Bonds are fixed-income instruments issued by governments or corporations to secure funds for diverse projects. They pay a fixed interest to the bondholder for the entire duration of the bond and repay back the principal upon maturity. These are low risk investments that are ideal to balance your portfolio volatility.  Similar to fixed deposits (FDs), corporate bonds also give regular interest and repay the principal at the end of the bond tenor. However, corporate bonds tend to offer higher returns (interest rate) than FDs. Thus, these can be a good alternative to bank FDs. 

What are Bonds?

Bonds are financial instruments issued by governments and corporations to raise funds for their business and capital requirements. These fixed-income securities offer a stable income source and capital preservation.

Bonds are issued in the primary market at face value. The bond issuer promises to pay the investor (bondholder) regular interest (coupon payment) for the duration of the bond.

Let’s say you buy a bond; you are lending money to the issuer for a specified period (bond tenor). In return, the bond issuer promises to pay you regular interest. The issuer will return the principal amount to you upon maturity.

You can invest in bonds to diversify your portfolio risk. However, picking the right bond for your portfolio is crucial. Before we understand the advantages and disadvantages of bonds, let’s understand some terms that are unique to bonds. Look at the unique features of bonds.

Key Terms of a Bond

The following are unique features of bonds:

• Face Value: It is the amount the issuer pays the investor (you) upon maturity. The bond’s market value and face value differ due to market fluctuations. It is also known as the par value.
• Interest or Coupon Rate: The bond issuer pays you regular interest for lending money. The interest depends on factors like tenure and credit rating.
• Coupon Date: The date on which you will receive the coupon payment.
• Tenure or Tenor: The period for which the bond is issued. Bonds are issued for short, medium and long term.
• Maturity Date: The date on which the bond issuer pays you back the face value of the bond
• Credit Rating: Credit rating significantly influences the coupon rate of a bond. Bonds from low-credit-rating issuers pose higher default risks, leading to higher interest payments. Government-issued bonds are typically stable and categorized as investment-grade. Others, like high-yield or junk bonds, carry higher default risks and thus offer higher coupon payments to offset the high risk.
• Liquidity: Bonds are tradable in the secondary market, allowing you to exit before the bond maturity.
• Yield: Yield is the return you get when the bond is held until maturity. This return is also called yield to maturity.

Advantages of Bonds

Bond investments provide several advantages, such as regular interest and principal repayment. These are popular and secure investments suitable for risk-averse investors seeking stable options. Following are some of the benefits of investing in bonds:

• Regular Income: Bonds offer regular interest payments, thus ensuring you a consistent source of income.
• Diversification: Bonds are low-risk investment options. Thus, they are a good addition to your portfolio to offset the impact of riskier assets (equities).
• Capital Protection: Bonds offer capital protection and are safer than equity investments.
• Lower Volatility: With lower price fluctuations than shares, bonds are an appealing choice for risk-averse individuals.
• Multiple Options: There are different types of bonds suitable for different investors. Thus, you can pick bonds based on your investment goals. For example, secured bonds, zero coupon bonds, tax-free bonds, etc. 

Limitations of Bonds

Bonds are considered safer than equities. However, no investment is entirely risk-free, and bonds are no exception. The following are some risks associated with bond investing and how you can mitigate them:

• Interest Rate Risk: Fluctuations in interest rates impact bond prices. Interest rates and bond prices are inversely related. Bond prices tend to fall when interest rates rise, resulting in capital losses.

Mitigation Strategy: Avoid investing in very high-maturity bonds.

• Credit Risk: Bonds from entities with lower credit ratings carry higher credit risk. Credit risk refers to issuer default. Thus, the higher the credit risk, the higher the chances of default.

Mitigation Strategy: Invest in secured and investment-grade bonds.

• Inflation Risk: Inflation can diminish the purchasing power of bond income, reducing real returns over time.
• Call Risk: Issuers can call/ redeem the bond before maturity. This can potentially lower your interest income.

