what are bonds and how to invest
Bonds pay you a pre-defined return on investment. This is a less risky investment compared to equity and hence many investors who do not have high appetite for risk go for investing in bonds. The bond market in India is completely dominated by Government bonds. The corporate bonds are still in their infancy by their size and market reach.
However, there have been initiatives by the Government, SEBI, and businesses to build bond market. One of the initiatives by the Government is to provide
against investment on infrastructure bonds up to Rs 20,000 an year.
The return on bonds can be paid in two ways, either through coupon payment which is done every 6 months and the final payment of face value after the end of the maturity. Or it can pay nothing in the interim but pay the face value at the maturity. Needless to say, the first one is more expensive than the second type.
Types of Bonds Available
Bonds come in mainly two types, corporate bonds and Government bonds.
Corporate bond: Corporate bonds are issued by corporations to raise capital. They are safer than equities. The bondholders get a specified return every period. These bonds can be of two types.
Convertible bonds: They can be converted into a pre-defined number of stocks as and when required by the investor.
Non-Convertible bonds: They are just plain bonds.
In both bond types, the payment schedule and amount is similar.
There are callable bonds too where the company can buy it back (or call the bond) as and when it wishes by usually paying a premium.
Government bonds are issued by Government to finance their activities. The Government bond market size is much larger than the corporate bond market size. They are also known as G-Sec. The bonds’ return depends on the prevailing interest rate. Usually, Government bonds pay a return of 7% to 10%. The maturity can be anywhere between 3 months to 30 years.
Central and State Governments both can issue bonds. These are safest of investments as Government doesn’t default on payment. The return, however, is less compared to corporate bonds.
Understanding bonds with examples
In 2003, Government issued taxable 8%
. The details are following:
Bond name: taxable 8% Savings Bonds
Coupon Rate: 8% annual
Payment: If non-cumulative, paid every 6 months @4%
If cumulative, paid at the end of maturity
Maturity: 6 years
Amount at maturity: (in cumulative mode): 1601 at the investment of 1000
Issue price: at par
This means if you have invested Rs 1000, your cash flow, in the non-cumulative mode, will be Rs 40 every 6 months for 6 years and face value i.e. Rs 1000 at the end of 6 years. In cumulative mode, you will receive Rs 1601 at the end of 6 years.
Take another example of Rural Electrification Corporation bond.
Bond name: Rural Electrification Corporation LIMITED
Coupon Rate: Option 1: Annual coupon payment and buyback after 5 years: 8%
Option 2: Annual coupon payment and no buyback: 8.1%
Payment: Annual payment
Maturity: 10 years
Issue price: at par
This bond requires a minimum investment of 10,000. Each bond costs 5,000. This means if you buy 2 bonds (by investing 10,000) with option 1. You will receive Rs 800 every year for next 5 years and the company will buy back the 2 bonds at Rs 10,000.
If you choose option 2, the company will pay you Rs 810 every year for next 10 years and pay the face value at the end of 10 years. You always have the option to sell the bond in the open market after the lock in period passes.
Check the rating of the bonds by agencies such as CRISIL, ICRA, Fitch, and CARE.
Understand the payment option of bonds and decide accordingly. Bonds are good for stable regular income. The return will be safe and normally assured unless the company faces some problem. Government bonds always pay you on time.
Look at the coupon rate and yield before investing in bonds.
Inflation and interest rate are two major risks in bond. If the inflation is 10%, the return of 8% from a bond is actually negative return in real term.
Government is also thinking of bringing inflation indexed bonds in the market. The return on inflation indexed bond is proportional to the inflation rate. Go for this when this comes to the market.
Finally, bonds provide stability to your portfolio and reduce risks. You should always invest some portion of your money in bonds. If you cannot figure out which bond to choose, you can invest in bond oriented mutual funds.