Capital Gain

How you should evaluate returns from bonds

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Retail investors have flocked to the ₹5,000-crore bond offer from Power Finance Corporation (PFC), prompting an early closure. One hopes they’ve applied with a good understanding of how this bond compares to other fixed-income avenues. The offer did have some attractive options for retail folks. But reports that did the rounds of the mainstream and social media suggested that when it comes to evaluating bond returns, it is quite okay to compare apples not just to oranges, but also to grapes.

Mind the risks

Company officials promoting the PFC bond were eager to explain how it offered better returns than the National Savings Certificates (NSC). This isn’t strictly true. But even if it were, higher rates on the PFC bond, far from making it more attractive, would indicate higher risks to your capital. In the bond market, high interest rates correlate directly to credit risk.

As a key lender to the troubled power sector with gross NPAs of 7.4 per cent in FY20, PFC’s business carries a fair degree of risk. This is mitigated by the Government of India owning 55.9 per cent stake in PFC, lending it a quasi-government status. The PFC bond is a riskier instrument than the NSC because the latter is Central government-backed and doesn’t require you to take on any business risks.

When evaluating an NCD, it is best to see how much of a spread (extra return) it is offering over a risk-free instrument, which is a Central government bond. Today, the market yield on the five-year government bond is 5.3 per cent. At 5.8 per cent, the five-year PFC bond offered a 50-basis point spread over the G-Secs.

At 6.8 per cent, the NSC, which carries lower risks than PFC, offers 150 basis points (bps) over the G-sec, making it a better choice. The average spreads on five-year AAA, AA and A rated bonds over comparable government securities are currently 37 bps, 104 bps and 300 bps, respectively.

 

Check tenure

Bank fixed deposits tend to be the default option for investors seeking safety. So, many comparisons have been made between the PFC bonds and bank FDs. Most of these are simplistic comparisons of 5- and 10-year PFC bonds (coupons of 5.8 per cent and 7 per cent) with SBI’s 1- to 5-year deposit rates (5-5.4 per cent).

But it is plain wrong to compare rates on a 1-5 year instrument with a 5-10 year instrument. In the fixed-income market, investors are always compensated for longer holding periods with higher rates, given the time value of money and higher business uncertainties that come with lending for the longer term. If you would really like to compare PFC’s bonds with bank FDs, you would be better off looking at similar tenures. PFC’s three-year bond offered 4.8 per cent against the 5.3 per cent on SBI’s three-year FD. Its five-year bond will fetch 5.8 per cent against 5.4 per cent on the SBI FD.

Even then, the decision on the tenure of fixed-income security what you should buy should be based on your view on how interest rates will move in future and not on absolute rates.

If you buy a 10-year bond today and rates move up in the next 2-3 years, you’d risk capital losses if you try to switch to better-rated instruments.

 

Beware of market risks

Some have compared PFC bonds to debt mutual funds and concluded the latter are better.

Debt mutual funds which invest in high-quality bonds (corporate debt funds and PSU & banking funds) have delivered category returns of over 9 per cent for one year and 8 per cent for three and five years.

But comparing trailing returns of debt funds to the future returns on PFC bonds is akin to zipping on a highway using the rear-view mirror.

Returns on debt funds in the last one, three and five years have been boosted by falling rates triggering bond price gains.

Should rates bottom out or begin to rise, these gains can swiftly turn into losses. To gauge future returns on debt funds, the current yield to maturity (YTM) of their portfolios and their expense ratios are more useful.

Current YTMs of corporate bond funds are in the 4.5-5.5 per cent range with annual expenses at 0.4-1 per cent for regular plans, pointing to returns of 3.5-5.1 per cent from here, without budgeting for rate hikes. PFC bonds, by offering you a predictable 5.8 per cent for five years, are a better bet if you think rates are bottoming out.



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