Buying Bonds from Secondary Market – Go through the checklist

[P Nair]

Buying Bonds from Secondary Market – Go through the checklist

 

As trading in bonds catches up in India, you should gear up for gaining by focusing on the following important elements of the game

 

Bond markets have always been shallow for retail investors in India. In spite of the fact that bond (debt) markets globally are two-thirds of total securities traded, in India in a stock exchange like NSE total traded amount for bonds in the capital market segment is hardly Rs850 crore compared to an average volume of Rs1.25 lakh crore in the derivatives segment and around Rs15,000 crore in the cash market. CCIL’s NDS-OM segment has a huge volume in debt market but this market is largely accessed by institutional investors.

 

However, things have started changing gradually. With more and more bond offers hitting the market and getting listed on stock exchanges, the opportunity for retail investors has started increasing in this segment. IDBI has started a portal called Samrridhi which gives opportunity to retail investors to buy government bonds from the secondary market. In every auction of dated securities, a maximum of 5% of the notified amount is reserved for non-competitive bids by Reserve Bank of India (RBI) in which retail investors can participate and buy bonds in primary market

 

 These bonds can be subsequently sold in secondary markets.

While the opportunity in bonds market continue to increase and generate prospects of decent returns, it is important to be educated to buy these bonds. A wrong selection of bonds can be as risky as a wrong selection of stocks. Hence due care needs to be taken to buy bonds from the secondary market. Some of the most important factors to be considered while buying the bonds in secondary markets are as follows:

 

Understand clean price and dirty price: Bonds trade at clean price and dirty price in different markets. In India, bonds trade at dirty price in the NSE corporate segment. Dirty price is the price of a bond with accrued interest. This means that a bond trading in the NSE corporate segment has accrued interest included in it. Accrued interest is the interest that has got accrued on a bond from last coupon payment date. As a buyer of the bond, you are supposed to pay accrued interest to the seller of bond.

In CCIL NDS-OM segment on the other hand, bonds are traded at clean price and when you buy the bonds you pay clean price plus the accrued interest separately. So when you see the price quoted of a bond on CCIL NDS-OM, do not get misguided by the lower price as it does not include accrued interest. So the dealer through whom you buy these bonds will ask you to pay accrued interest separately and hence your effective cost of the bond will be accrued interest plus clean price which is equal to dirty price.

 

Coupon of a bond is not your return: If a bond offers a coupon of say 10% and you decide to buy this bond on basis of the coupon, you may end up making a wrong decision. In secondary market, you should look at the yield of the bond. Yield is your return and not the coupon. A 10% coupon bond may give 8% return only, if the bond price has gone up since the time it was issued, while an 8% coupon bond may end up giving 10% return if the bond price has fallen since the time the bond was issued. In bond market, an inverse relationship between the bond price and the rate of interest exists. Thus, while deciding to buy a bond from the secondary market, look at the price of the bond and its yield.

 

Map the maturity of a bond to your investment needs: Bonds are available with different maturity periods in the bond market. Very few of us would be aware of the fact that bonds with 30 years maturity are available in the market today. The RBI had issued a 2041 GOI bond with 8.83% coupon which currently trades in the market. This bond still has 30 years left for maturity which means that you can continue to receive 8.83% coupon on a semi-annual basis for this bond for next thirty years. However, as mentioned above, the yield of this bond is lower than the coupon. Some bonds are maturing just next year i.e. 2013. As an investor, you need to map the investment needs with bonds maturity and returns. It is important to note that bonds with higher maturity are impacted more by the interest rate changes both on upside side as well as downside. This means high-maturity bonds are more volatile than low-maturity bonds.

 

Look at rate of interest pattern in the economy (yield curve): Though yield curve is a hard nut to crack, as a retail investor you can look at trends in the rate of interest. In a falling interest rate environment, bond prices go up and you can benefit by selling bonds that you hold. So the ideal time to buy bonds from the secondary market is when rate of interest has peaked. For an investor holding bond till maturity, the change in rate of interest does not matter.

A high coupon bond may command low price: You will be surprised to know that Muthoot Finance N6 series bond which was issued at a face value of Rs1,000 and coupon of 12.25%, currently trades at around Rs960 while a mere 8.2% coupon bond of NHAI trades at a price of above Rs1,040. This price difference is important to understand. The bonds trade at different prices because of the risk perception of the market about these bonds. So a person who had bought Muthoot Finance bond from the primary market will make a loss if he sells the bond in the secondary market now while a NHAI bond holder will make gains while selling bonds in the secondary market.

As a retail investor it is important to understand and invest in bond market. Bond markets are low risk investments compared to equity but the risks of the bonds are good enough to cause loss to a small investor.

^{Source :MLF}

Best Regards

Prakash Nair