Beware of the new low risk, high return promise
Products such as perpetual bonds may carry an aura of security, but in reality, there is not much to celebrate.
Sellers of equity products never fail to tell you that their products are subject to market risk. It is another matter that you only understand these risks with experience. But when it comes to debt, risk is not the key word. After all, your investment in debt is supposed to cover your other risks!
Over the past couple of years, sellers of debt products have gotten better at a narrative of high returns with little or no risk. Yes, we are talking about products like perpetual bonds, market linked covered bonds / bonds, mortgage backed bonds and even some of your debt funds.
In an age when your FD bank rates are low, a promise of disproportionate returns for low risk can be an easy lure for you. But at times like these, it’s best to go back to the basics of investing: when you have a product that offers much higher returns than your FDs, where and how does that return come from? Let’s take a few examples to highlight the risks of these products and why the “buyer beware” doctrine is more important than ever if you are a retail investor.
In 2019 and early 2020, perpetual or Additional Tier I bonds (AT1 bonds) issued by banks were sold to retail investors by the banks that issued them. What was the selling proposition? That AT1 bonds are high yield substitutes for bank FDs or non-convertible debentures. But this promise was far from the truth. First, these products are allowed to ignore interest payments if their Tier I principal falls below a certain level or if they experience losses or have insufficient reserves. They have no obligation to pay you later and cannot be sued for it. If that’s not a significant variation from your humble FD, here’s more.
Second, although there was no maturity date, perpetual bonds were often poorly sold as time-limited bonds. These bonds only have a “call option” and not a maturity date. This gives the borrower the right to redeem the bond after, say, 5 or 10 years. But this is an “option” and not a mandate. So if you need the cash at any time, you will have to sell in the market. It can also be at a loss if they are poorly traded or if the interest rate cycle is unfavorable.
The final nail is that the RBI can order a bank to waive this obligation entirely (remember Yes Bank’s perpetual bonds?) If it believes the bank is at a point of non-viability (PONV) or requires a injection of capital by another public sector bank to avoid disappearing. Yes, your capital can be written off and you will have no recourse. Now it’s worse than owning stocks, where you can at least get a market price for your assets.
A newer popular product among retail investors are Covered Bonds / Market Linked Debentures / Structured Products. These alternative investment products, previously available only to at-risk HNIs, are now made available to retail investors, apparently to give them “access to high-yield products”. Take the now popular covered bonds. These bonds, which are nothing more than a pool of loans, are sold with the security of an asset-backed, usually property or gold – two assets that immediately give you the illusion of security!
But if these bonds are safe, why are they earning you 10-11% versus 6% in banks? So here’s what you won’t know unless you dig. The loan pool that is packed to give you this bond usually comes from an NBFC that is not blue chip. Why do they need this money at such a high rate? Probably because they are unable to find funding through the usual channels or because they have a high cost. Why is that ? Because these NBFCs don’t have a high credit rating – with an A or even BBB rating.
And, as you can guess, a lower rated NBFC’s asset pool is unlikely to be made up of quality borrowers! But what about the real estate deposit? Yes, this can be liquidated if your due is not paid. But wait, aren’t the banks doing this for a living and struggling to sell and monetize these assets? Doesn’t it take time? Does it really give you a greater sense of security? And remember, there is no bond buyback reserve. There is no ₹ 5 lakh deposit insurance here as in the case of a bank. Besides, the RBI can come to the rescue of a sinking bank but did not do it for a sinking NBFC! In other words, there is a lot to find out before you can even consider a covered bond.
Then there are the super-rich market-linked debentures or MLDs (covered bonds can have this feature as well), which simply means that your promised returns are dependent on keeping a given benchmark at a certain level. In other words, you might not even receive interest if the index drops below a certain level. Much of what we have mentioned about covered bonds also applies here. But the appeal is this: MLDs benefit from a tax on shares, simply because they are (apparently) linked to the market!
I could keep adding to this list as these products are now innovating at a rapid rate while all other fixed income options are paying poorly now. In your fear of missing out (FOMO), don’t break the cardinal rule: If an investment product comes with the promise of higher returns, it also comes with a baggage of higher risk. In debt, this risk can mean not only zero return but also zero capital!
(The writer is co-founder, Primeinvestor.in)