What are Bonds and How to Invest in Them?

Rajesh
14 Aug 2024

Equities always take the spotlight; albeit debt is integral to the portfolio, very little gets written about it. Within debts, bonds are probably very rarely discussed, and the awareness about bonds is relatively low. In this article, we tour bonds as potential investment avenues.

How can you invest in bonds, and how does it differ from stocks?

Investment in bonds can be made either through the primary or secondary market. If done via the primary market, you have to subscribe to the public issue floated by large companies, akin to subscribing to an IPO to the equity of any large corporation. If you purchase the bond from the primary market, then you would be paying the face value to acquire the bond. Purchase and sale of bonds can be made in the secondary market via exchanges. Whilst purchasing the bond from the secondary market, often the bond price will be lower than or higher than the face value depending on the prevalent interest rate as against the interest rate that the bond is offering. Bond prices and prevalent interest rates have an inverse relationship. For example, if a bond with a face value of Rs. 100 yields 7% p.a. It is up for sale when the prevalent interest rate is 6%. Then the bond price will be higher than the face value as the bond is offering a higher rate than the prevailing interest rates.

Liquidity in bonds:

The general perception around bonds is that it is highly illiquid and has to be kept till maturity. However, given that they are traded on the secondary market, you can pre-maturely exit the investment in the secondary market, provided there are potential buyers for the bonds being put up for sale. The liquidity is not as robust as in the case of the equity stock market.

Assessing a bond investment opportunity:

The assessment of bonds for investment is starkly different from that of equity or any other investment avenue. Here, you are lending your money to the counterparty to carry out his business. You expect the counterparty to repay the aforesaid amount alongside fixed or floating returns in the form of interest rate. The owner of the bond is dependent on the issuer to gain his principal amount back (amount invested or amount lent). It is important to check the creditworthiness of the issuer.

To ease the process of checking for creditworthiness, there are credit rating agencies that provide ratings based on the due diligence and past credit record of the issuer. This is indicative of the creditworthiness of the issuer. Companies with AAA (triple A) ratings are considered to be high-quality issuers. If you are venturing into bonds, then it is advisable to invest in high-quality bonds only.

All investments are made with the intent to optimize returns. Bonds should be considered from the perspective of achieving stable returns at lower levels of risk. Bonds carry a coupon or interest rate. It is payable on an annual basis and is expressed as a % of the face value of the bond. Suppose the coupon or interest rate is 7% p.a. On a bond with a face value of Rs. 100, then you would receive Rs. 7 per year as an interest rate. The returns from a bond are defined by a measure termed Yield to Maturity (YTM). This remains one of the most common measures of bond returns.

The issuer of the bond can be a company or government. The risk of investing in a Government issued bond is much lower than that of company-issued bonds. Typically, the default risk of government-issued bonds is considered nil. Hence the returns of Government issued bonds may often be slightly lower than that of company-issued bonds.

Pros and Cons of investing in bonds:

Bonds are often compared with equity, which may be akin to comparing apples to oranges. Bonds fall under the debt category. It is best to compare them with other investment options such as fixed deposits, post office deposits, debt mutual funds, etc.

Pros:

1. Bonds remain a good option, especially if you can look at the prevailing high-interest rate over the long term.

2. It is also a great means to add a dimension to your portfolio. They help derisk the portfolio and provide a sense of long-term stability to the portfolio.

3. Since bonds are typically a long-term commitment ( 5-30 years), you have a long-term orientation toward your investment journey. There are other short-term bonds as well, which have a maturity lower than 3 years. However, the orientation of bonds is typical with a long-term perspective.

4. Also, investing in Government bonds is a highly safe investment avenue. It helps reduce the risk of the portfolio to a large extent. It is also apt for a conservative investor.

Cons:

1. On the flip side, the liquidity in bonds is relatively low. If you have any upcoming financial goals, investing in a long-term goal may not be prudent.

2. It may also not make sense to invest in a short-term goal, anticipating that you could sell it for profit in the secondary market. Often the liquidity is low for certain bonds, in which case holding them to maturity becomes inevitable. If the interest rate cycle is unfavorable, selling your bond in the secondary market may not be profitable.