The recent issue of tax-free bonds – that is, the interest is tax free – by the National Highways Authority of India (NHAI) has listed on the NSE. There are two bonds – a 10 yr at 8.2% and a 15 yr at 8.3%. You can also buy these bonds now, if you have a broker. (The codes are NHAI-N1 and NHAI-N2)

Note: Please read the excellent comments by Anon. The interest rate is a weird beast which I've had to use XIRR to calculate.

Since the interest is paid once a year on Oct 1, every passing day accumulates interest inside the bond, so the price keeps going up. The bonds are Rs. 1000 each, so if the yield remains the same, they will go from Rs. 1000 on Oct 1 all the way to Rs. 1082 (on the 10 yr) on Oct 1 the subsequent year. (Actually it will be till Sep 16, which is the record date, but I'm not going there!). Interest will be paid and the bond price will fall by that amount (Rs. 82 in this case).

Here’s a sheet that shows you updated calculations based on current prices:

I’ve included the yield calculation for the 30% and 20% brackets (I doubt the 10%’ers will care)

The listing has been good, at 1032 / 1041, which is about 3% higher. That’s not great by equity standards , but for bonds it’s a nice deal. Let’s wait for the three others (PFC, IRFC and HUDCO) to list as well.

(Bookmark this page – it will update prices automatically, you can come back next month to check, if you like)

When you invest in a fixed deposit, the interest you receive is taxed as income. At the highest tax bracket, you pay 30% on that interest. That means a bank FD that gives you 10% really only gives you 7%. Even if you a a longer term investor in the FD, you pay interest every year. (And the bank deducts 10% as TDS before you even see it)

The government has allowed certain entities to give you tax free interest; if you are an investor for the long term, 10 to 15 years, in certain infrastructure companies. Two of them have already issued bonds (PFC and NHAI) and if you missed those, you can subscribe to the next two coming up from Jan 27: HUDCO and IRFC.

* Retail applications are for individuals, for under Rs. 5 lakh, and the higher interest rate is only for the first allotment. Any sale of the security will drop the interest down to the “Others” level.

The bonds will list on the NSE and BSE, and if you can’t get in now, you can buy them off the exchange. (PFC and NHAI bonds will list soon) and the interest will still be tax free. However, in the above two issues, the “coupon” rate paid on the bond will drop, for retail investors.

Since the bond interest is tax free, this is equivalent to a high interest yielding fixed deposit based on the tax bracket you are in. That is, if you had an interest rate of 30% at your highest tax bracket, a coupon rate of 8.35% means an equivalent FD of 12.08%.

But this is a silly comparison. There is no liquidity – of course the bonds are listed but there’s no guarantee that there will be someone willing to buy. Even if there is, the price someone may be willing to pay could be far lesser – in terms of effective yield – than the price you want (An FD can always be returned early with no loss of principal and perhaps a little penalty on the interest) This is like a 15 year FD.

You needn’t invest in an FD to get a similar return, of course. If you’re thinking of exiting in a few years, you may be better off with a longer term FMP, where the post tax returns are around 9-10% nowadays. These mutual funds lock you in similarly, and are listed, but the interest is not taxed till maturity; they tend to yield between 9-11% (this is the rate for long term commercial bonds nowadays) and the fact that you get an indexation benefit will make much of the gain non-taxable.

(A 9% return with inflation at 8% means only the excess 1% is chargeable to tax – even at the highest bracket you’ll make 8.70%)

The comparison, for those who are thinking of this bond as a 1 to 5 year investment, is better off with a similar tenure FMP, or if you choose to be a little creative, with a bond fund.

I strongly believe that we have overcomplicated our options. Thinking in terms of “you can’t compare this with a gilt fund” etc. are simply skirting the issue. People like to think in terms of “debt” versus “equity”, and then long versus short term. FD is debt, as is a bond fund, as is a HUDCO bond. If interest rates fall, a bond fund and the HUDCO bond will increase in market price, but nothing changes with the FD. If you are in for more than five years, and believe that interest rates will fall to below current levels, the HUDCO or IRFC bond is a good idea.

If you’re in for less than five years, consider a longer term FMP or a bond fund instead.

If you’re retired, these bonds are fabulous, because they give you cash flow on which you need to pay no taxes. And for fifteen years!

And finally if you’re a short term investor with the idea that you’ll speculate on these bonds, the trade will clear itself when the PFC/NHAI bonds list either Friday or Monday. Wait to see if there’s a listing gain available.

Data from CCIL shows that last Friday, the 10 year bond yield inched above 9%, which is inching towards the high of 9.35% set in July 08. (Note: that was just one month before it reversed)

The spreads are incredibly tight, but they’ve been that way earlier, in 07-08 as well. For yields to fall, there needs to be either a rate cut or a crisis (when people will run to the safety of government bonds).

