When we think about investing, most of us instantly think of stocks.
But the world of investing is very vast, and there are several avenues you can consider investing in. Bonds are one of such instruments and are often considered a fail-safe option by many as they are less riskier compared to stocks.
Want to know more about bonds and if you should be investing in them? Here’s everything you need to know:
What are bonds?
Bonds are a debt instrument issued by a corporation or the government to investors to borrow money. The investor extends the investment amount in the form of a debt to purchase the bonds from the issuer and also receives regular interest payments. Bonds are issued for a specific period. Upon maturity of the bonds, the issuer also repays the principal amount (the investment amount) in full to the investors.
In simple terms, bonds can be considered as a loan that a company or the government takes out. But instead of a bank, the loan amount is provided by the investors. That’s why when you invest in a bond, you become a creditor of the entity issuing the bond.
Here are a few key terms you need to know to understand how bonds work as an investment:
- Face value: Refers to the worth of the bond at maturity. The interest payable on bonds is also calculated on the basis of its face value.
- Coupon: Refers to the fixed rate of interest that the issuer pays its bondholders. It is usually payable annually or on a quarterly basis. It is calculated as a percentage of the face value of the bond. For example, if the face value of the bond is INR 1000 and the coupon rate is 8 percent per annum, you will get INR 80 every year.
- Yield: Refers to the rate of return. But unlike the coupon, which is fixed, the yield varies and is determined by market forces.
- Maturity: The date on which the issuer returns the investment money lent by the investors.
- Yield to Maturity: Refers to the total return expected from a bond it is held till maturity. You can think of it as the internal rate of return on investment from a bond held until maturity, provided the investor receives all payments as scheduled.
You can invest in bonds during the initial bond offering by the issuer or purchase them from the secondary market through a brokerage.
Are there different types of bonds?
Depending on the issuer, bonds can be broadly classified into:
- Corporate bonds: Corporate bonds are issued by both public and private companies. The money raised from issuing the bonds is used for funding operations. Companies can issue both secured and non-secured bonds. Bonds issued by companies can be unlisted or listed on stock exchanges.
- Government bonds: Such bonds are issued by the Government of India directly and are often backed by guarantees from the government. Sovereign Gold Bonds and G-Sec bonds are examples of government bonds.
Depending on the rate or type of interest or whether they can be recalled or converted, or taxed, bonds can be as:
- Zero-Coupon Bonds: Such bonds don’t pay any coupon or interest. Such bonds are purchased at a discount price but do not pay any periodic interest or coupon to the bondholder. Interest is paid only when the bond matures.
- Convertible bonds: Such bonds are hybrid instruments with both equity and debt components. While it is issued as a debt instrument, it gives an option to the bondholders to convert it into equity and hold a pre-determined number of shares of the issuing entity.
- Non-convertible bonds: These are pure debt instruments and cannot be converted into equity. They are issued for a specified tenure and pay a fixed interest to the bondholder.
- Tax-Free Bonds: The interest earned on such bonds are not taxed. Companies such as the Indian Railways Finance Corporation, HUDCO, National Highways Association of India (NHAI) issue these bonds
What are the benefits of investing in bonds?
Here are some key reasons why you should consider investing in bonds:
- Safe investment: Compared to stock, investments in bonds are considered relatively stable. Unless the bonds are listed on the stock exchanges, fluctuations in the market do not affect the interest rates. Moreover, certain bonds such as corporate bonds, are also credit-rated by credit rating agencies. The higher the rating, the safer the investment, as the likelihood of interest payment and principal repayment is high.
- Diversification: Investing in bonds is a great way to build a more diversified portfolio. Since bonds are not as volatile as shares, having them both in your kitty can reduce your overall financial risk significantly.
- Steady income: Another benefit of bonds is that they offer a steady income from their investments as you receive the interest payments.
- Liquidation preference: Since bonds are in the nature of a debt, bondholders are creditors of the issuing company. In case of bankruptcy, creditors are paid before stockholders.
Are there any risks associated with bonds?
Let’s face it — like any other investment, investment in bonds also comes with its fair share of risks.
For instance, in the case of corporate bonds, the issuer may not pay the interest and principal on the due dates. Or in the case of bonds with a call option, the issuer may pay off the bonds in case the interest rate declines substantially. This can hurt the investors that they will need to let go of a high-interest instrument and be forced to reinvest.
Since bonds are long-term investments, you also run the risk of facing changes in the interest rate. For example, you invest in a 10-year bond that offers 4% interest per annum. A few months later, the same issuer offers a similar 10-year bond at 5% interest. In such a case, the bond you are holding depreciates in value.
Should you invest in bonds?
Bonds are an excellent option for risk-averse investors who don’t want to overthink the market conditions but want a steady income from investments. Plus, if you’ve already invested in stocks and want to diversify your portfolio for reduced risks, investing in bonds is a great way to shield yourself from market volatility.
Ultimately, whether bonds are right for you is a question you need to answer. You can also get in touch with our team of advisors at Moneyfront, and we can recommend whether putting your hard-earned money towards bonds is a smart choice.