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How To Build a High Yield Bond Portfolio Using Retail Bonds

This is Capitalmind Premium post by Deepak Shenoy published in Oct 2018


Buying bonds has a certain set of advantages (and disadvantages) over doing something else. But first, what is that something else?


You could just buy liquid funds. Or ultra short term funds. Or just debt mutual funds. Which then will go and buy some of these bonds.


You could also, like many on twitter, bask in the glory that your favourite mutual fund house has bought only government bonds so there’s no risk or some such thing. But there’s one real problem here: the fund could quickly change what it’s buying, without telling you, and you just have to trust them to not to do something crazy.


In the short term, liquid funds have done reasonably well, but consider this – even the best liquid fund in terms of 3 month returns today (Quantum Liquid) is at 1.88% in three months. That’s a return of 7.5% in the last three months, which is ok, but not all that great. If you look at the bonds they own, their “Yield To Maturity” – the amount they are likely to get on their money today – is 8.26%. (Liquid funds invest in paper that matures in the short term.). But, the same fund has a cost of 0.65% a year – so they’ll get you 8.26%-0.65% = about 7.6%.


In comparison, buying a 364 day T-Bill from the government, today, would have given you  7.5%. No risk of default. Nearly the same return on a one year basis. 


But, you say, that’s a 364 day T-Bill! You have to lock in your money for a year!


Of course. But most of us don’t mind the 1 year fixed deposit, and don’t mind a one year lock in on our money. The 1-year horizon is mostly fine with us.


So compare it with longer duration funds, you might say. Something with a one year duration. These are now called Low Duration funds. That’s also possible, but those funds have an issue too.


Many charge you a high management fee, so your net returns fall to the 7.5% or 8% levels after fees anyhow. Others will walk down the risk path – and go buy stuff that could default (potentially) or see an impact of a rating downgrade. See a relatively less risky fund – HDFC Short Term Fund – which has a bunch of securities that you could say are safe: Like ONGC, or HUDCO or REC. But it also has an Indiabulls Housing Finance bond, and a Tata Sons bond and so on. Many of these are AAA rated today – but if there’s a fear in the debt markets, these could easily see a downgrade and thus, prices will fall.


If the net return, after all this, is just 8.4% or so (as their one month returns seem to indicate) then the extra risk isn’t actually being compensated. Why get a measly 0.9% more when you’re getting so much more risk?


To be honest, if you want 8.5%, you will get that much from some banks in Fixed Deposits nowadays.


Aren’t Bonds More Risky?


Government bonds – the shorter term ones – are not risky. If you buy a T-Bill and are willing to hold till maturity, the risk is even lower than an SBI fixed deposit.

Anything longer term has risk – this time it’s the risk that interest rates go up. In the last year, as rates have risen, even government bonds have seen negative or no returns – because longer term bonds fall in price when interest rates go up. However if you hold them till maturity, risk is lower.

Everything else has a risk. And it’s difficult to evaluate that risk. Let’s figure out if there’s an opportunity.


The Long Term Retiree: Lock in your Returns


In India, you can’t get good annuity products. Meaning, take a lumpsum and give me money every month. Insurers provide this, but they provide it at yields of 6.5% a year. That’s horrible. Plus you don’t get to withdraw more even in an emergency.

Banks offer fixed deposits, but even those are limited to 10-15 years. If you’re retiring and want to lock in income for 25-30 years, you don’t have a bank deposit that will guarantee it that long.

Government bonds, longer-term, offer that to you as a service. The 2055 bond – a 37 year bond – was traded at 8.28% yield today – which would effectively mean a fixed deposit at 8.28% guaranteed all the way till 2055. And if you have an emergency you can pledge it for a short term loan (it is considered super pristine) or even sell some of it for cash, even if there’s a risk of the price being lower.


You could also buy longer term debt mutual funds, but they don’t provide similar kind of guaranteed returns, and don’t match tenures (so they could hold shorter term bonds if they like and reduce your returns).


The point is: for a retiree who has no other income, the long term government bond, bought directly, is a very good option, and now, through brokers, we get access.


Creating a Risky Bond Portfolio


What if you’re ok with a little risk?


You might say: Look, I think IDFC Bank – which is a bank and has access to RBI funds – is showing me a 2021 bond at 10.84%. Now that’s not bad at all, and I don’t mind taking the risk of a bank if I can get 10.84%.


In about 2 years and 4 months, the bond pays out Rs. 10800. In one bullet payment.


