Caveat Emptor Bonds can burn you too

Bonds are becoming increasingly popular, but don’t forget the inherent risks. Just because they are fixed-income investments, doesn’t mean that bond holders will get paid.

Many Indians are warming up to the idea of investing in bonds — both in India and abroad. Direct (government) bond investments are now possible through the Reserve Bank of India retail Direct online platform, brokerage firms, and even online bond platforms that have been established.PauseUnmute

Disclosing the interest of individuals in bond platforms, PayTM mentioned in June 2023 that 85,000 people had checked out the company’s bond platform launched on May 22, 2023.

In simple terms, a bond is an investment contract, where the issuer (usually a company or the government) borrows money from individuals and organizations. In return, the principal borrowed is repaid on maturity, while interest is repaid monthly, semi-annually, or annually.

Flourishing investment avenue

Now one has the luxury of investing in bonds from the comfort of one’s home. Recent changes in the taxation of debt mutual funds in the Finance Bill, of 2023, have also piqued the interest of individual investors in bonds.

Investors, however, need to deepen their understanding of bond markets. From what the ratings indicate, how interest rates in the market impact your bond, to different types of bonds such as green bonds, junk bonds, Additional Tier 1 (AT1) bonds, etc., you need to have a good understanding of how bonds work.

Apart from understanding the risks involved in chasing bond yields, one needs to understand that the priority of payment for each bond is different. Take the case of Siddharth Dhama, a Mumbai-based software engineer. When he invested in the L&T Finance Capital bond and Federal Bank Financial bond, he wasn’t aware that one of them was a secured bond and the other was a subordinate debt paper. Subordinate debt is one that will be paid after secured debt in case of liquidation. “I saw the coupon (interest) rate and checked if it had an A rating,” he told moneycontrol.com. He said that that was all he understood about bonds at the time. But that’s not enough.

Dharma is one of many. While awareness programs are regularly carried out for equity and mutual fund investors, there are hardly any for the complicated debt markets.

Wealth managers serving high net-worth individuals (HNIs) are aware of conditions in debt markets. But retail individuals haven’t yet learned the ropes.

“Retail clients who put money in unsecured or perpetual (AT1) bonds are mostly unaware about where bonds come in the payment hierarchy, as was evident when Yes Bank defaulted on its AT1 bonds,” says Manish Jeloka, Co-head of Products & Solutions, Sanctum Wealth.

While an ‘A’ rated bond signifies relative safety, a ‘B+’ rating indicates there are some issues with the company.

Also read: Will credit risk funds make a comeback?

“More learning is required to differentiate between issuers, especially when pricing between single-A and BBB-rated bonds is nearly the same,” said Goenka.

The payment hierarchy

Where your bond falls in the hierarchy of payments in case of default or bankruptcy of a firm or financial institution can be found in the bond issuer’s offer document.

While investing, one needs to understand the type of bond one is investing in, and whether the coupon rate is better considering the risks.

“Senior secured bonds offer the highest safety, followed by senior unsecured bonds, subordinate bonds, and AT1 or perpetual bonds, in that order. Among senior secured bonds, those that are issued against specific collateral tend to have a better recovery than those that are secured against the overall assets of an issuer,” added Goenka.

Can you change the order?

No. There is no way through which one can rise up the food chain to seek payments before others from firms that default.

“The enforcement mechanism in India does not allow for this,” says Jeloka.

While investing, one needs to understand the type of bond one is investing in, and whether the coupon rate is better considering the risks.

No consolidated statement

Ajay Marathe, a Mumbai-based retiree, invests in bonds only through the RBI Retail Direct platform. Hence, he is able to pull out a consolidated statement for all his bond holdings as he only uses one platform.

But for those investing across demat accounts, RBI Retail Direct, and other online platforms, there is no consolidated view that tells investors about the maturities of the bonds they hold.

Also read: Using RBI Retail Retail Direct for bond investing is safe, but not tax-friendly

The investor or the wealth manager would have to manually maintain an Excel sheet, or use some software to pull details from various sources. This makes it difficult for investors to track their bond portfolio, and maturity dates, and to pull out a common tax statement for the financial year.

National Securities and Depository (NSDL) and Central Depository and Services (CDSL) offer statements that give a consolidated view of one’s investments in mutual funds and stocks.

“All wealth management firms have systems in place that give their clients a single report of all their holdings. This helps clients analyze their returns and plan their cash flows,” said Jeloka.

But wealth managers with a smaller setup find it difficult to service requests for such statements.

“An automated portfolio view is not available unless all the investments have been made in demat format and the broking firm offers a statement. So, either the investor or the IFA (independent financial advisor) has to do it, which is cumbersome,” said Deepali Sen, an IFA.

Wealth managers also point out that currently there are few clients who directly invest in bonds. Hence, they are able to organize the data for their clients.

“Regulatory intervention can help address this,” said a portfolio manager not willing to be named. That would make life easier for retail bondholders, and also help expand the market.