Zero Coupon Bonds - Part 5 Of New Series - How To Invest...

Ref: 0909-032A of 2009.09.01 Many centuries ago, Indians and Egyptians were regarded as great mathematicians. They invented the calendars of 360 days and measured the speed, rotation, angles of various planets around the earth. The Indians, known as Hindu, had invented one of the greatest theories of the mankind. It was ZERO. Hindu believed that the entire universe was created out of Zero. In Hindu parlance, it was known in Hindi as “ Shunya me se Shrushthi” . Modern science created non verifiable dictum – Big Bang theory - for which there were neither understanding nor enough scientific evidence. The whole world revolves around numbers 1 to 0 or 1 to 9 and then Zero. Another series begins after each “Zero”. Everything around us moves in rhythmic motion in perfect unison. There are also 9 planets – 7 major and 2 minors – 7 days a week, 7 basic colors, 7 seas, 7 wonders, 7 musical nodes, 7 mountains etc. All numbers are in perfect harmony over years, centuries and ages. This is the perfect Arithmetic, the most powerful branch of mathematics. In Investment world a similar principle was invented – known as Zero Coupon Bonds. It was Zero that created enormous wealth for brilliant investors, and yet very few consciously knew about it. WHAT IS ZERO COUPON BONDS? Understand the word “Coupon” first, often abbreviated as CPN. The coupon is the rate of interest. When a bank says that it pays 2% for Savings, 3% for Short Deposits, 5% for medium term deposits and 8% for Long Term deposit, the % rate is known as Coupon. If there are no coupons, then it is known as Zero Coupon. In normal bonds or deposits, the interest is paid regularly at monthly, quarterly, half yearly or annual interval. So, if you deposit 100 with 6% CPN at annual rest (that means, interest on interest is compounded at the end of every year). At the end of one year, you get #100 as principal and #6 as interest, making a tally of #106. In Zero Coupon, the yield is built in the principal itself, that is, the interest is not paid separately, but the principal value is discounted to the extent of interest rate built it. Thus, if 10% interest rate is built in, the #100 bond is discounted to say about #91, so that one gets #100 on maturity in return on investment of #91 in one year. Most of the treasury bonds of government are issued on this basis. They are treasury zeroes. The higher or lower than #100 price determines the yield (interest rate per year)with reference to the period of issue.

If the bond period is 10 years carrying a built in coupon of 10% but paid only on maturity, the #100 bonds is issued at about #38.55 as per the following table:

This is known as Zero Coupon bond for 10 years with Yield of 10% (Yield = built in interest rate). In this case, the maturity value is 100 but it is discounted to 38.55 at the time of issue. The issuer undertakes to make the payment of #100 on maturity at the end of 10 years for each lot of #38.55 CASH CERTIFICATES In some Public Sector Unit (PSU) banks in India, they issue deposit known as “Cash Certificates” where the deposit is issued for #100 face value @ #38.55. The difference between “Cash Certificate” and “Zero Coupon Bonds” is that former does not trade on the stock exchange. But the latter does trade on stock exchange. If interest rates go lower, the value of bond goes higher, and vice versa. The bank deposits do not move with interest rates. If the bond maturity period is longer, then the interest rate will have multiplier effect. In interest bearing bond, the rise could be just 5% to10% but in Zero coupon it will be 30% to 40%. See the following table of 25 year bond Zero Coupon Bonds issued by IDBI in 1992 for 25 years with built in interest rates of 15.6% with initial value #2700 or multiple thereof. I take #27,000 as initial value and #1 million of maturity value after 25 years. That is, your #27,000 becomes #1 Millions after 25 years, or 37 times nearly. In other words, you make 3600% return in 25 years or 140% every year on simple interest basis. See the following table:

Table for Discounted Value: #27,000; Maturity Value also known as Face Value = #1 Million; Investment period #25 years, Rate locked in 15.544% presumed to be Annual Rest (Interest compounded every year) and 365 days = 1 year.

