Be wary of buying and selling in secondary market

Lack of liquidity hinders buyers and sellers from getting a reasonable price in bonds and in certain securities

Be wary if planning to buy securities from the secondary market to earn better returns than from fixed deposits (FDs). You may not be able to get these at a reasonable price. Worse, there may not be sellers for the security you wish to buy.
 
Not just buyers, even sellers find it difficult to offload investments in the secondary market. The secondary market for securities such as non-convertible debentures (NCDs), sovereign gold bonds (SGBs), tax-free bonds, government securities (G-Secs) and closed-end mutual funds lacks depth. The total turnover for retail trading in corporate debt is Rs 7.63 crore with volumes of 2.68 lakh on the Bombay Stock Exchange. The turnover value for government securities is only Rs 28.22 lakh while the volume is a mere 934. SGBs and closed-end MFs have even more dismal trading numbers.

 
“Despite the efforts of finance ministers and regulators, the secondary market for these long-term securities has grown at a very slow pace. Most investors stay away from the secondary market due to lack of liquidity,” says Satish Menon, executive director, Geojit BNP Paribas. Even savvy investors fear that even if they buy securities from the secondary debt market, they may not be able to resell at a profit. “That’s why many prefer FDs, which can be easily liquidated by paying a small penalty,” says Menon.
 

There are, however, times when investors can benefit of the secondary market. At the beginning of this financial year, investing in  tax-free bonds could have worked in a falling interest rate regime. And these investors now have bonds in their portfolio that offer them a post-tax  annual return of six-seven per cent. To make a profitable trade in long-term instruments, investors should be able to evaluate the bond yields, understand the different risks involved, take a call on interest rates or movement in prices of the underlying asset class, and factor in the tax impact.

Bonds, G-Secs and NCDs: If a bond, G-Sec or debenture has a coupon rate of, say, 10 per cent and you decide to buy it on this basis, your returns can fall drastically. In the secondary market, you need to look at the yield to maturity (YTM) of a bond, which is the actual return one makes. If you were to buy a 2012 Rural Electrification Corporation’s bond that has a face value of Rs 1,000 and a coupon rate of 7.93 per cent, you will need to pay Rs 1,092 in the secondary market. The YTM for this bond comes to 6.54 per cent. Whenever interest rates fall, the prices of bonds go up, and vice versa. If you were to buy this bond in a rising interest rate environment, you might get a YTM that is higher than the coupon rate.

 
“While tax-free bonds are relatively safer, as they are issued by government-backed companies, an investor needs to be cautious about the credit risk in NCDs,” says Abhijit Bhave, chief executive officer (CEO), Karvy Private Wealth. Remember that a company’s credit rating is for a limited period. When issuing the bond, a company could have been AAA-rated but this can change in a year.
 
Feroze Azeez, deputy CEO, Anand Rathi Private Wealth Management, suggests investing in tax-free bonds would make sense if the YTM is higher than 6.5 per cent. “If that is not available, one should look at arbitrage funds that offer an average return of 6.5-7 per cent and do not attract tax after one year of investment,” he says. It’s better to avoid NCDs, as they are difficult to evaluate. Invest in different issuers to diversify the risk.

 
Sovereign gold bonds: While assessing their right price is easy, buying or selling at a reasonable price is difficult. One should compare the spot gold price for 24-carat gold and the trading price of SGBs. There should be a marginal difference (less than five per cent) between the two. But, if you look at the offer and ask prices, there’s usually a difference of around 8-10 per cent. Also because SGBs that are listed on the exchanges offer 2.75 per cent every year. As this is based on the face value of SGBs, this doesn’t attract any premium. “SGBs will be sold at a discount only when the price of gold rises substantially (15-20 per cent or more). An existing investor will leave some discount for the buyer once he has made his returns,” says Azeez.

 
Closed-end equity funds: Trading volumes are low in these funds. Where there are buyers, sellers are missing, and vice versa. The asking price for Reliance Capital Builder Fund-Series C (Growth Plan) is Rs 9 - a 25 per cent discount to the prevailing NAV. However, there are no sellers at the price. “Investors in the scheme are not even aware if they can sell it at the exchanges,” says Shankar Raman, chief investment officer at Centrum Capital.
Raman explains that even in schemes where a few units are bought and sold, it hardly makes sense for new investors to enter scheme unless they are sure of the fund manager’s ability and scheme’s performance. Ideally, an investor should get into this product at least one year prior to maturity, to avoid tax outgo on the gains. If he enters the fund only because of the discounts, he may still end up with losses if the scheme doesn’t perform well. “If there’s a any immediate money requirement, there’s provision to get a loan against most of these products. In most cases, this can  be a better option,” says Azeez.