It was a classic case of a lakhpati dream turned sour. Circa 1996. IDBI came out with its flexibond issue which met with a phenomenal response in the markets. Not surprising because a one-time investment of Rs.5300 in a deep discount bond would translate into a maturity value of Rs.2 lakhs in 25 years. In other words, IDBI was assuring the investors an annualized yield of 16 percent over the next 25 years.

Not surprising then that investors plumped for the offer. An assured return of 16% over the next 25 years, beneficial taxation effects and the prospect of becoming a lakhpati were too attractive to ignore. Add to that investors were freed from the reinvestment risk and hence were in a position to precisely match their future liabilities with their expected cash flows.

Today the lakhpati dream of millions of investors stands soured for the simple reason that IDBI has decided to exercise its call option. In other words the Rs.5300 bond of 1996 is going to be redeemed in 2000 at a value of Rs.10,000. This exposes the investors to two kinds of risk. Firstly their yield is going to be far below what was originally promised. Secondly, investors who had matched their future liabilities with the estimated cash flows after 25 years will suddenly find their plans vanishing into thin air. More so because interest rates are currently falling and are almost 500 basis points (5%) below the 1996 levels. So where exactly did the investor go wrong in his calculation?

Error#1: Investors failed to carefully read and understand the fine print of the IDBI bond issue back in 1996. The prospectus clearly mentioned that IDBI reserved the right to call back the bond after year 2000 if the interest rate situation so warranted.

Error#2: Most investors went wrong on their estimates on the extent of the interest rate fall. Actually a 2-3% fall in interest rates would not have spurred a redemption by IDBI since the administrative costs would have far outweighed the benefits of redemption. But a 5% fall in interest rates since 1996 was a golden opportunity for IDBI to reduce its cost of funds. In fact, according to conservative estimates, IDBI is likely to save Rs.100 crore in interest costs over the next 20 years due to this redemption.

Error#3: Most investors estimated that IDBI being a government organization would not go back on its commitment. Little did they realize that all government organizations today are being run by the dictats of the market. A cost saving of Rs.100 crore was therefore too much for IDBI to resist.

That then is the story of a lakhpati dream turned sour for millions of investors. The moral of the story is that investors need to read the fine print of the offer document more carefully in future.

T S Harihar