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Sunday, Jan 25, 2004

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IDBI: A truly floating rate bond, at last

Suresh Krishnamurthy

Tax Saving bond: Subscribe
Regular Income bond: Avoid
Floating Rate bond: Avoid
Money Multiplier bond: Avoid

IDBI has reduced the rates on offer in the latest offering of Flexibonds. Compared to the offer made in December 2003, there is a 0.25 percentage point reduction in coupon rates. Among the lot on offer, the Tax Saving Bond appears attractive for retail investors. For `high net worth' individuals, the Floating Rate Bond and the Regular Income Bond too appear attractive.

Tax Saving Bond: The Tax Saving Bond is attractive from an investor's perspective, given the yield-to-maturity on these bonds, which is about 10 per cent. There are four options on offer. The first two offer annual interest and the other two are in the nature of deep discount bonds.

Deep discount bonds are tax-inefficient if one holds a portfolio of such bonds with a total investment in excess of Rs 1 lakh. In such a case, the tax treatment makes investing in deep discount bonds unattractive. However, for investors with less than Rs 1 lakh invested in deep discount bonds, these bonds are attractive, provided the limit under Section 80-L of Income Tax Act is already exhausted. If not, it would be better to opt for the annual interest payment option since it would provide better after-tax returns.

Option A and C of the Tax Saving Bonds have a lower term-to-maturity compared to options C and D. Given the prevailing interest rate scenario, opting for longer term options appear sensible. The coupon rate on the longer-term option is also marginally higher. However, if after three years, investors wish to park their money in substantially long-term debt securities of, say, 10 years or more or invest in an altogether different asset class such as equity, then the shorter-term option would be preferable.

Floating Rate Bond: Investors now have a truly floating rate bond to contend with. Floating Rate Bonds offered earlier did not link their coupon to the yields of government securities or had a cap on the extent of rise in interest rates. Importantly, this bond does not have either a put or call option. The yield on the bond is benchmarked to the secondary market yield on government security with a residual maturity of five years. The coupon rate will be 1 percentage point more than the yield on the 5-year government security. The interest is payable semi-annually.

The yield on five-year government security is now hovering at about 4.85 per cent. If the secondary market yields stay stable then investors would get about interest payments of 5.85 per cent per annum.

Indeed, this does not look attractive when compared to the coupon rate of 8 per cent offered by the Post-office Monthly Income Scheme. This bond is, however, not for investors who have money to invest only in small savings bonds.

High net worth investors will savour these features though. A rise in secondary market yields of government securities appears possible if credit growth in the economy rises sharply. Since economic activity appears to have improved, this bond does offer value to such investors.

There is, however, a catch. The coupon rate is to be calculated based on trading data for six days preceding March 5 and September 5 each year. Suppose trading in those six days are unusual and the yields, therefore, are low, investors may not be able to fully capture the benefits of any upward movement in secondary market yields of government securities. This, however, does not appear a substantial risk.

Other bonds: IDBI offers two other options for investors — Money Multiplier Bond and Regular Income Bond. Compared to small-savings schemes, the yields on offer are not attractive. So, if investors have not exhausted the limits available for investment in small-savings schemes, avoiding the IDBI Bond would appear prudent.

Compared to investment options other than small savings, the yields on IDBI Flexibonds are, however, attractive. For instance, the 10-year regular income bond offers 6.2 per cent.

This is higher than the yield of about 5.1 per cent that a similar government security offers. Similar-rated securities or bank term deposits also offer lower rates for retail investors.

In this context, investors with larger sums to invest can consider parking a portion of their surpluses in the 10-year Regular Income Bond. The Money Multiplier Bond is generally not suitable for investors with surpluses of more than Rs 1 lakh, since it is not tax-efficient.

On the other hand, for those with smaller sums, small-savings schemes are more suitable. As such, the Money Multiplier Bond appears unattractive to most investors.

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