There has been plenty of action in the bond market in recent weeks, with a number of new tax-free bonds hitting the market. What has added to the euphoria is the high coupon rate these bonds offer, thanks to the rising yield on the 10-year G-Sec, to which all these bonds are linked. There have also been other bond issues (taxable) by companies through non-convertible debentures, which have offered attractive rates.

Look to the secondary market

The easiest way to invest in these bonds is to subscribe at the time of the issue. However, there is no guarantee of allotment, as some of the issues get fully subscribed on the opening day itself. In such a scenario, the secondary market offers yet another avenue to buy bonds. For existing investors too, it is important to track the performance of their bonds in the secondary market.

This is because switching to other bonds may at times provide better returns, although most investors prefer to hold till maturity. Here’s what you should know when trading in the secondary markets:

Choosing among bonds

When an issue opens in the primary market, the coupon rate on the bond is clearly stated, which is the annual rate of return. But in the secondary market, the coupon rate does not matter. This is because the bond in the secondary market may trade below or above its issue price. What matters is the yield to maturity.

Yield to maturity (YTM) - is the effective return you can earn on a bond by way of interest and repayments, by buying it at its current price. As bond prices fall, yields rise and hence there is an inverse relationship between the two. YTM is calculated by arriving at the discount rate which equates the sum of all future cash flows from the bond (interest and principal) to the current price of the bond. This can be done with the help of a financial calculator or excel.

Let us understand this with some examples. The Rs 1,000 tax-free bonds issued by Rural Electrification Corporation in March 2012, at 7.93 per cent for 10 years, is now quoting at Rs 986 on the BSE, at a 1.3 per cent discount. Here, the YTM works out to 8.2 per cent and this is your return on the bond if you hold till maturity.

How does this compare with other options? Similar bonds issued by the company recently in the primary market offered 8.01 per cent (8.26 for retail investors).

Hence, we can see that although the coupon rate is lower, the yields in the secondary market have aligned themselves to the current rates.

If you have not subscribed to the recent public issue, you can buy in the secondary market instead, since the returns are comparable.

You should also compare other options in the secondary market. Power Finance Corporation (PFC) bond issued in Feb 2012, at 8.2 per cent interest is now trading at 2 per cent discount — YTM works out to 8.5 per cent. Since this bond is also AAA rated and offers attractive yields, this could be another option in the secondary market.

The caveats

Ideally in case of a rising interest rate scenario such as now, the price on existing bonds falls and there is an opportunity to invest in the secondary market. However, there are other aspects to consider too.

One is the credit risk of the issuer. In spite of the attractive price and yield, investors must refrain from investing in low rated bonds. Particularly as the macro environment is riddled with challenges, it is best to stick to AAA or AA+ rated bonds for now.

The perception of risks attached to a particular issuer may also alter the pricing of bonds in a similar category. For instance, India Infoline issued its NCD for 72 months in September 2012 offering 12.75 per cent. This bond in fact is trading at a premium of 4 per cent at Rs 1,035. The YTM works out to 12 per cent; closer to its recent public issue.

On the other hand, Muthoot Finance NCD which offered 12 per cent for a five-year tenure in Nov 2012, is now trading at a discount of 3 per cent. In spite of similar rating on both these bonds (AA-) one trades at a premium while the other at a discount as the market perceives the risk on both issuers differently.

The second factor to consider is the liquidity.

Unlike equity or G-Secs that trade on the exchanges under an order matching system, corporate bonds in the secondary market are traded over the phone via a broker.

Hence, when you need to buy or sell a particular bond for a particular tenure, the broker gives you the quotes available in the market. However, as the liquidity is negligible in most cases, actual trades happen at negotiated prices which are different from quoted prices, a majority of the time.

Finally, the trend in the interest rates is also a deciding factor. While older bonds are now trading at a discount, there is further possibility of a price correction as new issues may offer higher rates.

In such a scenario, it will be better to adopt a wait-and-watch approach till interest rates stabilise.

(This article was published on October 24, 2013)
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