Not a fan of investing in equities? Not comfortable with the volatility in the markets? If you prefer regular income and can tolerate marginal fluctuations, you could consider debt instruments like bonds. There are many Advantages Of Investing In Bonds.
What are bonds?
Bonds are a debt security instrument the borrower issues (typically, government or corporate) for a sum the bondholder (i.e., a creditor) lends. The companies raise funds with the help of bonds where they agree to pay a fixed interest for the bonds issued following a fixed repayment schedule to the bondholders.
The interest paid on bonds is either payable annually or semi-annually based on the terms of conditions between the issuer and the bondholders.
Let us understand some of the terminologies related to the bonds. For better understanding, let us take a straightforward example. A company issues 10,000 bonds at INR 120, par value of INR 100, at a 7 percent interest rate per annum for 10 years.
- Coupon rate
It is the rate of interest paid to the bondholders. The bondholders will get 7 percent every year.
- Par Value
The par value is the face value of the bond, which is the amount promised to be repaid to the bondholders at the time of maturity. In this case, the bondholder will get INR 100 per unit.
- Discount / Premium
Bonds typically do not trade at Par Value; they sell at a discount or a premium to the par value. In the current example, the bond trades at an INR 20 per unit premium.
- Maturity of the bond
The company typically raises funds with the help of bonds, promising to repay the debt within a stipulated time. It is known as the maturity of the bond. In the current case, the bond has a maturity of 10 years.
- Yield to Maturity (YTM)
YTM is the actual return for the bondholder based on the coupon rate, premium, or discount paid to purchase the bond units and the maturity time. So, for example, the actual return for the investor will not be 7 percent (i.e., the coupon rate), but it will be much lower because of the premium paid to purchase the bond.
What are the different types of bonds?
- Fixed interest bonds
A fixed interest bond pays a fixed rate of return to the bond holders throughout the bond term. Therefore, an investor who does not want volatility in the returns aligned to the changes in the market risk should opt for a fixed interest rate bond.
- Floating interest bonds
Floating interest rate bonds and the RBI issues are the most prevalent in the Indian market. These bonds have a six-monthly payout as well as a re-rating. Every 6 months, the bond’s interest rate is adjusted based on the prevailing market condition.
- Inflation-linked bonds
Inflation-indexed, or inflation-linked bonds are instruments whose interest rates are tagged to the prevailing inflation rate in the country. Such bonds are prevalent in a developing economy where inflation is typically higher because of higher spending and higher liquidity in the market aiming for growth. Therefore, the principal amount of these bonds is linked to the country’s inflation.
- Perpetual bonds
A bond with no maturity is called a perpetual bond. It is not redeemable and pays a steady interest income forever. In such bonds, the amount invested is not returned.
Advantages of investing in bonds
- Regular income
Bonds offer regular interest payments to the bondholders, creating a steady stream of passive income.
Bonds act as a great asset class for portfolio diversification. It is because bonds are linked to the interest rate prevailing in the market. Bond prices are inversely related to the interest rates on lending. So, an interest rates hike means the bond prices will fall, but bond prices go up when the interest rates fall.
- Capital repayment
If you hold the bond until maturity, you will get the principal’s investment back. As a result, there is higher certainty of capital security compared to investments in equity.
- Potentially profitable investment opportunity
If you analyze and study the bond markets and predict the changes in the interest rate, you can trade in the bond market and sell bonds at a higher price. You make profits from buying and selling in the bond market.
- Less risky compared to other asset classes
Bonds are less risky than equity, real estate, commodities, or cryptocurrency. It is because the prices are less volatile, offering a consistent flow of income.
Disadvantages of investing in bonds
- Limited returns compared to equity
Bonds pay lower returns than equity markets. Bonds are a form of borrowing for the company which raises capital. Borrowers or debt instruments typically don’t participate in the profits or losses of the company. Hence they bear the limited risk and offer a fixed limited return.
- Default risk
Bonds are not guaranteed instruments. Most often, you get your capital back on maturity. But in a few cases, the companies can default on capital repayment if they go out of business. So risks of default are higher for corporate bonds than government bonds.
- Bond yields can fall
The bond yield is based on the prevailing market interest rate the central bank of any country sets. If there are frequent changes in the interest rate, your bond yield is impacted. It is typically a significant issue for bonds with a fixed interest rate.
As a thumb rule for asset allocation, your allocation to equity vs bonds depends on your age. You can take more risks when you are younger and need to drive towards higher allocation to bonds as you come closer to retirement. The rule suggests deducting your age from a factor of 100. For example, if your age is 25 years, then you should allocate 75 percent of your capital to equity markets and 25 percent to debt markets.
As you move towards retirement, i.e., 60 years, your allocation towards debt and safer investments (generating regular income) should be close to 60 percent, and your equity allocation should reduce to 40 percent.
All in all, allocation to debt funds provides stability to your portfolio and downside capital protection in case of significant drawdown in equity. Therefore, bond investment is most suited for investors who want to avoid stock market volatility and dynamic moves.
However, if you want to create substantial wealth and become financially independent, subscribe to the 5 in 5 Wealth Creation Strategy and start investing today.
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