Investing in Bonds
Bonds are the safest bet among various investment alternatives available on the market. But, if you invest in them without first learning the essentials, you risk jeopardising your financial objectives. So here are the things you must know about bonds.
What is a Bond?
In layman's terms, bonds are a sort of loan that the government or corporations take out from the general public (investors). The borrower then uses the funds for the intended purpose, while investors profit from the interest. As a result, a bond's market value tends to fluctuate over time.
Bonds have a set maturity date. The issuer must repay the investment amount plus profit after the period has expired.
Different Types of Bonds in India
Here is the list of bonds in India:
- Government securities (G-Sec) bonds:
Such bonds are issued by the state or the central government, primarily for development purposes such as building highways, dams, etc. G-Sec has a longer maturity period. They might have fixed or fluctuating interest, and it can be paid annually or half-yearly. Some examples of G-Sec bonds are treasury bills, zero-coupon bonds, and municipal bonds.
- Corporate bonds:
These are issued by large companies to accomplish their expansion plans or to start a new project. Investing in them earns you a regular interest rate and principal repayment on maturity. However, such bonds are considered risky investments due to the credit risk attached to them.
- Convertible bonds:
These bonds have the feature of both regular bonds and equities. In addition, it gives you an option to convert the bond into a specific number of shares. If you choose this option, you will become a shareholder of the company and will be eligible for many additional benefits.
- Zero-coupon bonds:
These bonds do not pay interest during their life. You can get them for a fraction of their face value. On maturity, the entire face value amount will be paid to you. These bonds are ideal for you if you have long-term goals in mind, such as a child's marriage, a retirement fund, and so on.
- Inflation-linked bonds:
It is yet another bond issued by the government. The primary advantage of these bonds is investment protection from inflation risk. However, due to their indexation with inflation, the principal and interest move in tandem with the inflation rate.
- Sovereign gold bonds
These bonds are issued by the central government and are ideal for those who do not want to store gold physically. In addition, sovereign gold bonds are extremely safe, and the interest they yield is tax-free.
Benefits of Investing in Bonds
Here are the benefits of investing in bonds:
- Provides income
Bonds provide you with a steady flow of income. It safeguards you from market volatility and provides you with returns even if the market is not performing well.
- Offers diversification
Investing in bonds offers greater diversity. It provides you with better risk-adjusted returns when compared to equity-oriented portfolios.
- Capital preservation
The key benefit of bond investment is you don't lose your capital when the market is not favourable. Let's understand this with an example.
Assume you have invested in the stock of XYZ Company, which has solid financials. However, the market crashes heavily owing to a global incident. In this instance, you stand a good chance of losing your capital. The situation becomes worse when you want to redeem your investment to achieve some near goals. But if you invest in bonds, your capital remains intact even if the market falls.
- Tax advantages
In the context of tax, there are two different types of bonds. The first is tax-saving bonds, while the second is tax-free bonds. According to Section 10 of the Income Tax Act, interest earned from the tax-free bonds is exempt from taxes. On the other hand, tax savings bonds allow you to save up to ₹20,000 under Section 80CCF.
Things to Keep in Mind When Investing In Bonds
- Never get tempted by higher yields if the credit rating agencies have not rated the bond well. Such bonds are risky to invest in. Always remember that high-yielding bonds come with larger risks.
- Always keep your objectives in mind. For example, you may be investing to pay for your child's education or marriage expenses in the future. A clear goal might help you determine your risk tolerance.
- Always consider the cost associated with bonds. Check if your broker is compensated based on market movement or on a one-time basis.
- Regardless of the bond rating, you must still pay attention to the purpose of bond issuance. Be cautious if a company is issuing bonds to pay off its debt.
Also Read: What is Debt Trap & How to avoid falling into it?
- Focus on your investment strategy instead of speculating the rate of interest. It will help you achieve your objectives more smoothly.
How to Buy Bonds?
Various broking firms allow you to purchase bonds through their online platforms. If you want to buy government bonds, you may also register to bid on them directly on the stock exchanges. Apart from that, mutual funds are another option for investing in bonds.
Bond investing, or having a bond in your portfolio, reduces risk significantly. Nonetheless, before investing, make sure you check the bond's rating and assess your risk appetite.
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Frequently Asked Questions
The answer to this relies on the type of bond you have and your holding period. For example, if you hold a bond until it matures, you will be entitled to the fixed interest rate. But, the rates will be determined by market conditions if you sell them prematurely.
Yes, just like you diversify your portfolio by adding both equity and bonds, diversification of bond investment is recommended as well. It will safeguard you from non-systematic risks. Spread your portfolio across bonds with different ratings, different maturity dates, etc.
You can invest in sovereign gold bonds for as low as one gram. Whereas; the maximum investment limit is 4kg.
YTM refers to the internal rate of return (IRR) of the bond if you hold it to maturity. It is the total amount you will earn if your bond pays the entire interest and principal.