Investing in Bonds
“Investment in Bonds” is another avenue for investors to get fixed income and tax-free benefits. Some Bonds benefit the investors when are redeemed or traded at a premium. At times, some bonds provide the investors an option to convert into shares, etc and bondholders can gain windfall gains.
So, let us understand in detail about bonds.
What are bonds?
Bonds are fixed-income instruments with which governments or companies borrow money from investors. In return, the bond issuer promises to pay back the amount borrowed, with interest, over a certain period of time.
In simple words, when a company or an institution, or government wants to raise a loan from the general public/investors for a specific purpose, they can decide to issue bonds. The bonds are nothing but Loan instruments issued by the borrower to the lender. Hence, in substance, the companies issuing bonds become the “borrower” and the investors become the “lender”. Naturally, the investors will receive “interest” on the issuance of bonds.
Bonds have a fixed coupon rate and fixed tenor. At the maturity of the tenure mentioned, the bonds are redeemed or repaid by the bond issuer. Sometimes the bonds are sold at a value higher than the face value. That means it is sold at a premium. On the other hand, if the bond is sold at a price lower price than its face value, then it is called sold at discount.
Coupon Rate v/s Interest Rate
The steady income that an investor receives from the bond issuer is denoted in the form of “Coupon rate”. Every bond instrument carries a “Coupon Rate” at which the bond issuer pays the interest to the investor.
Prima facie, the “Coupon rate” is another nomenclature given to “interest rate” that debt instruments carry like bonds/debentures. However, there is a slight difference between the “coupon rate” that a bond carries and the “interest rate” that any other deposit/loan carries. The coupon rate is the interest on the “face value” of the bonds that the bond issuer promises to pay. Hence, for a bond whose traded value is different than the face value, the interest rate is different than the coupon rate.
For eg: A bond has a Face value of Rs 1000 and carries a coupon rate of 7% p.a. This means the bond issuer will pay Rs 70 per bond to the bond issuer as interest till maturity. Now suppose the bond is currently trading at Rs 1100 and an investor purchases 1 bond at Rs 1100. Still, he will receive Rs 70 annually i.e Rs 1000(FV) * 7%, and not 7% on 1100. In other words, the interest or yield that an investor derived by purchasing the bond from the market is at 6.36% i.e. (70/1100) and not 7%.
Hence, when an investor buys bonds at discount, his yield is higher than the coupon rate and on the other hand, if an investor buys bonds at a premium, his yield is lower than the coupon rate. If an investor invests in bonds at face value on the issuance of bonds and keeps it till maturity, his yield is the same as “Coupon rate”.
Why should you invest in bonds?| How to invest in bonds in India?
Indian bond market has now significantly matured over the last few years. There are different types of bonds available in India to invest in, like, tax-free bonds, infrastructure bonds, corporate bonds, etc (Click here to know more about different types of bonds). These bonds are suited for different goals of investment like, saving capital gains or gaining tax advantage, etc. The basic advantages of bonds are:
⇒ Adequate Stability / Capital Protection: Bonds offer reasonable capital protection against other instruments like equity. Moreover, in India, many bonds are issued by the government as a part of their borrowing program and hence they are considered safe to invest in.
⇒ Reasonable and steady Income: Bondholders receive income periodically say annually or quarterly as mentioned in the instruments
⇒ Tax-free bonds: Some bonds issued by the Government of India as “tax-free” and hence can provide tax advantage. These bonds can be used by high tax bracket individuals as a part of tax saving.
- Additionally, if you want to diversify your portfolio to safeguard yourself from market fluctuations, some part of investment in bonds is recommended.
- Last but not the least, when one invests in municipal or government bonds, it, in turn, helps the society as the government uses that money for the particular activity mentioned in the instrument say, for building roads, etc
Investment in bonds is a very good option for a steady income with stability in the portfolio. Every individual must allocate some portion of its fixed-income investments to bonds. One can look at the credit rating of the bonds and decide on the safety of the funds and invest accordingly.