firms with weak balance sheet issuing debt. However a lot of public sector firms and blue chips regularly issue bonds so there is no scarcity of good issues, but care needs to be made while selecting.
3. Longer duration: 10-15 year bonds are not uncommon, while rarely people go for fixed deposit with maturity of more than 3 years. Hence good quality bonds make an excellent retirement portfolio addition.
4. Less Liquidity: Companies don’t raise capital (from public) everyday and looking at the previous few issues it is a seller’s market. The company decides the interest rate, the terms and conditions (esp. the call schedule) and also when they want to issue the bonds. Also except on the explicit put/call dates it is very hard to get the money back from the company. Also most bonds are very thinly traded.
5. Demat: Now days most bonds are issued in demat format. This helps in liquidity a lot. Even if the bonds are not being traded, you can transfer it to one of your friends or relatives for cash/other consideration. I have done this OTC transaction for both bonds certificates in physical as well as demat format and trust me demat is so convenient (provided you have a buyer)
6. Convertible option/Debentures: A lot of company sweetens the deal by offering a convertible option. Shares for a predetermined price. So if the stock market rises, people can convert their bonds into shares at a discounted price. Else they can always get their money back.

Bonds allow you to capture the wealth created due to interest rate fluctuations. Interest rates are quite high these days and RBI has ruled against possible rate hikes in the future. (not very trust worthy as policies can change in the next quarter) Now say 2 years down the line you have a FD which gives you a solid 10% return and the prevailing FD rate is only 6%. Of course it is very frustrating because the bank will not compensate you for this extra interest rate that you are foregoing. Also FD are not transferable (you can take a loan but sometimes it does not make logical sense), however bonds trade on the basis of YTM (yield to maturity) and allow the holder to exit at a profit hence capturing the benefit of fall in interest rate. (beware you could lose also because of it)

Please look out for a post on Bonds vs Debt Mutual funds.


Property Prices

I am sure you guys must have read at least 1000 articles on property prices right now. So consider this article as a musing/ or notes to myself.

Being 28 years old with a stable job and a family’s future to secure, I am under tremendous peer pressure to invest in real estate. However I have second thoughts in investing 40L (about $100,000/- USD) for a small 1000 square feet big apartment or 1,200 square feet plot.

If I look at the affordability metrics, then I believe anybody earning 6L p.a. should be able to afford a 2 BHK house by paying no more than 40% of basic (or about 30% of his post tax take-home). So that is about 150,000/- INR per annum or 12,500/- per month. The rental for a decent 2bhk is around that value (this includes maintenance), but the opportunity cost on the house value is not of this level. Because by this calculation a 2BHK should not cost more than 15,00,000/- which is about 40% of the current valuation.

The primary reason for this mismatch is inflation/property appreciation. Rental in India is about 3% of the property value (i.e. a 10,00,000/- property would be rented out for 30,000/- p.a. or 2,500/- per month) and the owner expects that the rent and property value should increase for 7% per year (for an apartment).

But these days I have beginning to doubt this very hypothesis.

Firstly being a firm believer in the affordability pricing theory of assets, I would say that an antique, an autographed book, or even a stamp is worth what an collector can afford to pay. Land has become so expensive that no longer it is possible for someone to buy it unless they are ready to commit 60-70% of their income in housing. That includes lost interest on your own money; bank EMIs, maintenance of the property etc. So unless the salaries continue to grow at 15-20% per year for eternity, I don’t see housing expenses going down to 30-40% of take home, which to me is the worldwide average (and also the comfort zone for most individuals).

Secondly, I have beginning to doubt the very notion that an apartment is an asset. A land might be an asset which appreciates over time, but I know for sure the concrete structure crumbles over time. Periodically one has to pay to keep it from crumbling down and yet it will not last forever. Any civil engineer will corroborate, but no-one designs the structure to last for more than 60 years. With the quality of construction that our contractors do in order to meet their schedules and cut coroners, I would be surprised if they lasted for more than 40 years. After 20 years the apartment is labeled as old-fashioned, not too much attractive etc. and its value goes down. So after 20-40 years what is left is part ownership in a tiny piece of land. Surely that is not what you would intend to leave for your kids as your legacy and their inheritance.

Thirdly, the notion that the land prices will increase and the city will keep on expanding indefinitely forever is not what I am comfortable with. Pick any city and you would see the most coveted areas shifting over time. Old areas become too crowded for the rich and affluent people to live in. New malls/commercial centers/offices cause a shift in people’s commuting habits. Metro/ring roads/flyover encourage people to locate near them etc. Hence if I buy a prime property today, it might not be so much valued after 10-20 years. Buying land in the outskirts and hoping it to appreciate become the city would move in its direction is akin to speculation. My parents bought a house in Greater Greater Greater Greater Noida… So even though he calls it in Delhi, it took me 3 hours from the Railway Station (Connaught Place) to reach the spot. I if soon builders would be quoting land in Jaipur by saying just 6 hours away from Delhi… would be recognized as part of Delhi in another 5 years.