Much has been made of the US 30 yr bonds now returning more than stocks. India is new in terms of data, and I acquired 20+ year bond index data from CCIL (only since 2004) and I plotted the five year returns, since November 2006, of the Total Returns Index in both cases. You need to take total returns – which includes interest paid for bonds and dividends for stocks.

Bonds can outperform stocks and as recently as September, the bond return came close to stocks. Remember this is when the 20yr+ bond index had a yield of 8.05% in Nov 2006, and is now at 9.06% (a rising yield means dropping prices, which means the principal component of your return is lesser today).

As a comparison, over the last five years, as of Nov 3, 2011:

Nifty Annualized Return: 8.33%
20+ yr bond Annualized Return: 6.38%

Also read: Cherry picking 30 year bond data?

Bloomberg posts an article about how in the last 30 years, bonds have beaten stocks. But turn the clock back 30 years ago, and what do you find?

In 1981, the Volcker move had taken interest rates – and thus yields – to big highs. The 30 year was available at 15% yields, which means a return of 15% per year (sure, not compounded).

(Higher yields = Lower prices)

Given that, wouldn’t the 30-year bond have outperformed in any case? Equities in the US have returned around 12% compounded since then, I think. Perhaps a case of appropriately fitting data, one thinks?

In India, I don’t have enough data, but stocks have done better over the last 10-15 years.

Brazil's and India's government yield curves are inverting, a condition in which short-term rates rise above longer yields. Historically, such an inversion almost invariably precedes a recession, as investors temporarily accept lower long rates in anticipation of the decline in yields that typically accompanies an economic downturn.

(HT: Deepak Singh)

At this point the 10 year bond is at 8.26% and the 182 day T-Bill went yesterday at 8.22%. The five year bond is at 8.34%. In a way, the curve is already inverted here.

Yield curve inversion has seen worse time, like I've mentioned in an earlier post (Inverted Yield Curves=Slowdown):

The last time curves got close to inversion, markets went up like crazy first and then reversed. When it finally inverted (July to Oct 2008) interest rates were high - repo rate was 9%. The new chart

It just gets worse!

Btw, in that article - Brazilian interest rates are 12.25%. Remember that when they try to tell you we'll "probably only go up to 8%".

Look at the yield charts over 10 years:

(Click for larger pictures)

The rates have been going way up. The last time the yields were so high were between July 2008 and October 2008. It's when the Lehman crisis broke that RBI cut rates down by 1% and that brought yields down. (The Repo rate at the peak was 9% compared to just 7.25% now)

This was the short term auction. Although trading is light, the last T-bill quote in the market that big banks play in (NDS) was around 8.45% for a 364 day T-Bill (which matures in March 2012, so it's more like a 9 month-er)

Look at the long term bond - the 10 yr. 2021 bond is at 8.28%. And the 4 year, 2015 bond is trading at 8.39%.  That's slightly inverted already, but it could take another few hikes.

This is fairly negative for any leveraged industry that borrows short term. Banks and financiers for one, real estate and infrastructure companies for another. Luckily, till now, the interest rates being paid on short term CDs and Commercial Paper (CP) is still 10-11%, unchanged from March. (CDs are short term wholesale borrowing through <1 year bonds by banks called Certificates of Deposit, and CP is the same thing for companies) But if the T-Bill rates keep going up, those CD and CP rates will go up as well.

Cues: Diesel price will probably be hiked on Jun 9 but it's not quite a given, since the political situation right now is shady. On Jun 16, RBI is likely to hike rates again, probably another 0.25%. This is going to be a rough month, volatile both ways.

I would be very selective in the market now - long very specific small stocks and short the overall market.

(Legend - size of the circles is the total amount traded, X axis is days to maturity , and Y Axis is the yield in % to maturity, annualized)

CD trades are short term (<365 days) and are quoted as discount to maturity (there is no coupon interest rate). So you buy at 99.5 and get back Rs. 100 in N days.

Importantly, the last few days have been been seeing heavy and high yield trades at the low end of the game - look at the top left, there are a number of trades above 11.5% in the <20 day range.

People are willing to pay more (and therefore get less yield) from a 1 year CD, where yields are around 10%, than for a 15 day deposit where it's 11%+. In general that would mean an inverted yield curve (basically lack of near term money, but people expect that in the long term, rates will come down). That situation has been a negative for equities the world over, and while it hasn't yet shown up in bonds (where the yield curve is between the 1 years and the 20 year bonds) the CD market is showing signs of stress. It could be a March 31 effect, since strange things happen near the end of a financial year.Or it could be more deep and systemic - we'll see in the first week of April. In my view it should ease up in April, but my view is not important.

This post is written by Deepak Shenoy, at Capital Mind.

Also see: "SBI Will Sell Bonds at 9.95%"

How do you work this sheet?