Note the following: 1. The Face Value of the Bond will be #10 Lakhs or 1 Million (also known as maturity value) 2. Deep Discounted value (original investment value) = #27,000 3. Interest locked in 15.544% for 25 years. 4. At the end of 10 years, IDBI refunded #120,000 (Normal value was # 114,500 as per table above). That is they paid early redemption premium of 5,500 or about 5% a. That is, if the investor invested #27,000, he got back 120,000 after 10 years on first call date. Call Date is the option reserved by the issuer (IDBI in this case) under which it may redeem the bond (cancel the bond before maturity) at certain value + 5% redemption premium. (it is decided at the time of issue by the issuer) b. Although the bond was quoted for 25 years, the investor may sell it at any time in the market. c. When the bonds are sold, the interest rate is worked out until the date of settlement. For instance, if the bonds are sold after 5 ½ years, the market price will reflect the enhanced return, depending on the demand and supply situation. 5. Presuming that the bonds were not recalled (say, it did not have recall clause) the holder may a. sell it unit by unit as under: after 15 years, sell one – realize 235,801 (or more if rates go down); b. sell second unit after say, 20 years (realize 484,593) and c. sell 3rd after 23 years (realize #749,049), presuming that he was holding 3 separate units of 27,000 each investment value having #10 Lakhs (1 million) face value. d. In other words, he will have increasing cash flow every 5 years, after initial 15 years. 6. Above is hypothetical example with real numbers (as issued by IDBI – the numbers may not exactly match due to minor details) 7. RECALL or EARLY REDEMPTION OPTION: Some issuer does write early redemption rights in case the rates turn in their favor later. If there were no recall clause, the issuer is obligated to pay full face value on maturity. a. it happened to Sardar Sarovar (Gujarat, India) Deep Discount Bonds issued in 1997 for 15 years where the company’s attempt to retire the bonds early by force were thrown out of window by Gujarat High Court). The bonds carried built in interest of 19% whereas market rates dropped to less than 6% at one time causing enormous loss to the issuer. HOW INTEREST RATES AFFECT BOND PRICES? Bank deposits (except CD or Certificate of Deposits in USA) do not rise or fall in value with fall or rise in interest rates. The interest rate risk is assumed by the deposit issuing bank. In treasury or commercial bond, the interest rate risk is assumed by the investor (CPN interest rate is the contracted rate of the issuer) For instance, a company issued bonds for 5 years with 8% CPN. That is, the company will pay interest rate @ 8% for a period of 5 years. Supposing, at the end of first year, the market interest rates for remaining 4 years dropped to 6%. The prices of 8% CPN Bonds will rise in value to the extent of yield differential. For holder of 8% CPN Bonds, the yield is 8% . However, market yield being 6%, the bond price will rise by 8/6x100 = 133.33, so that a person investing in that bond will get a yield of 6% (8/133%). In other words, the bond prices will be so adjusted that its yield reflects closely the market yield.

The longer the period, higher the bond prices in early years in falling interest rate regime. Similarly, the lower bond prices in early years will reflect the higher interest rate regime. In other words, the bond prices have “inverse relationship” with the Market Interest Rates (MIR). If the MIR goes higher Bond prices go lower; if MIR goes lower, the bond prices get higher. This is where the ZERO CPN BONDS with longer maturity give the best return. In Zeroes, the initial capital base being low, the % return becomes very high. Zeroes lock in interest rate for long time at minimum value. This is why Zeroes are best bought when the rates are near high and have tendency to go down later. If one is a foreign investor, he also locks in currency at favorable rates when the rates are highest. Contrary to popular belief that higher rates make a currency stronger, only the reverse is true. Interest rates are like a “support stick” for the currency. If the currency can not stand on its own, it needs higher interest rates to support its value. If the currency is strong, the rates move down. For example, • When Indian currency became very weak due to FOREX crisis, the rates shot up to 15% to 19% on deposits. o This is when IDBI, ICICI, SIDBI and LT came out with Zero coupon bonds showing the people moon, hey give me #2,700, we give you back #1 Lakh (#100,000) after 25 years. • When the currency strengthened to 39/$ during BJP rule, the market interest rates (MIR) dropped to 3% to 6% on deposits and housing loans prospered creating biggest rally in real estate market. • When the RBI manipulated the exchange rates by constantly intervening in the market via Sterilization measures, the rates shot up with the result that Real Estate prices crashed. • This is why stronger local currency is in the best interest of the nation. This is the reason why United States always wanted strong US$ so that its interest rates could be kept low and import cost reduced. The people world over imitates US in every respect, but never follows its exchange rate policy. • Now, that US is running into severe economic problems, with UK and EU, a time is going to come when the people will start demanding higher interest rates to compensate them hold weaker currency. o When these governments are not able to raise money by normal interest bearing bonds, they will start issuing Zero CPN Bonds. o Wait until when that happens, when the rates get into high double digits similar to what India faced in 1992. o That will be the time to invest in USD/GBP/Euro when those currencies are weak and the interest rates are high. HOW DID I MAKE MOST MONEY via ZERO COUPON BONDS? I have already explained how I made most money in IDBI/SIDBI/Sardar Sarovar Deep Discount Bonds. I learnt Zeroes early state (first when my father taught me investment through NSC or National Savings Certificates issued by Government of India). I made more money in Zeroes when during my search on the net. I used Bloomberg dedicated terminal when I was the stockbroker. It was 100 times more powerful than what you see on internet.

