Bonds – Whenever we talk about investing we think of mutual funds or Stocks. A 100% equity-focused portfolio is not good for long-term investment. Last year in 2020 the market fell nearly 40%. Years of gain were destroyed in a month of fall (Think about March 2020). The good thing is that the market has recovered from that point. But imagine if the market finishes its bull run & enters into a bear market. You require capital then you might have to sell your stocks, Mutual Fund, & take a huge loss. This is why one should have some asset allocation toward debt investment. Bank FD gives you a 6% return. India’s inflation is 6%, in this case, your real return is 0%. That is why you should allocate some of your debt investment towards a Bond.
What is a Bond?
A bond is a fixed income instrument that represents a loan made by an investor to a borrower. This borrower may be the central govt. state govt. or Companies, and lenders can be you & me. In short, a bond is a loan that is made by you to a company or govt. for a fixed term. In return, you earn the bond interest, and at the end of the maturity, the borrower pays you back the face value. When you purchase a bond you become a debt holder for the company. People who hold equity are called stakeholders. In the case of bankruptcy, the company is liable to pay the debt holder first. Then the stakeholder or equity holder gets paid.
Bonds Features and Terms
Face value of a Bonds
It represents the underlying value of a bond. Each unit of bond price is represented by face value. For example, one company is bringing out a bond in the market with a face value of Rs 1000. If you invest in them at the end of maturity, the company is liable to pay you Rs 1000 back at the end of that bond’s maturity. Also, the coupon or the interest that was promised by the company will be credited to you. Bond face value is nothing but the value of each unit of the bond.
Bond Coupon rate
When you put money in bank FD, we get paid with interest. In the bond market, the interest rate is traditionally known as the coupon rate. So the bottom line is that the coupon rate is nothing but the interest that you earn from a bond.
It is very similar to bank fixed deposit maturity. Bond maturity can be after 5 or 10 years from the date of issue.
Bond and bank interest have an internal relation. If bank interest goes up then the bond price fall. On the other hand, if the bank interest goes down then the bond price goes up. For example, you may see a 1% fall in bonds if the bank interest goes up 1%. Another hand bond will increase 1% if bank interest decrease 1%.
Credit rating agency assign rating towards every bonds that are issued in the market.
These rating can be AAA,BBB,BBB- etc. Credit rating shows the creditworthiness of a particular company. If you seek a loan from a bank, the bank will always check your Credit score or CIBIL score. If you have a good credit score you get a loan from a bank easily. And If your credit score is worse then the bank rejects your loan application. Similarly, in the bond market, every company is assigned a credit rating. AAA-rated bonds are considered safe, and these bonds are investment-grade bonds. A bond with a credit rating below B- Known as junk grade bond.
- How to identify businesses with a competitive advantage?
- Why the economy is falling but the stock market is rising?
Advantages of Bonds
A 100% equity portfolio is not good for a long-term investment. !00% equity-focused portfolio can crash as bad as a market. That is why one should include bonds in their portfolio. Last year march 2020 we saw a fall of 40% in the stock market. Only equity-oriented portfolios witnessed a similar kind of fall. A well-mixed portfolio with equity debt might not fall 40%. So if you add a bond into your portfolio, it acts as a protection against volatility.
If you hold a bond until its maturity. Every bond that you buy pays you coupon interest annually or semi-annually. You can treat the coupon interest as regular income. Most of the senior citizens in India greatly depend on interest income. Bank FD or the post office MIS scheme is offering reduced interest, which is around 5% to 6%. By investing in bonds senior citizens can earn a little bit more. If you are a senior citizen you may allocate some of your money in bonds to enhance your earning.
Profit on Resale
You can sell your bond in the secondary market and earn from it. If the economic growth is slowing. Stock market crashes or central banks reduce the interest, in this situation the demand for bonds goes up. So if you have a bond that you have purchased earlier. Due to the above reason, the price of the bond goes up, but the face value remains unchanged. You can sell your bond at a higher price in that situation and make money from it.
Disadvantages of Bonds
Every bond has its credit rating. AAA-rated bonds are safe, and also the entity pays you the coupon interest on time. A junk grade bond with a BBB credit rating, which makes it really risky bet. And offer more coupon interest to attract investors. So check the bond credit rating before you invest. Because a junk grade bond is less creditworthy thus may default in the future. BBB bonds are risk and may default. Check the credit rating before you put your money in it.
As you can see that PSU bonds are always with AAA ratings. So they consider as the safest investment option that carries minimal risk.
The annual inflation in India is around 6%. If you think that the inflation in India may rise in the future let’s say 8%. Your bond coupon is 8% then your real return is 8%-8% = 0%. That is why any economy or any country that may have the chance of higher inflation can’t make much money out of the bond. High inflation is the enemy of the bond market.
Bonds Liquidity Risk
The stock market is very liquid. When you sell stock there is a buyer in the market. But in the case of the Bond when you want to sell, there is no one to buy the bond in the market. If there is no buyer in the market then you stuck with it. You may see this liquidity issue in the bond market. This is not too often but it may or may not be.
Types of Bonds
Zero coupon bond
It doesn’t provide you with any interest. The bond issuer issues the bond at a discount rate, and at the time of maturity. The issuer pays you the bond face value. For example, a zero-coupon bond with a Rs 1000 face value can be issued at the price of Rs 700. At the end of the bond maturity, the issuer pays you the face value which was 1000. In simple words, you buy the bond at the price of Rs 700, and you sell it for Rs 1000. Rs 300 is your profit. Remember a Zero Coupon bond never pay any interest, rather you get to buy it at a discount.
Fixed rate bond
In the case of a fixed-rate bond, the coupon rate or the interest rate remains the same throughout the maturity of the bond.
Floating rate bond
The coupon or the interest on this bond always fluctuates depending on the economic situation, stock market, and bank interest.
Tax free bonds
The coupon interest that you earn is completely tax-free. PSU companies are the one offers this kind of bond in our country. PDU like REC, HUDCO, etc issues PSU tax-free bond. By simply investing in them you don’t pay any TDS on your earning.
How to Invest in Bonds?
There are many ways one can invest in bonds. You can purchase it from the primary market or through ETF. Even you can invest through Mutual Funds.
Difference between Bonds & T-Bills
A bond is a G-sec that is an issue for more than a year. A T-Bills (Treasury bills) is a G-Sec that is an issue for less than a year.
If you are not comfortable buying out bonds directly, then invest in bonds through ETF or the Mutual Fund. One should definitely include a bond in his or her portfolio.