Covered bonds have become the talk of the town. The roller coaster ride of debt mutual funds in the last couple of years and the low-interest rates has prompted many investors to look for new investment options. And, it looks like covered bonds aim to address these issues.
In this article, we will talk about covered bonds.
Structure of a Covered Bond
Non-banking finance companies are the leading issuers of covered bonds. The NBFC creates a loan pool of similar loans. For example, gold loans that the NBFC have disbursed to their customers will form one pool, while vehicle loans may form another pool.
Based on these pools of loans, the firm issues covered bonds. The asset, i.e. the pool of loans, comprises secured loans, i.e., the loan is backed by gold or some physical asset.
This shows the two layers of safety: the first layer is the loans and the second layer is the physical assets and documents that back these loans. This is why these bonds are called covered bonds.
Let us consider the following scenario. Consider the item Wint Bricks Jul21, for example. It’s a covered bond with Rs. 20 crore asset size.
The asset size refers to the bond size issued by NBFC U GRO through Wint Wealth. The size of the collateral is 1.3 times the amount of the asset. The property loans serve as collateral in this case.
And the property that backs it up would serve as collateral for the loan. The entire worth of the properties, according to the website, is about Rs.85 crores.
The NBFC will pay the pre-tax interest rate of 9.5% per year after the maturity term of 24 months. If the NBFC goes bankrupt, however, the platform would endeavour to recoup the debts used as collateral. Assume these loans’ borrowers also defaulted. In such a situation, Wint Wealth will aim to recoup funds from the collateral used to secure the loans, usually real estate.
Another security feature is that covered bondholders are the first nominees if the NBFC fails. This is where Covered bonds differ from other types of bonds, such as corporate bonds.
How does it help NBFCs?
Most NBFCs would like to raise funds to meet their daily operations from the market.
But, many NBFCs find it challenging to raise capital from the market as these NBFC’s debt instruments do not have AAA ratings. AAA is the highest credit rating. And it indicates that NBFC is high on its creditworthiness. As a result, in the current environment, few institutional investors like mutual funds and insurance companies would be prepared to take the risk and invest in the company’s debt papers.
So, covered bonds help these NBFCs to raise capital at a lower cost. This could boost the company’s credit rating, making it easier to access credit in the future.
What are the advantages for investors?
Covered bonds are in high demand among investors seeking interest income and capital security. In this low-interest-rate environment, many investors are looking for fixed-income assets with a reasonable rate of return.
Covered bonds are less risky than equity investments and provide higher yields than bank fixed deposits. The pre-tax return has drawn several investors, which ranges from 9% to 11%.
Covered bonds were an investment option for high-net-worth individuals in India (HNI). A minimum investment of Rs. 10 lakhs or more was required. However, investors can invest in covered bonds with a minimum initial commitment of Rs. 10,000.
How are covered bonds taxed?
Covered bonds are a tax-efficient investment option product, with a 10% tax on the gains if you invest for more than 12 months.
What are the differences between covered bonds and debt mutual funds
Debt mutual funds invest in debt papers such as government bonds and commercial papers. The market value of the securities determines the rate of return on debt mutual funds.
Non-Banking Finance Company develops a loan pool and companies such as Wint Wealth issue bonds. This collection is referred to as an asset. This secured loan pool serves as collateral for the asset. The loans are secured by gold or property. As a result, they are referred to as covered bonds.
Systematic Investment Plan (SIP): Becoming disciplined is the key to becoming a better investor. And you can do so by establishing a Systematic Investment Plan (SIP), which allows an investor to invest a specific amount of money at regular intervals. Investors can begin investing in a debt fund with as little as Rs.500 per month via SIP.
However, there is no SIP facility in covered bonds.
Minimum investment amount: As previously stated, the minimum amount required to invest in a debt fund via SIP is Rs.500. Furthermore, the initial minimum amount for a lump sum investment is Rs. 5000. The minimum investment amount for covered bonds with WintWealth may vary from Rs.10,000 to Rs.10 lakhs.
As a result, rather than covered bonds, one can easily invest in a debt fund.
Returns: In most cases, covered bonds give an annual interest rate of 9 to 11 per cent. The issuer sets the interest rate on these bonds, and investors get both the interest and the capital invested after maturity. Returns on debt mutual funds, on the other hand, are market-linked. Furthermore, because there are many types of debt mutual funds, debt fund returns will vary.
Diversification: The underlying asset of a covered bond is a pool of comparable loans, such as gold loans, that the NBFC provided to their customers as loans. On the other hand, a debt mutual fund invests in various debt securities issued by corporations or the government. As a result, debt funds are more diverse than covered bonds.
Management: Fund managers are in charge of debt funds. As a result, you get competent portfolio management without paying much money. Investment in covered bonds, on the other hand, is entirely up to you.
Liquidity: Debt funds are liquid because they are open-ended. As a result, you can invest and redeem your investments whenever you like. Covered bonds, on the other hand, are only accessible for a limited time on Wint Wealth. The issue, however, is closed once the issue is wholly subscribed. So, unless you are an existing investor or were referred by an investor, investing in these covered bonds may be difficult.
Tax: Covered bonds are tax-efficient financial instruments. If the investment period exceeds 12 months, an interest tax of 10% is levied. For an investment period of fewer than 12 months, the interest is added to your income, and the applicable tax rate based on your tax slab is evaluated.
If you invest in debt funds for fewer than three years, the capital gains are added to your income. It is then taxed as per your tax bracket. However, if you hold your investment for more than 36 months, capital gains are taxed at a flat rate of 20% after indexation.
What are the differences between Fixed Deposits and Covered Bonds?
The first significant distinction between Fixed Deposits and Covered Bonds is one of safety. A fixed deposit provides a fixed interest rate, whereas covered bonds are subject to fraud, liquidity, and credit risk. FDs are risk-free, while covered bonds carry an element of risk.
However, because FD deposits carry no major risks, the returns are significantly lower than those of alternative investing options. Because covered bonds are riskier than fixed deposits, they pay higher interest rates.
A bank FD requires a minimum investment of Rs.5,000, but a covered bond requires a minimum investment of Rs.10,000.
Both FDs and covered bonds have a predetermined maturity date. Banks provide a variety of tenures ranging from seven days to ten years. Covered bonds, on the other hand, have around a two-year maturity duration.
The final distinction between the two is taxation. The interest earned on your FD is added to your income, and banks deduct TDS if your interest income exceeds Rs 40,000. If the period of a covered bond exceeds 12 months, the interest is subject to a 10% tax.
Things you need to keep in mind before investing in Covered Bonds
The high tax-efficient interest rate is also accompanied by considerable risk. It entails greater risks than debt mutual funds.
Platforms such as Wint Wealth are not liable if the NBFC goes bankrupt. They are a platform that receives a commission from lenders who offer covered loans on their platform.
It is not an alternative substitute for a fixed deposit (FD).
If you wish to start investing in covered bonds, you can allocate 2-3% of your portfolio to these bonds.
So, should you invest in bank FDs, debt mutual funds or covered bonds? People with a low-risk appetite may be interested in FD. Investors who seek liquidity, affordable regular investments can look at debt mutual funds.
Covered bonds can be purchased by those familiar with the debt market and want a greater rate of return.
Note: Please consult your financial advisor before investing in any of the investment options mentioned in this article.