S Murlidharan

Ring out equity, ring in debt

S. MURLIDHARAN | Updated on March 10, 2018

Infrastructure bonds… A catalyst for growth of bond market. — P.V.Sivakumar

The much-hyped equity cult built admittedly in part by the redoubtable Dhirubhai Ambani has, alas, come home to roost, with the hapless middle-class chary of equities, having burnt its fingers repeatedly. Both corporates and investors have not taken a fancy for corporate bonds, and have done precious little to make these bonds attractive. This perhaps explains the lack of debt culture in the country.

Pundits aver that investors would subscribe to bonds if there is a healthy market for them, so that they can profit from the fluctuation in the interest rates, given that the price of the bonds in the bourses and the current interest rates are inversely related.

To wit, let us say an investor has subscribed at par to an 8 per cent bond with a face value of Rs 1,000 and with a maturity of five years. Three months later, let us say the interest rates in the economy shoot up, and fresh offerings for similar maturity have to fork out 10 per cent interest.

The first bond would register a, fall to Rs 800 — to a buyer in the market it gives the same present yield of 10 per cent, that is, Rs 80 on an investment of Rs 800. And should the reverse happen, that is, should the interest rates fall to 7 per cent, the first bond would climb to Rs 1,143 approximately so as to reflect the current interest rates — Rs 80 on an investment of Rs 1,143 yields 7 per cent, the current rate.

Such inverse relationship might entice a financial savvy investor but the truth is households would evince greater interest in bonds if they are resilient enough to offer higher interest to compensate for the ravages of inflation. And this precisely is what the inflation-adjusted interest rates would give them and, in fact, gives them in the western markets including the US.

Steady, assured income

Let us say the bonds of a company carry a coupon rate of 8 per cent per annum. Should the annual inflation rate be 6 per cent, the company would have to fork out 8.48 per cent as interest on these bonds. Of course, this calls for a reliable inflation index being published timely and with authority sans the manoeuvring that has shamelessly gone on over the last couple of years in the fixation of Libor.

In other words, for the common man with an eye on steady and assured income, inflation-adjusted interest is what the doctor has ordered, given that inflation takes a heavy toll of fixed-income earners.

Households do not have the time and inclination for making profits from interest rate swings, the raison d’être trotted out by the market enthusiasts for investments in bonds. On the contrary, they are likely to fall over themselves to subscribe to inflation-adjusted interest carrying bonds.

When we can have flexible interest rates for home loans; when we can have a regime of computing inflation-adjusted cost of a capital asset while calculating capital gains tax; when we compensate our government employees with inflation-determined dearness allowance and our long-term contractors with price escalation clause, a fortiori, we should have, in all fairness, flexible interest rates on bonds as well.

This may not be required for savings bank account because people place their money in deposit accounts of their own volition, whereas with bonds, the invitation for subscription comes from the corporates, and it is for them to supply the necessary sweeteners.

Perhaps the government should take the lead by asking government-owned infrastructure finance corporations such as IDFC to offer inflation-adjusted interest on their bonds that would most certainly act both as a catalyst for the growth of the bond market as well as something the corporate world would immediately like to emulate.

Tax sweeteners

Tax incentives goad taxpayers into action. Therefore, it would be in the fitness of things if the extra interest paid relatable to the inflation is allowed a weighted deduction of, say, 150 per cent.

To wit, if the coupon rate is 8 per cent and the inflation rate is 6 per cent, thus making a grand tally of 8.48 per cent, the amount of interest attributable to the extra 0.48 per cent should beget the corporation a 150 per cent deduction, a la R&D spend, which begets now a whopping 200 per cent deduction that encourages both charlatans and wannabe researchers.

And just as earners of capital gains are spared the burden of having to pay tax on the illusory gains represented by inflation, the interest earners from these bonds should also be spared the burden of paying tax on interest that is compensatory in nature — to cushion the impact of inflation.

In the above example, it would mean, while the coupon interest of 8 per cent should be taxed, the extra 0.48 per cent shouldn’t be.

The cost inflation index, published by the Central Board of Direct Taxes (CBDT), for calculating capital gains comes with a year’s lag. This would not do for interest payments. A more nimble-footed calculation and dissemination would be required. This is something that can be worked out satisfactorily.

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

Published on August 01, 2012

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