I found the South African Rand Zero Coupon Bonds. I had set the following agenda (this applies to all overseas citizens outside their country of citizenship – such as NRI or Expatriate). 1. Find the currency which is the weakest over the last 10 years 2. Find the country where the interest rates are also higher with weak currency 3. Find the country whose strength of currency depends on its export products that are also at the weakest point. This is when I found the South African Rand, Canadian dollar, Australian dollar, Russian Ruble, Brazil Real. I found the South African Rand the most attractive due to following reasons: 1. United States and other Western countries were deliberately suppressing Rand to control the gold, silver, palladium, and other commodity prices. Some major banks started issuing Zero Coupon Bonds in SA RAND as hedging operation. 2. SA RAND was depressed to 12.81 per $ versus 2 per $ during apartheid days. 3. Interest rates were above 10% 4. SA MAIN EXPORT products such as gold, silver, palladium, coal, iron ore etc were near 20 years low. 5. I guessed that if the commodity prices go higher, the SA RAND (symbol ZAR) will go higher, rates will fall, so the Zeros will give me the best return. I had learnt this from IDBI DDB earlier. 6. Most of the issuers were World Bank, Swedish export import bank, Deutsche bank, and some South African entities like DBSA (Development Bank of South Africa) and ESKOM (largest electric utility 7. I took the view that other international issuers were gamblers and issued ZAR Zeros to short the currency. Since only South African government could issue ZAR, I preferred issues of SA entities like DBSA and ESKOM, although they were rates A or A+ compared to AAA of other banks. It was my view that the only way for Aaa to go was only down, not up, whereas A or A+ could become AA or AAA, that is up (and down also) 8. I bought DBSA at 2.79 to 6 level, and ESKOM from 1.90 to 5 level, paying for Rand from 11.30 to 12.31 per $. a. Today, after about 10 years, my bonds are at 17 and 12 level (they rose to 21 and 16 at one time) and currency improved to 7.8 today (it rose to 5.81 at one time). b. Thus, my return is almost 800% in my local currency in 10 years or 80% per year, fully guaranteed by Government of South Africa. c. SA is rated A+ whereas India’s rating is still BBB For full details of SA RAND Bonds, please click SOUTH AFRICAN RAND ZERO CPN BONDS . I used to buy these Zeros through RBC Dominion Securities (investment branch of Royal Bank of Canada), Morgan Stanley, HSBC, Rabo Bank, Deutsche Bank, Barclays and Merrill Lynch. RBC was the best. If you have account with them, ask them to send you full list of zeros with bid/offer prices and full details/table. Beware of banks like HSBC who give you the most inferior exchange rates. Once I lost about 8% in exchange rate alone. It is a lousy bank – it converts your USD into HKD and then converts HKD t o RAND, causing enormous loss to the customer or investor. 60% of HSBC profit comes from such cheating, because there are millions of TT and other exchange related transactions every day – just imagine, when they take the spread of 0.25% in both currencies, they make clean 0.5% per transaction when they do not pay even 1% interest per year. There is no one in Hong Kong to listen to such complaints. Better it is one opens an account with SAXO BANK or still better INTERACTIVE BROKER (you see their Ad on Bloomberg channel always). IAB will let you buy anything anywhere in the world at minimum cost and giving you the best exchange rates, and lowest account maintenance charges.

HOW ZERO CPN HELPS PLAN EVERYTHING IN YOUR LIFE, Personal or Business This article is long. So it is written in two parts. You will find second part (part 6 of the New Series) under REJOINDER below within 3 days before I head off for India tour. This will be most useful part of Zero CPN bonds how it helps you most. from 4/9 to 16/9 during which I will not be posting anything NOR will reply to any of reader’s queries (because of lack of internet access over there). With Warm regards Kalidas (Anil Selarka) Hong Kong, 1st September, 2009 Document Statistics: Pages 6; Words 2,676; Paragraphs 77; Lines 234 Characters (no spaces) 12,124; Characters (with spaces) 14,801; Author’s Blog : http://anilselarka.com Author’s Bookweb: http://www.subprimeresolved.com