Basil has a moderate risk profile and wants to invest for the medium term without thinking about the short term volatility of the stock market. He decided to meet Anandu, a financial advisor to understand more about bonds.
Anandu: Bonds are generally considered less risky investment compared to equity and hence many investors with a low risk appetite invest in bonds. For diversify the investments in various asset classes you can include bond instruments also in your portfolio. You can invest in long term and short term instruments according to the investment objectives of the investor.
A bond is a debt instrument that a government or a company issues to raise money from the public. Governments raise money for funding public expenditure programs. Corporates use the money for a variety of purposes such as building a new plant, purchasing equipments, or business development.
In simple words, bonds are nothing more than a loans for which you the lender. The organisation that sells bond is the known as borrower. The issuer of a bond should pay the investor something extra in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is referred as ‘coupon’. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are also known as fixed income securities because you know the exact amount of cash you get back if you hold the instrument till maturity.
Basil: How can I invest in bonds?
Anandu: Bonds can be bought and sold in the open market just like you buy and sell stocks, before the agreed time period.
Here are a few terms about bonds that you should be familiar with:
- Yield to Maturity
- Market price of the bond
- Credit Risk
Bonds have a face value (what it is sold for initially/principal amount), however they also have a market value (price at which the bond trades in the secondary market) and this keeps fluctuating.The coupon rate of every bond is based on its face value.
The return investors get on a bond is known as the yield. It is the rate of interest the bond pays, expressed as a percentage of its market value.
For example, if you bought a bond at Rs.1,000 par value with a 5% coupon, your yield would be 5%. (Coupon divided by value of bond x 100)
And the yield of a bond is inversely related to its current price: this means, if the price of a bond falls, its yield goes up.
For example, if a bond with a face value of Rs.1000 falls to a market price of Rs. 900, the yield would rise to 5.55% (5/900 x 1000).
But if the price of the bond rises to Rs1100, then the yield would fall to 4.54%. (5/1100 x 1000).
Even though the market price of a bond fluctuates, its face value (i.e. what it can be redeemed for at the end of the fixed period) remains the same. In this case it is Rs.1000.
The higher the yield of a bond, the riskier it is seen to be and the greater the chance that a company or government which issued it may not be able to repay the money. This is where bond rating agencies like ICRA, CARE, CRISIL etc., help us as they grade fixed income securities based on current research. This rating system indicates the likelihood of the issuer defaulting either on interest or capital payments.
Basil: What are the types of bonds?
Anandu: There are mainly, two types of bonds i.e., corporate bonds and Government bonds.
Corporate bonds: are issued by companies to raise capital. The bondholders get a specified return every period. These bonds can be of two types.
Government bonds: are issued by the Government to finance their projects. And in India, the market size of Government bond, also known as G-Sec, is much larger than the size of the corporate bond market. The bond’s return depends on the prevailing interest rate. The maturity can be anywhere between 3 months to 30 years.
Tax-free bondsare issued by government enterprises. Some examples are bonds issued by NHAI, NTPC, Power Finance Corporation, HUDCO etc which offer a fixed interest rate, and hence is a low-risk investment avenue. As the name suggests, it’s most attractive feature is absolute tax exemption as per Section 10 of the Income Tax Act of India, 1961. Tax-free bonds generally have a long-term maturity of typically ten years or more.
Basil: What are the advantages and disadvantages of investing in bonds?
Anandu: Bonds pay off in two ways first, you receive income through the interest payments.
Second is capital gain that you receive if you resell the bond at a higher price than you bought it.
Bonds can help offset exposure to more volatile stock holdings.Like stocks, bonds can be packaged into a bond mutual fund. A bond fund can also reduce risk through diversification.
The disadvantages are:
Bonds pay out a lower return on your investment than stocks. They have credit risk. The issuer may default on its bonds i.e. they may fail to timely make interest or principal payments. (the default risk is high for corporate bonds)
Interest rate changes can affect a bond’s value. Rising interest rates will make newly issued bonds more appealing to investors than. To sell an older bond with a lower interest rate, you might have to sell it at a discount.
Valuing bonds can be confusing because bond yields move inversely with bond values, i.e., the more demand for bonds, the lower the yield.