WHAT IS THE CATCH IN HIGH-YIELD PSU BONDS ?

WHAT IS THE CATCH IN HIGH-YIELD PSU BONDS ?
5 min read . Updated: 10 Aug 2020, 03:25 PM IST - Neil Borate
Default in PSU bonds is not unheard of, so it's important to do your homework on the rating and financial health of the PSU in question

In an environment where bank fixed deposits (FDs) are offering interest rates of 4-5%, the lure of high-yield PSU bonds is compelling. These bonds trade at yields as high as 8-10% and are marketed by brokers and wealth management outfits to their clients.
We explain how they work and whether there is a catch to this investment product.

How do they work?
Brokerages buy bonds from institutions like banks, mutual funds and pension funds on the secondary market. They then sell the bonds to you at a higher price. For example, the broker might buy a bond at ₹100 and sell it to you at ₹102.

Another way of saying this is that they sell bonds to you at “lower yield" than the yield at which they buy the bond. Yield is defined as interest divided by price.

However, in spite of the broker’s cut, the yields on some of these bonds are extremely high and that is why they garner interest from investors.

Note that this kind of transaction (called over-the-counter or OTC) is completely opaque. The broker does not tell you exactly how much it has earned on the transaction. This is unlike, say, the expense ratio of a debt fund which is transparently disclosed.

The yields on offer

Yields on many of these bonds are far higher than the market rates. For example, UP Power Corporation Bonds of 2025 maturity are trading at 10-11%, while Rajasthan State Road Transport Corporation Bonds with 2022 maturity are being offered at 9%.

These higher yields usually have a good reason for their existence. The PSU in question might have a weak balance sheet or may be making losses.

Another category of high-yielding PSU debt is the perpetual bonds issued by PSU banks. These bonds are particularly risky because they can be written down when the capital of the bank falls below certain thresholds. The bank does not have to be bankrupt from these bonds to be written down. The bank can be bailed out and continue to function as happened with Yes Bank, even when the bonds are written off.

Taxation

The interest (coupon) on the bonds is taxed at your slab rate. However, if you buy the bond at a price more than its face value (called buying at premium) and hold it till maturity, you make a long-term capital loss (LTCL). This can be set off against long-term capital gains (LTCG) from any other asset.

Similarly, if you buy the bond at a price lower than its face value (buying at discount) and hold it to maturity, you will make a LTCG, which can be set off against a short-term capital loss (STCL) or LTCL on another asset. For example, if you purchase a bond at ₹110 but its face value is ₹100. At maturity, you will only get back ₹100 and you will make LTCL. You would make this kind of purchase at a premium because the interest rate on the bond might be higher than the market rate. For example, it may be 9% for a five-year term against the prevailing rates of 5-6%. Thus, while the coupon is taxed at your slab rate, the principal corpus may be taxed as capital gain or loss.

In case of listed bonds, the holding period for LTCG is one year and for unlisted bonds the period is three years. LTCG on bonds is levied at 20% and you get the benefit of indexation. However, for shorter holding periods, short-term capital gains (STCG) tax applies which is as per your slab rate.

Can PSU bonds default?

Yes, this is not unheard of. In September 2019, the rating of Bengaluru Metropolitan Transport Corp. (BMTC), a state government PSU, was downgraded by ICRA to D (default) on account of delays and irregularities of payment. At the time, BMTC had only bank loan facilities rather than bonds, but a downgrade equally impacts both kinds of borrowing.

“With regard to PSU debt, typically state government PSUs trade at higher yields to central government PSUs, especially in the case of state discoms. Defaults in state PSUs are not unheard of so you should check the credit rating and financial parameters of the borrower before investing in such bonds," said R. Sivakumar, head, fixed income, Axis Mutual Fund.

Fund managers also warn against investing in perpetual bonds of PSU banks (typically, classed as additional tier 1 or AT1 bonds). “I would not recommend state government-guaranteed or bank AT1 bonds for retail investors. Many jurisdictions do not allow AT1 bond sales to retail investors. Similarly, I would not recommend state government-guaranteed PSU bonds directly to be sold to retail investors. If anything, they can look at state development loans (SDLs)," said Rajeev Radhakrishnan, head, fixed income, SBI Mutual Fund. SDLs are state government (as opposed to state PSU) bonds.

What should you do?

There is no substitute for doing your homework on the rating and financial health of the PSU in question. Mere PSU status is not a guarantee of repayment. “I do not recommend direct purchase of high-yielding bonds, even if they are PSU bonds. You often cannot tell what’s wrong with the paper in question but usually something is. Instead go through a mutual fund where the fund manager has done some diligence on these bonds," said Kalpesh Ashar, founder, Full Circle Financial Planners and Advisors.

“You should study the credit rating and financials of the PSU in question. State government PSUs have unquestionably defaulted in the past. There is no iron-clad guarantee behind them," said Prateek Pant, co-founder and head, products and solutions, Sanctum Wealth Management.

Investors should be extremely cautious when such bonds are pitched to them by wealth management firms.