IDFC Bank could go bankrupt, of course – but let’s say you’re okay with that risk. (Read more: we wrote about such bonds by IDFC Bank in the past)


Then, you can allocate part of your debt allocation to this bond. At nearly 11%, it’s a decent return for the period. (Note that in the long term, even an equity fund like the Nifty ETF has returned around 13%, and less than 11% in the last two years)


You could go even safer. There’s the PFC bond (Marked PFC BS2 there) That’s nearly at 10%, again for about two years.


You can see bonds in there that mature in 2020 (less than a year away) all the way to 2029 (10 years).

It can be useful to construct such a portfolio for a debt allocation.


Building a bond portfolio then can use the following metrics:


Narrow down on Risk


Go to issuers you find relatively safe. In the list, a PFC may be safe, as is an NTPC perhaps.Some risk will exist in others – like an SRTRANSFIN, an IDFC Bank or others.


Diversify


You don’t want more than, say, 10%-15% of your allocation to each issuer.That means you’re going to need 10 companies that are in your risk criteria, at least.Some companies (like PFC?) can be given a higher allocation say 15% or so, and others can be given a lower allocation like 5%.Also, you want some bonds maturing in the short term, others in the longer term. Shorter term risks are easier to assess. So say 30% of the portfolio matures in a year, another 30% in three years, and the rest in a longer term.


Estimate post tax returns


If in the end, the post tax return to you is too little, there’s no point.Every bond should yield, at the beginning, more than, say, 9.5%.Some bonds pay no interest, but a larger sum at maturity, this has a huge tax advantage. Because if you hold these bonds for more than a year, you pay only 10% tax on the gains if you sell them in the market. That’s like saying a 12% bond = 10.8% returns after you pay taxes.


Buy Carefully


This is a super illiquid market, so you can’t put market orders.Every single day, the same price means something else.Because every single day, you get one day closer to maturity.So for the same yield the price will go up.Unless of course, there’s an interest payment. Then, the price will go down.Cross check, and buy carefully. You’d have to buy in small amounts and build volumes over time.Don’t attempt to trade. There’s no liquidity.


Track and Sell If Necessary


This is a mad market. Bond yield can go even higher.But it won’t last forever. Yields will come back.Indeed, government 10 year bonds were trading at yields of 8.2% just last month, and have since fallen to 7.9%.Remember, inflation is at 4% or lower. The “real” return of bonds, even in the short term, is decently positive.If the market cools off, these yields of 11% that we are seeing now, are likely fall to more reasonable levels in the longer term.Let’s say the yields fall to 9% in a year – the IDFCBANK-N6 bond will trade at 9600 or so, a 13% return from today. That’s a good time to sell, if you find other opportunities at higher levels (or just want to derisk).Note: this applies to many “tax free” bonds today – they trade at 6% yields and were originally sold at 8%+ yields. Selling today and buying a different set of bonds at higher yields makes sense, when you can find liquidity.

And that, for a “high-yield” portion of your debt allocations. The rest can be in “safe” fixed deposits, if you like.


Liquidity Issues And Other Stuff


You can’t easily buy or sell these bonds. There’s not enough liquidity. But the bond market will deepen over time, and I believe there’s a lot more to come.


Next year onwards, if things go right, all companies need to issue bonds for about 1/4th of their borrowing. That will, hopefully, bring more liquidity into the retail market.

The current crisis in NBFCs is a sign that we need more participation, not less. Some of these NBFCs are paying 9%+ for 60 day commercial paper – and they are relatively sound companies. They might pay 10% for a longer term bond – and that won’t hurt them that much because they lend out at 18%.

Companies, too, can diversify away from bank loans this way. Banks can refuse to lend them money. (they are doing it right now to NBFCs). Mutual funds can refuse too (which is also happening to NBFCs). Having retail bonds will give them a fund raise alternative, even at higher rates.


In the longer term, liquidity issues should ease, but they won’t go away. Never buy unless you are willing to hold to maturity. And, never buy unless you’re willing to lose money in some of these bonds.


Lastly, this is a portfolio fraught with risk. Buying debt, especially when it looks like the debt markets are going to burn down, is a very difficult thing to even think of. But in that light, we should consider that sometimes, even good debt will fall in price and give great yields, simply because the seller is panicking or needs cash at any price. It’s useful to allocate a portion of a debt portfolio to such times (not all of it of course – because there’s that much risk).


If you want to know more:


When you should and should not buy bonds from the CM Bond Desk


An introduction to bonds for Indian retail investors



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