Introduction to bonds
Bond is simply a loan taken by the companies or government in order to finance their activities. Investors lend money and receive interest from the borrower at pre-determined intervals. Normally the periods can be quarterly, half-yearly and yearly. The bond can be considered as IOU from the borrower to the lender. The original value of the bond is called as face value.
The rate of interest is called coupon and the period of holding is called as maturity. If you choose not to withdraw the interest, the interest amount is added to your investment amount and earns you interest. At maturity, the amount you get is called as maturity value.
Example, if you buy a bond with a face value of Rs 100, with a coupon of 7 per cent, you get Rs 7 at the end of each year. If you opt to get this interest half-yearly, you get Rs 3.5 every 6 months.
Types of bonds
The bonds are of various types: capital gains bonds, taxable bonds, company bonds, commercial paper, treasury bills, strips, zero-coupon bonds and foreign currency convertible bonds, available to non-residents. Most of these bonds are taxable, while some like those issued by NABARD are tax-free.
Trading in bonds
Unfortunately trading in bonds is not available for Indian retail investors. You have to hold the bonds till maturity or till the borrower decides to repay the loan.
Factors affecting the bonds
The most important factor affecting the bond returns is the rate of interest. As the interest rate goes up, the returns from the bonds go down, since you are stuck at the lesser coupon. Another factor that can affect the bonds is the liquidity risk. This is true for company bonds, as the company may land in financial crisis and would be unable to repay the bonds. This makes bonds a riskier investment option than FDs.
Asset allocation for bonds
Since bonds are quite risky, it is advisable to opt for bonds issued by government or reputed corporate entities. Crisil gives credit rating for various bonds. The bond you want to go for should have at least AA+ rating. Once you do that, you can allocate 10 per cent of your portfolio towards bonds. If possible, choose short-term bond fund to protect yourself against interest risk.
Why choose bonds?
Besides offering you safety, bonds also tend to give you capital tax benefits. It is advisable to opt for mutual funds investing in bonds, as you enjoy the benefit of liquidity. Also you get exposure to different types of bonds at a mere amount of Rs 5,000.
For example, IDFC Dynamic Bond fund has managed to generate returns of 8.8 per cent, since 2002, when it was first introduced. Over the past 1 year, it has given a return of 18 per cent, as compared to the its benchmark, Crisil Composite Bond that offered a return of 7.8 per cent.
Bonds are an excellent diversification tool for those looking for stability and tax-saving. But they also carry certain risks. It is advisable to find out the reputation of the borrower as well as your risk appetite before investing.