The common consensus is that keeping money in a Savings Account keeps your money safe, but think again.
With inflation and tax on the interest earned, what you are left with is a fall in your purchasing power.
Many of us lack the appetite for the risk that comes with Equity Investments. One of the biggest markets that remains untapped by most retail investors is the Bond market.
If you want to earn interest consistently without taking on the same level of risk as equities, the Bond market is definitely worth exploring. We can also take the route of Mutual Funds to take advantage of the expertise of professional fund managers and gain exposure to this sector.
Before we dive deeper, what are Bonds?
Companies, Banks and Governments all need money in order to function and fulfil their objectives.
One of the ways by which they can raise these funds is by issuing Bonds. These Bonds usually come with a maturity period and a pre-fixed coupon rate.For example, suppose Company ABC wants to raise funds. It decides on the amount of money it wants to raise. Depending upon that, it decides on the number of Bond units to issue, their face value, and undertakes the necessary regulatory steps to reach the public at large.
This is the stage where the coupon rate and maturity are decided.The coupon rate is the fixed interest that the Bond will pay to its investors. Maturity is the tenure of the Bond, after which the Bond is redeemed and the principal amount is returned to the investor.In order to understand Bonds, it is very important to differentiate between Interest Rate, Coupon Rate and Yield.
Interest Rate is the prevailing rate of interest in the economy.Coupon Rate is the pre-fixed rate of interest that the Bond pays on its face value.
Yield is the return earned by the holder of the Bond. It depends upon the price at which the Bond is purchased. If a Bond is held till maturity, the investor earns the Yield to Maturity (YTM), which considers both the coupon payments and any gain or loss arising from the purchase price.
Now that we have a basic idea of Bonds, it is important to understand that this is an entire universe in itself. We will, however, keep it simple.
Now, why Bonds?
Before we jump into it, let us understand what Risk is.
Risk is any deviation that can take place from the expected return, whether positive or negative. If an investment is expected to deliver a return of say 9–11%, and it delivers 15%, it is still a deviation. And of course, if it delivers less than 9%, that is risk too.You should consider Bonds as a part of your portfolio because of the following reasons.
Limited Risk : Equity Investments are risky. Period.Whether you invest yourself or take the help of Mutual Fund houses, equities carry risk. The market has to perform well, the company has to perform well, and various economic, political, geographical and social factors can influence stock prices. Even changes in the global economy can impact the sentiment of investors and consequently the performance of your portfolio.Now that this is clear, Bonds carry comparatively lower risk. It is like a loan that you have given to the issuer, which will be repaid to you after a certain period of time, along with interest.There are a number of Credit Rating Agencies, and every Bond has to be rated on a regulatory level. You can decide the level of credit risk you are willing to take, and accordingly choose the Bond that suits your investment objective. Naturally, the lower the credit rating, the higher the interest rate that investors generally expect as compensation for taking higher risk.
Taxability: Bonds can be both Listed and Unlisted.Listed Bonds are those that can be traded on the Stock Exchange, whereas Unlisted Bonds cannot be traded on the Stock Exchange.The taxation of Bonds depends upon whether they are Listed or Unlisted and also upon the prevailing tax laws. While interest earned on Bonds is generally taxable, the tax treatment of capital gains depends upon factors such as the type of Bond and the holding period.One way of postponing tax on the interest component is by investing through Mutual Funds that invest in Bonds. Instead of distributing the interest, the fund generally reinvests it within the portfolio, allowing the investment to continue compounding until redemption. However, the taxation of Mutual Funds is governed by separate tax provisions.
Diversification : We all know the saying that you should not put all your eggs in one basket, and diversification means exactly that.You must already have investments across different asset classes. Diversification into Bonds helps reduce the overall risk of the portfolio by balancing the volatility associated with equity investments.
Arbitrage : You can always take advantage of arbitrage opportunities that exist due to increasing or decreasing interest rates, as the case may be. While this is generally more relevant for experienced investors and institutions, opportunities may arise whenever there are temporary price differences in the market.
Capital Gains : If you hold a Bond for a longer period but realise that interest rates are decreasing in the market, you can choose to exit from the Bond before maturity.Interest rates and Bond prices have an inverse relationship. Existing Bonds paying a higher coupon become more valuable when new Bonds are issued at lower interest rates. As a result, Bond prices appreciate in a falling interest rate environment. This gives investors an opportunity to earn capital gains by selling the Bond before maturity and utilising both the gains and the proceeds for other investment opportunities.
Predictable Cash Flows : In the case of a Bond, you already know what the future payments are going to be like, and therefore you can plan your finances accordingly. This predictability makes Bonds particularly suitable for investors looking for regular income or those planning for specific financial goals.
Risks Associated with Bonds : Of course, there are a number of risks associated with investing in Bonds, and it is equally important that we understand them.
There is Credit Risk, which means that the issuer may default on its interest or principal payments.
In an increasing interest rate scenario, there is Interest Rate Risk. As newer Bonds offer higher interest rates, the market value of existing Bonds may decline.
There also exists Liquidity Risk, which means that if you want to convert your Bond into cash immediately, you may have to sell it at a price lower than its fair value if there are not enough buyers in the market.
Reinvestment Risk is another important risk that needs to be discussed. When Bonds mature during a period of lower market interest rates, the proceeds may have to be reinvested at lower rates, thereby reducing future returns.
Conclusion : For you, as an investor, Bonds form an important concept to understand because they give you an opportunity to earn interest on your capital while taking comparatively lower risk than equity investments. While they may not replace equities in a portfolio, they certainly complement them by providing stability, predictable income and diversification. Like every investment, Bonds too come with their own set of risks, and understanding them is the first step towards making informed investment decisions.