Why monthly interest payout option in a bond may not be as good as it sounds

While there can be many other reasons for investors to opt for bonds that pay interest at monthly intervals, there are also reasons why bonds with such an option may not be as good as they sound.

Recently, we have seen some public issues of non-convertible debentures (NCDs) offering monthly interest payouts. For example, in June 2023, IIFL Finance offered five-year NCDs bearing 8.65 percent interest with monthly payouts. Earlier in March, NCDs issued by Indiabulls Housing Finance offered to pay interest at monthly intervals. The NCDs of 24- and 36-month tenures offered interest rates of 9.64 percent and 9.89 percent, respectively.

Generally, retired individuals and those seeking regular cash in hand to pay for their expenses, invest in bonds that pay interest at monthly intervals, as well as in other fixed-income instruments. This helps them meet their regular cash flow. Sometimes even individuals with regular cash flows – salary, business income, and pension adequate to pay for their expenses, opt for bonds that pay interest at monthly intervals. This is done chiefly to meet: 1) Liquidity needs: Cash in hand ensures better liquidity, which is a comforting factor, and 2) Low credit risk: Some investors believe such regular payouts lower the loss in the event of a default. As interest is paid each month, it does not accumulate, and to that extent, the money at stake is reduced compared to the interest being payable at maturity.

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While there can be many other reasons for investors to opt for bonds that pay interest at monthly intervals, there are also reasons why bonds with such an option may not be as good as they sound. These are:

Leakages

Money so received at regular intervals may get spent in the hands of a significant number of investors. This becomes especially true when the money received is a relatively small amount, is kept in a bank account, and gets spent on trivial things. The investor may not be savvy enough to spot the best investment opportunities month-on-month, leading to the money being spent in an unplanned manner.

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Sub-optimal returns

Such leakages mean low returns on the overall portfolio. Here, even if the money does not get spent but remains in the investor’s savings bank account, it earns a low rate of interest, typically, 3 percent. If the investor knows that he does not need the money immediately, then he should invest it in some bonds which could offer far higher returns. Good-quality corporate fixed deposits of a one-year tenure currently offer 6.5 to 7 percent returns. If the original bond paid 8 percent per annum interest at monthly intervals, and this money was kept in the bank account paying around 3 percent interest, the portfolio returns would suffer substantially.

Compounding

In most cases, investment portfolios are constructed for the long term. They are expected to compound money at a rate higher than the inflation rate. Equities beat inflation but are volatile in the short term. Bonds offer stability to the portfolio but fail to beat inflation. In such cases, one has to ensure that the accrued interest is put to productive use. The money needs to be invested from time to time to improve the overall portfolio returns and compound the money.

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Reinvestment risk

Many investors also underestimate reinvestment risk. Once the money hits the bank account, they have to scout around for investment options. Even if they are efficient in exploring all investment options available in the market, they have no control over the then prevailing interest rates. Interest rates keep changing, and one may have to reinvest the interest payouts at a lower rate than the earlier contracted rate. For example, an investor may have to invest the interest payout received from a bond with an 8 percent rate of interest at 6 percent if at the time of receipt of interest, the overall interest rates in the economy have come down drastically.

Taxes

Interest is taxed at the investor’s slab rate. Most investors prefer to pay tax on interest received on an accrual basis, and hence, a yearly payout could make sense.

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However, if the investor would like to delay his tax liability on interest received on bonds, then he should look at investing through debt mutual funds (MFs). These MFs effectively reinvest the coupon received on the bonds they hold. They also ensure risk management. Though the capital gains on debt MFs are taxed at the slab rate like any other interest income, the tax liability crystalises only at the time of selling the units of debt MFs. Smart investors would postpone selling their debt fund investments until their golden years, when their income would go down.

A structured approach to investing in interest-bearing bonds can thus help better compound the money, provided there are no regular income needs.
Another efficient way to earn a regular income is through the systematic withdrawal plans (SWPs) of MF houses. Here, the investor instructs the MF house to pay him a fixed sum of money by selling a required number of units from his existing MF investments. This approach ensures that the remaining MF units continue to compound your money. In the case of an SWP initiated out of equity-oriented MF units, the taxation works out to be far better. These gains on the sale of units are considered capital gains and are taxed at concessional rates compared to the higher slab rates.