Beware of new low-risk, high-return promise

Products such as perpetual bonds may carry an aura of safety but in reality there is little to cheer

Sellers of equity products never fail to tell you that their products are subject to market risks. It is a different matter that you understand those risks only with experience. But when it comes to debt, risk is not the key word. After all, your debt investment is supposed to hedge your other risks!

In the past couple of years, sellers of debt products have become better at a narrative of high returns with no or least risk. Yes, we are talking of products such as perpetual bonds, market-linked debentures/covered bonds, home loan-backed bonds and even some of your debt funds.

At a time when your bank FD rates are at a low, a promise of disproportionate returns for low risks can be an easy lure for you. But at such times, it is best to get back to basics of investing: when you have a product that delivers far higher returns than your FDs, where from and how does that return come? Let us take a few examples to highlight the risks in such products and why the doctrine of ‘buyer beware’ is more important now than ever before if you are a retail investor.

Perpetual attraction

In 2019 and early 2020, perpetual or Additional Tier I bonds (AT1 bonds) issued by banks were sold to retail investors by the banks issuing them. What was the selling proposition? That AT1 bonds are high-return substitutes to bank FDs or non-convertible debentures. But this promise was far from the truth. First, these products are allowed to skip interest payouts if their Tier I capital falls below a certain level or they suffer losses or have insufficient reserves. They have no obligation to pay you later nor can they be sued for it. If that isn’t a significant variation from your humble FD, here’s more.

Second, although there is no maturity date, perpetual bonds were often mis-sold as limited-period bonds. These bonds only have a ‘call option’ and not a maturity date. This gives the borrower the right to redeem the bond at the end of, say, 5 or 10 years. But this is an ‘option’ and not a mandate. So, if you need the money any time, you will need to sell in the market. This can also be at a loss if they are poorly traded, or the interest rate cycle is adverse.

The final nail is that the RBI can direct a bank to fully write off this bond (remember Yes Bank’s perpetual bonds?) liability if it thinks the bank is at a point of non-viability (PONV) or requires capital infusion by another public sector bank to prevent going defunct. Yes, your principal can be written off and you will have no recourse. Now, this is worse than holding equity, where you can at least get a market price for your assets.

Safety illusion

A more recent popular product among retail investors are covered bonds/market-linked debentures/structured products. These alternative investment products, earlier made available only for risk-taking HNIs, are now being made available to retail investors, seemingly to provide them with ‘access to high returning products.’ Let’s take the case of the now-popular covered bonds. These bonds, which are nothing but a pool of loans, are sold with the safety of an asset backing, typically property or gold — two assets that immediately provide you with an illusion of safety!

But if these bonds are safe, why are they paying you 10-11% returns as opposed to 6% in banks? So, here’s what you will not know unless you dig in. The loan pool that is packaged to give you this bond typically comes from an NBFC that is not top-notch. Why do they need this money at such a high rate? Likely because they are unable to source funding through the regular channels or they come at a high cost. Why so? Because, these NBFCs do not have a high credit standing — with an A-rating or even BBB rating.

And, as you can guess, a lower-rated NBFC’s pool of assets is unlikely to be made up of quality borrowers! But how about the property backing? Yes, that can be liquidated if your due is not paid. But wait, don’t banks do this for a living and struggle to sell and monetise these assets? Is it not time consuming? Does that really provide you with greater sense of safety? And remember, there is no debenture redemption reserve. There is no ₹5 lakh deposit insurance here as in the case of a bank. Besides, the RBI may come to the rescue of a sinking bank but hasn’t done that for a sinking NBFC! In other words, there is much to uncover before you can even look at a covered bond.

Then there are the ultra-rich, fancied market-linked debentures or MLDs (covered bonds can also have this feature) which simply means, your returns promised is contingent upon a given benchmark index remaining at a certain level. In other words, you may not even be paid interest if the index goes below a certain level. Much of what we mentioned about covered bonds applies here too. But the lure is this — MLDs enjoy equity taxation, simply because they are (seemingly) linked to the market!

I could go on adding to this list as these products are now being innovated at a fast pace when all other fixed income options return poorly now. In your fear of missing out (FOMO), do not break the cardinal rule: if an investment product comes with the promise of higher returns, it also comes with the baggage of higher risks. In debt, this risk can not only mean just zero returns but also zero capital!

(The writer is Co-founder,

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