Retail investors don’t seem ready for complex offerings
PremiumWe should offer easily grasped bonds that are both safe and tax-free instead of government securities
The 7.72% GS-2025 bond has a yield of 6.83%, while the 8.20% GS-2025 bond has 6.92%. Both are for the same tenure. Yet, their yields differ. This is confusing for the retail investor looking to enter the market for government securities (G-Secs) that was opened up by the Reserve Bank of India (RBI) through a direct retail window. This basic anomaly can explain why retail investors won’t flock to the debt market.
Retail G-Secs have evinced little interest as the market is hard to understand. The yield on a bond changes regularly and moves inversely with its price. The layman must do some hard thinking to grasp what is going on.
To begin with, understanding how these bonds are named is a challenge. There can be multiple bonds with a similar date but different coupon rate. There are, for example, five securities with 2031-32 as their maturity dates, which makes them 10-year bonds. Second, once the security is bought, it may not be traded again for some time, as not more than five are heavily traded (which serve as benchmarks) and maybe another 5-10 would be on the screen with more than 10 trades a day. This also means that if one wanted to sell the bond, it is possible that there would be no buyer, as only benchmark papers are usually traded. Liquidity is thus a challenge here. Whoever enters the market should be prepared to buy a security and hold it to maturity after calculating the implicit yield at the time of purchase. Also, note that irrespective of the price paid at the time of purchase, the investor will receive the bond’s face value of ₹100 on its maturity. Third, the security that one buys today, say the benchmark, 6.54% GS-2032, after a year becomes a 9-year paper and will just move off the trading screen. A new 10-year benchmark will emerge with a suffix of GS-2033.
In such a situation, should we really be encouraging retail investors to get into this unknown territory?
As financial markets have evolved with more sophisticated products being offered and made accessible to everyone with the aid of technology, there appears to be a strong case for retail participation. When it comes to the market for corporate debt, one of the recommendations made is that there should be more retail participation. But one company will have dozens of securities that are listed, though none may be traded. For the commodity derivatives market, a similar case is put forth for expanding the contours of this segment on the logic that if retail investors are buying equity derivatives, then commodities should not be far behind. This logic can be extended to the forex derivative market too, where individuals could take advantage of currency rate movements.
At the same time, our markets regulator Securities and Exchange Board of India (Sebi) worries about the mis-selling of financial products. The question asked is whether or not the retail investor knows the implications of the product she is buying?
Under the umbrella of financial inclusion, a lot of effort is being put in to improve financial literacy, which includes helping people go beyond plain vanilla bank deposits. But this has major pitfalls. In fact, even for bank deposits, few were aware that there is an upper ceiling for insurance and all savings above ₹5 lakh are technically exposed to risk. Also, remember the case of a private bank that had several investors for AT1 bonds (i.e., perpetual bonds counted as a part of its capital)? These had no insurance and once it collapsed, this money was lost. Umbrage was expressed when AT1 investors found that these bonds were unsecured. But then people can be excused for being naïve, as a bank that usually has protected deposits may be assumed to issue protected bonds too, which was not the case here.
With little knowledge to go around, expecting retail investors to buy bonds of either the government or corporates is fraught with the danger of future regret on account of current ignorance. Government bonds are at least safe, as they are sovereign-issued, but in the case of corporate bonds, there have been instances of large defaults, especially in the non-banking financial company space, even by some of India’s better rated companies.
It is often said that ideally retail investors should not enter these markets directly and instead use the mutual funds (MFs) route. They can choose the type of fund that they would like to invest in and get the advantage of portfolio diversification too. But here, too, no one can take returns for granted. In case of, say, a gilt fund, as bond prices move in the opposite direction of interest rates, a rising interest rate scenario will not augur well for the net asset value of a debt scheme. Education on downside risks is needed for MFs too.
An interesting conclusion emerges here. A retail investor who enters the market for equities, debt or MFs cannot escape risk. For a G-Sec, if the idea is to buy and hold till maturity, it would make sense, as the return is guaranteed, unlike the gilt fund which can lose value. But G-Secs offer less flexibility in terms of selling it before their due date. Bank deposits provide such a cushion.
The way to draw retail investors into the Centre’s borrowing programme by offering higher returns than bank deposits is through tax-free bonds. While these have been discontinued of late, they could be relaunched. Earlier, it was done by public sector units. But there is no reason why the government cannot keep such an attractive window open for a part of its annual borrowing agenda.
This option needs to be considered by the government as a way to provide alternatives to retail investors.
These are the author’s personal views.
Madan Sabnavis is chief economist, Bank of Baroda and author of ‘Lockdown or Economic Destruction’