Remember whenever you buy a house look at the average occupant. If he/she cannot afford to pay the interest on the property price, then probably the property is overvalued.

It might be return of the saying “Fool make houses for the smart to rent into” but then I have not seen the future and I might be wrong. Comments/directions/guidance are more than welcome.

HDFC FD and Shareholder Loyalty programs

I remember that 14 years ago, when demat accounts just started, my broker joked:
A DEMAT account is just like a savings account. Only difference is that instead of the book keeping being done in INR, it would be done in RIL.

Maybe now one might not get the context of the joke, but at that time Reliance Industries was one of the most widely held companies in the world (not just India). For most people (esp. Gujarati) NIFTY/Sensex performance meant nothing, their entire portfolio consisted exclusively of RIL shares. (Of course many Indians also owned UTI’s Unit 64, but at that time it was never perceived as a mutual fund, it was classified as an fixed deposit scheme with annual dividends)

However there has not been any other Indian firm that has ever enjoyed so much of investor loyalty. HDFC has a simple and effective scheme. It offers its shareholders 25bps higher interest rate. Not too high to create a dent in its income statement, but just high enough to entice non-traders to consider buying the stock. (typically customers investing in Fixed deposit schemes are likely to be investors who invest in a stock and forget it for a couple of years… and not the typical trader/speculator which invests in indian companies)
Most Indian companies don’t pay much attention to shareholder relations (so forget shareholder loyalty). The quarterly results are not published in time, transcripts of earnings release are not published, annual report is sketchy etc.
However it seems that HDFC has realized that, thanks to BASEL norms for higher capital adequecy requirements, and robost growth in credit demand, no bank can grow at 15-25% yoy without having to tap into the stock market every couple of years.
Hence the determining factor between a bank that is able to grow and one that is not is its shareholder loyalty. Diverse shareholding pattern can help stock price survive bear runs. Hence enabling firms to grow in spite of the Dalal street sentiments.
Also firms are increasingly issuing ESOPs to retain talent. This would be effective only if the firm shows consistent growth in its share price. And the only way to do that is to attract investors rather than speculators.

PS: This post is less about how good HDFC banks are but more about why firms should develop shareholder loyalty programs and how little it costs them.

Futures and Options: Rolling Yield

Suppose instead of investing in the stock market, you put 3,00,000/- in a bank FD which pays you 7.25% interest paid every quarter (i.e. 5437.5/-). After this you go long on 90 day nifty futures. What you will observe is that typically they are available at a premium of 60-70 points above the prevailing spot rate. So net of brokerage 2300-1800/- every quarter. (more if you face an contangio or bearish market). Over the year this would translate into an additional gain of about 7-10k for every 3 Lakhs invested.

All you have to do is buy the nifty futures that expire after 90 days and hold it till the maturity date. On the maturity date you roll over the contract. I.e. pay 60-70 points premium and buy a new contract that matures after another 90 days. If the market goes down, the nifty contract will also lose the same amount hence making it a perfect hedge. Another advantage is the ability to leverage. Irrespective of the margin requirement, I believe that leverage higher than 5:1 in Indian market is risky. Hence by a minimal investment of 60,000/- you can have a market exposure of 300,0000/-

Note: consult your financial adviser before following the strategy blindly.

East India Company

Incorporated in 1600 was one of the first traded stocks in the world. There is no dearth of evidence that East India’s operations were highly profitable and they reaped profits in shiploads (boatloads). Apart from India, the company had near monopoly in trade with China (opium) and America (before Boston Tea party). It was so successful that it was called ‘The Company’ during its heydays.

What is surprising is that throughout its 2 century of profiteering, the company did not make much wealth for its investors. In 1772, no one was ready to loan money to the Company because of rampant corruption in the ranks. The top man, Warren Hastings was impeached on corruption charges and his predecessor Robert Clive also faced many corruption charges. In 1773 (when company was at its heights) the British Government passed Regulating Acts to control corruption. However Company’s finances never recovered and in 1857 it declared bankruptcy and transferred its assets (right to rule India) to the Crown.

I do not want to start a patriotic debate, but just want to raise the importance of corporate governance while choosing one’s stocks. Traditionally Indian businessmen were infamous for over-invoicing and pocketing part of the proceeds raised from banks/government and stock market. The practice has been slowly changing, but still there is no dearth of company which makes huge yoy profits and yet little or no dividend/capital growth.