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Need to promote bonds, rather than equity

S. Muralidharan
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Bonds will ensure greater corporate discipline in the use of capital.
Bonds will ensure greater corporate discipline in the use of capital.

If the government of India wants investors to switch from equity to bonds, it must dispel the notion that equity is a low-hanging fruit.

The overwhelming response to the NHAI tax-free bond issue — subscription received thus far for Rs 25,000 vis-à-vis the issue size of Rs 5,000 with a green shoe option to accept another Rs 5,000 crore — holds out several lessons, especially to policymakers.

The equity cult has proved to be evanescent, and by and large a mirage, with the share market proving to be the happy hunting ground only for the well-heeled, and those with their ears to the ground, namely, insiders and their hangers-on and to a lesser extent, institutional investors.

To be sure, the secondary market has been disciplined over the years and made transparent, but that alone cannot be cause for cheer for the average investor. That investment in equity produces by far the best returns during a sufficiently long period of time hasn't served to assuage the feeling of hurt in him — given the prolonged spell of gloom and numerous instances of listing losses, when what he was looking forward to was listing gains.

The FIIs, the darling of gung-ho liberal economists, have always been fair-weather friends, especially in the absence of a Tobin tax deterrent that can tie them down to the country for a decent length of time.

If, before the nineties, the market was said to be shallow, defying proper price discovery, the advent of foreign investors has made the Indian bourses vulnerable to the happenings abroad. Now more than ever before, the BSE sneezes when the NYSE catches cold.

RETURN ON BONDS

Policymakers in India should realise that investment in equity isn't the only counter. The bond market has always witnessed low volumes, the blame for which must be taken by the government on two counts — its gluttonous appetite for funds, crowding out private sector borrowings, and its laissez-faire approach to IPOs.

A thriving market for bonds would end the starry-eyed fixation with the mirage of equity. Bonds offer a higher coupon rate vis-à-vis safe bank deposits, besides allowing capital gains, given the inverse relationship between bond prices in the bourses and the interest rates.

A Rs 1,000 bond, carrying an interest of 10 per cent per annum, maturing after ten years, would sell at Rs 1,250, should the interest rate for similar maturities fall to 8 per cent per annum, say, after six months.

Contrariwise, should the reverse be the case, that is, had interest rate risen from 8 per cent per annum to 10 per cent per annum after six months, the bond quotation would suffer a diminution to Rs 800. In other words, bond prices react to the new rates vis-à-vis the offer rates — if the interest rate in the economy for similar maturities falls below the offer rate, the bond is more prized, and hence commands a premium and vice-versa.

The rise or fall takes place to bring about parity in the return on investments. The short point is investors itching for action are satisfied even in the market for bonds. Unlike deposits, bonds then aren't static. There is a lot of scope for earning capital gains as well from investments in bonds, and by that token, for capital losses as well, though, admittedly, the scale of gains and losses wouldn't be as staggering as they can be with reference to shares, unless the issuer has gone bankrupt, or his securities turn out to be inadequate to pay off the investors, as is happening in Europe currently.

EQUITY ILLUSION

Companies in India have been preferring equity to bonds, secure in the knowledge that while interest has to be paid regularly, no matter what the bottomline is, there is absolutely no such compulsion in the matter of dividend — so much so that many companies tend to be not only blasé about the whole thing, but even have the gall to tell investors to seek their rewards from the bourses, ignoring blithely in the process that the investors gave their money to them and not to the bourses.

If the government of India, in fact, wants to make investors switch from equity to bonds, it must not only curb its own gargantuan borrowing tendencies, but also do everything in its power to disabuse the notion among the corporates that equity is a low-hanging fruit.

In India, investors in equity, without their knowing, often function as venture capitalists, a role that's reserved for the well-heeled and the knowledgeable, when they subscribe to shares of companies based on tall promises, with nothing to show for the nonce in terms of production, much less in terms of profits. Only companies with a performance record of profits for a sufficient length of time must be allowed to raise equity from the market, like in the US. All others have to seek venture capital assistance, or the less attractive but intrusive loans from financial institutions.

Bonds then drive home the message to companies that there is no free lunch insofar as capital is concerned. A hundred per cent dividend on a share with a face value of Rs 2, issued at Rs 525, translates into a yield of 0.38 per cent, given the fact that dividend in India is expressed as a percentage of face value. Alongside pure bonds, the government should also encourage investments in optional convertible bonds, so that companies behave more responsibly, and don't take investors for granted.

Foreign Currency Convertible Bonds (FCCB) allow the foreign investors to decide if they have to exercise their conversion option. So should the bonds issued to Indian investors. Optional convertible bonds would enable nascent companies to raise capital, with the bait being conversion on favourable terms.

(The author is a New Delhi-based chartered accountant.)

(This article was published on January 11, 2012)
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