Mitigation Strategy: Diversify by investing across bonds with varying tenors. 

• Liquidity Risk: Some bonds may have lower liquidity. In such scenarios, you may not be able to sell them at desired prices, especially during market downturns.

Mitigation Strategy: Invest with the intention of holding the bond until maturity and invest through platforms that offer liquidity.

• Limited Capital Appreciation: Although some bonds may promise capital appreciation, the potential for significant price gains is generally limited.

How to Invest in Bonds?

You can invest in bonds through banks and online trading platforms. However, before investing, you must pick the right bond that suits your investment needs, tenure and risk profile. To invest in bonds, you need a Demat account.

You can start investing in corporate bonds through our platform, Incred Money. Incred Money hand picks the best secured and investment grade corporate bonds based on their credit rating and a multitude of other factors.  Following are the steps to start investing:

• Sign up/ Sign in to the platform using your mobile number.
• Shortlist and select the bond that you wish to invest in.
• Complete your KYC by providing details like PAN, date of birth, annual income, and gender. Upload address proof, provide bank account details and link your Demat account.
• Next, complete the transaction to start your bond investment.

Who Should Invest in Bonds?

Investing in bonds is crucial for diversification. They are efficient to counterbalance the volatility of equities. Bonds deliver a steady income stream through interest payments, which is particularly beneficial for retirees or investors seeking consistent cash flow. You can consider investing in bonds if you seek low-risk and low-volatile investments compared to equities.

Strategically investing in tax-efficient bonds will help you optimize your overall tax liability. Bonds have the capacity to offer higher returns than fixed deposits.

However, picking the right bond based on your investment tenure and risk profile is essential.

Things to Consider Before Investing in Bonds

You must consider the following factors before investing in bonds:

• Investment Goals: You must invest in schemes that suit your individual preferences. Make sure you pick bonds that match your risk, return, liquidity, and tax-saving expectations.
• Risk and Return: While bonds are deemed safe, they aren’t risk-free. They are exposed to inflation, interest, liquidity, and default risks. Thus, before investing, you must compare and analyze different bonds in the same category to understand which suits your risk and return expectations.
• Creditworthiness of the Issuer: Default risk is the biggest concern while investing in bonds. You must evaluate the issuer’s credit rating, as higher ratings indicate lower risk and vice versa.
• Tenure: Bonds with longer maturities generally offer higher yields. However, they are more sensitive to interest rate changes. In contrast, short-term bonds yield lower returns but are less vulnerable to changes in interest rates.
• Liquidity: Some bonds have higher liquidity than others. Simply put, you can easily buy and sell them. It can be challenging to exit bonds with lower liquidity.
• Tax Implications: Tax-saving and tax-free bonds offer different tax benefits. On the other hand, interest income from other bonds is taxable. Thus, it is essential to consider the tax implications before investing.

Conclusion

Bonds are low-risk investments that can add the element of diversification to your portfolio. They also pay a fixed interest, which can help you create an additional source of income. However, before investing, you must do your due diligence with regard to the bond. 

Frequently Asked Questions (FAQs)

What does a 7% bond mean?

7% bond means that the bond’s coupon rate is 7%. For example, if the face value of a bond is INR 1,000, it pays INR 70 (7% of 1000) as interest. 

How can I make money in bonds?

You earn regular interest payments, and upon maturity, you are paid the entire principal amount.

What is YTM?

Yield to maturity (YTM) is the total expected return for an investor if they hold the bond to maturity.

What is the difference between Coupon and Yield?

The coupon rate is the interest rate paid on the face value of the bond. The yield is the total return you earn when you hold the bond to maturity. 

Are returns earned from my bond investment taxable?

Yes, interest and capital gains from bond investments are taxable. The short-term capital gains (where the investment holding period is less than 3 years) are taxed as per the investor’s applicable income tax slab rates. While long-term capital gains (where the investment holding period is more than 3 years) are taxed at 10% without indexation or at 20% with indexation benefit. However, interest on tax-free bonds is not taxable.