Interest Payment: The coupon rate that is paid out every year. It's on the face value of Rs. 10,000 - so 9.75% means Rs. 975 per bond per year, regardless of the current market price of the bond.

Redemption Date: If everything works out and SBI doesn't go bankrupt or something, you will get Rs. 10,000 (the face value) back on this date.

Current Price: What the bond is currently trading at in the market.

Call Option: SBI retains the right to, after a while, call back the banks and tell you, "Listen, here's your Rs. 10,000 per bond and Rs. X as accrued interest. We redeem these bonds". For some bonds the "call option" is after 5 years, for others its after 10.

Embedded Interest: SBI bonds pay out interest once a year (record date is usually 17th of March every year) So as the days go by, the interest gets added up - the Rs. 975 per year in the above example is about Rs. 3 per day. The subsequent calculation of the yield needs to remove the accrued interest, which is part of the price. (This is also why you will see the price DROP by Rs. 975 or so every March 16 for that bond).

(Thanks to @lukkha for pointing me to this article that confirms we have to reduce the accrued interest)

Yield: I've split this into two parts.

SBI Takes Call: Means that on the call date, SBI returns you the money. They will only do this if the market rate of interest is less than the coupon rate - I'd assume they will exercise the call option only if rates go below 9% for them. What you see in this row is the return if SBI decides to exit early.

SBI doesn't: Let's say interest rates are higher than 9-10% and SBI decides to carry on. You get a longer period of holding, so your yield changes.

Yield is simply what you make as a return, expressed in a way that is understandable as a compound interest return over time.

Cut out the bullshit

If you're thinking - dude, get to the point, did I make money or not? Well, if you bought in the IPO you probably got about Rs. 50 per bond as interest till now. You'll get another 15 days of interest after April 2, which is another Rs. 42. (even if you sell the bond today) That's interest of about Rs. 90.

Look at the prices: Three bonds are quoting at a loss (less than 10,000). There, you've lost money, but if you include the interest you are still okay.

But then, if you consider that you could have put the money in the bank, which could have gotten you some interest, and adjust for that, you might still have lost money. But since this is "cut out the bullshit" mode, I won't go into that.

The N5 bond - the 9.95% retail bond - appears to be doing the best, in terms of yield it's actually the N4 bond that's done well. The best buy remains the N3 bond.

Remember, they're all SBI, and the difference between 10 years and 15 years to most people is "way too far away to bother". So the rates should be fairly close by - to give you an equivalent example, the 10 year Indian bond (okay, 11 year) is trading around 8.08% while the 15 year bond is at 8.34% - the difference is a narrow 0.26%.

Will I buy this? Er...no. I'm getting fairly good returns, post tax, through debt mutual funds for my debt exposure. All interest is fully taxable, which post tax is a return of 7% or less; I get a far better deal on short term debt funds which are giving me around 8% post tax (if I hold). The risk remains that interest rates will fall - but honestly, I don't expect that to happen.

Also see: A 9 minute Video on the Concept of Bond Yields, as a MarketVision Short Take, recorded by me.

This post is written by Deepak Shenoy, at Capital Mind.

Size: Upto 10,000 crores from retail, but official issue size is 2,000 crores.
Listed: Yes, on the NSE/BSE.
Interest rates:

9.95% for retail on the 15 year bonds, and 9.75% for retail on the 10 years.

Call Option: SBI has the right to buy back the bonds and pay you back the face value of the bonds. The call option is after five years for the 10 year bonds and, after ten for the 15 year bonds.

Tax Deducted at Source: Yes, before annual interest payments.

NRIs, Overseas Corporates, PIOs: Cannot apply.

What about tax: Tax is payable on the interest in full - i.e. the interest gets added to your income. That will pull the net yield down. You can choose to buy and sell on the exchange between interest payments, but the profit is added to your income (as short term capital gain).

What do I think?

This is a great issue for someone looking for a locked fixed income instrument for a long time. Given that fixed deposits are now yielding 10% you may want to think twice, but the 15 year lock-in is fantastic. Sure, they have a call option, but that will only impact the market value of the bond in later years, if interest rates are lower. (Different discussion)

But the cynical me is thinking - why is SBI doing this? They don't need to. They're really smart people. Let me reiterate that. SBI has extremely smart people. If they could have offered a lower rate, they would have. That means this is actually a low rate compared to what they expect rates to go to. Meaning, there will be more rate hikes, and the 9.95% that looks good now, won't look so great if you can get, say, 12% outside. (Don't tell me 12% is out of reach, please. Even 10% was out of reach a couple of years ago) So that's the risk - the feeling of regret if rates go up to 12% - in fact, you will think of it as a "loss" because the market value of the bonds will be below par, in that case. But if you have a different view on interest rates or can swallow such regret, go ahead.

The full prospectus and application forms etc. will be available shortly. More info then.

This post is written by Deepak Shenoy, at Capital Mind.