FIXED INCOME: Key things to know before you invest in bonds

The other type of risk associated with bonds is interest rate risk.

By Hemanth Gorur

Conservative investors in India flock to fixed deposits when in doubt. However, fixed deposits have lost their shine of late. Interest rates have been dipping and risk-averse investors seem to be left with no options.

Bonds are a good alternative in such cases, but one needs to know how they work before investing. Let us have a look.

How bonds work
Put simply, bonds are the opposite of loans. When you take a loan, you borrow money from someone, so you become a borrower. When you take a bond, you lend money to someone, so you become a lender.

Bonds are issued with a “face value”. This is what you receive when the bond matures. Along with this, you receive interest on the amount you invested in the bond. This guaranteed interest payout is called “coupon rate”. The “yield to maturity”, on the other hand, is the effective rate of interest you get when you equate the bond’s coupon payments, amount received at maturity, and any accrued interest to the current price of the bond.

Bonds are usually long-term instruments. The period for which the bond is taken for is called “term to maturity”.

Types of bond issuers & risks associated
There are majorly two types of risks associated with bonds: risk of default and interest rate risk. The risk of default is the probability that the bond issuer will not repay the amount invested in the bond. This depends chiefly on the type of issuer and their creditworthiness.

Bonds can be issued by the government, government bodies, public sector undertakings, financial institutions, and corporate entities. Bonds issued by the government are the safest since there is little or no risk of default. The risk of default of any bond can be gauged by the bond ratings issued by ratings agencies like CRISIL, ICRA, or CARE.

The other type of risk associated with bonds is interest rate risk. Bond prices can fluctuate with market movements and economic trends. When interest rates in the market go down, bond prices go up. This is because investors may flock to stable investments like bonds as they are not getting good returns from traditional risk-free investments like deposits. This drives up demand for bonds. However, this also drives down the yield to maturity since the investor has paid a premium on the current price of the bond. This leads to interest rate risk.

Investing in bonds vs bond funds
Since bonds are long-term investments, the maturity value is realised only if the bond is held until maturity. If you want to exit earlier, you can trade the bond in the secondary markets but this requires knowledge of the bond markets and a keen eye on interest rate movements.

An alternative way is to invest in bond funds. Bond funds are mutual funds that invest in different bonds as per the fund’s theme. This takes away the burden of having to analyse bond price movements or market rates. Thus bond funds are a highly defensive investment since bonds themselves are nearly free of the risk of default if the issuer has a high credit rating, and the diversification afforded by the bond fund takes out much of the interest rate risk.

However, a note of caution is relevant here. There is a human element in the management of bond funds: the fund manager. It is advisable to invest in bond funds managed by fund managers who have been in the business for long and have a track record of consistently profitable returns from the funds managed.

Bonds can be your go-to option when interest rates are going down. But, as in all investments, carefully assess the instrument and the markets before investing.

BONDS OF SAFETY
Bonds are issued by PSUs, the government, government bodies, financial institutions, and corporate entities
Risk of default of any bond can be gauged by the bond ratings issued by CRISIL, ICRA, or CARE
Bond funds are a highly defensive investment since bonds themselves are nearly free of the risk of default if the issuer has a high credit rating.
Diversification afforded by the bond fund takes out much of the interest rate risk in individual bonds

The writer is founder, Hermoneytalks.com