Bonds offer Fixed Income to investors, and are relatively less risky investment category as compared to other asset classes (viz. Equity, Commodities, Alternative Investments etc). Bonds provide a fixed-return to investor (similar to a Fixed-Deposit), but are relevant for investors who wish to go for higher returns vs FD’s, while bearing a little higher risk.
An allocation of your investments to Fixed Income Investments is necessary for portfolio diversification, intended to minimize overall risk of your portfolio.
A Bond is a fixed income instrument that represents a loan given by an investor (bond holder) to a borrower (bond issuer). Borrowers (Issuers) range from Central Government, States, Public Sector Undertakings, Corporates, Municipal Corporations etc., who want to raise funds. When you “buy a bond” (i.e: lend money to the Issuer), the Issuer will pay you interest for the tenure they borrow the Principal amount, and will return the Principal at the maturity of the Bond.
Fixed income instrument play a crucial role in an investor’s portfolio. Owning bonds helps in diversifying a portfolio’s risk, as changes in the bond prices are not correlated with changes in the equity market. This helps in reduction of overall risk of the Portfolio (Ex: Bond prices were not affected in Equity Market correction in 2018, providing stability to overall Investment Portfolios of investors).
It is important to note that Bond Prices are affected by changes in Yields in Bond Markets, and Yields in Bond Markets are in-turn dependent on Macro-economic variables. From a retail investor’s perspective, who generally hold the Bonds till their maturity, fluctuations in Bond prices have no practical impact on their portfolio.
When investing in Bonds, it is very important to understand the rating profile of the bond issuer, which can be gauged from their Credit Ratings. Highest credit rating is AAA (least risky) and lowest is D (Default category). The spectrum of ratings is as follows: AAA, AA+, AA, AA-, A+, A, A-, BBB+ and so on till Category D.Investors can understand the risk by going through the Rating Rationales available in public domain, from prominent rating agencies are CRISIL, ICRA, INDIA RATINGS, CARE etc.
How to Invest in Bonds?
Typically, there are two options available to invest in bonds;
Option 1: One can use Primary market route to invest in Corporate Bonds by subscribing to Public Issuance (similar to Equity IPO).
Option 2: Secondary market quotes are mainly available in inter-bank market only, and access of inter-bank market is limited to institutional players like banks, mutual fund, insurance companies. However, bonds can be purchased in secondary market by Individual investors via SEBI registered intermediaries like ICICI, Kotak Wealth, HDFC and Tipsons.
Let’s look at an example of how investing in bonds works:
Example for Primary Market:
Let’s say Mr. Y invests Rs. 1,00,000 in a 10-year bond that pays him a 12% fixed annual interest rate. This means that Mr. Y will be paid Rs. 12,000 per year for 10 years until he receives back his principal or Rs.1,00,000. (He will receive the principal amount back on the “maturity date”).
Example for Secondary Market:
- On 24-Apr-2019, Mr. Y wants to invest Rs. 1, 00,000 in bond issued by Banks. He selects high coupon bond issued by Karnataka Bank. Bond details are;
- Bond Issue Date: 18-Feb-2019
- Bond Maturity Date: 18-Feb-2029
- Bond Face Value (Value of one bond): Rs. 1, 00,000
- Coupon Rate: 12.00% (Interest payment on 18-Feb annually till maturity date)
If current price of the Karnataka Bank bond is 100.50 (Price represented in % terms of face value) and current market yield is 11.88%.
Mr. Y has to pay Rs. 100,500 as principal amount (1, 00,000 X 100.50%) plus accrued interest Rs. 2,137 (holding period interest) to the seller. Total amount payable to seller is Rs. 1,02,637.00 (Principal value plus accrued interest).
If current price of the Karnataka Bank bond is 99.50 (Price represented in % terms of face value) and current market yield is 12.06%.
Mr. Y has to pay Rs. 99,500 as principal amount (1, 00,000 X 99.50%) plus accrued interest Rs. 2,137 (holding period interest) to the seller. Total amount payable to seller is Rs. 1, 01,637.00 (Principal value plus accrued interest).
Under Both Scenarios:
Mr. Y will get annual interest payment of Rs. 12,000 every year on 18th February till the maturity of the bond. On maturity Mr. Y will get back his Principal (Rs.100,000) along with that year’s interest.
Accrued Interest Calculation:
No. of days = 24/April/2019 – 18/February/2019
= 65 days
Now, calculate interest on Principal value:
= Rs. 2,137