Besides being a fixed income-earning instrument, bonds offer a bouquet of choices, says Priya Desai

Is there any advantage if I invest in bonds? I have some cash that I need to invest. I wonder if investment in bonds can be a profitable alternative?” This casual query from one of my silver friends set me thinking about the pros and cons of bonds as a financial instrument.

Silvers are always on the lookout for fixed income-earning instruments to park their funds for a stable inflow. Given that they are easy to comprehend, offer a fixed income and are placed with banks, financial institutions and reputed corporates, the natural choice often veers towards fixed deposits (FDs). The calculation of income earned in FDs is fairly straightforward. However, when the question of investing in bonds arises, the issues do not remain as simple. This is because bonds are intrinsically very different from FDs and stocks.

Bonds

When we think ‘bond’ one is reminded of the legendary line, “My name is Bond, James Bond”, an integral part of all James Bond films! But if one moves away from Hollywood, bonds are essentially a commitment for various purposes. For example, while accepting employment in a company, the prospective employee might be required to sign a bond. But in finance, a bond is an instrument that indicates indebtedness to the bondholder.

A bond is a financial instrument issued for the purpose of raising capital, and various institutions use this method to garner funds. Among them are the central and state governments, government institutions and financial institutions as well as private entities such as companies.

As a bond indicates the indebtedness of the issuer, it is a debt security under which the issuer owes the debt holders (the investors) certain obligations or terms. According to the terms of the bond, the issuer has to pay the investor an interest, which is also called the coupon; and/or repay the principal at a later date, referred to as the maturity date.

The interest is usually payable semi-annually or annually, i.e. at a fixed interval just like FDs. However, just like stocks, bonds are securities with a difference. When an investor buys a stock, s/he obtains an equity stake in the company. In contrast, a bondholder has a creditor stake in the company, as s/he is a lender.

Hence, a bondholder has a priority status over the stockholder. In case of a situation of bankruptcy, a bondholder will be paid before the stockholder but not before the secure creditors. Most bonds have a defined term for redemption but stocks remain outstanding for an indefinite period of time. Bonds are less volatile than stocks; this is also why they have much lower performance compared to stocks in the long term.

Choices galore

Unlike FDs, when you invest in bonds, there are a number of varieties to choose from. An investor needs to determine the requirements or objectives while choosing a particular type of bond. Details about these bonds are available on websites of various financial institutions and asset management companies.

Some of these bonds are available in the secondary market and are tradable, while others are not. For instance, Government of India Savings (Taxable) Bonds are not traded on the secondary market. Let us look at the features of a few bonds:

• Tax-Free Bonds are one of the most popular, owing to their special feature of freedom from the payment of tax on the interest income earned. These bonds are issued by government institutions and public-sector companies at different times depending upon government programmes for garnering funds for various purposes through these bonds. Some public undertakings that raise funds through the issue of tax-free bonds are Indian Railway Finance Corporation Ltd (IRFC), Power Finance Corporation Ltd (PFC), National Highways Authority of India (NHAI), Housing and Urban Development Corporation Ltd (HUDCO), Rural Electrification Corporation Ltd (REC), National Thermal Power Corporation Ltd (NTPC), National Hydroelectric Power Corporation Ltd (NHPC), Indian Renewable Energy Development Agency Ltd (IREDA), etc. These are traded on the stock exchange and are liquid. If sold before one year, short-term gain tax is applicable while long-term capital gains tax is 10 per cent. So, unlike stocks, they do not enjoy the benefit of tax-free capital gains. One can remain invested for 10 to 20 years in these bonds.
• Government of India Savings (Taxable) Bonds enjoy a coupon of 8 per cent payable semi-annually. The interest earned on these bonds is taxable as per the income tax slab of the investor. Both options—cumulative and non-cumulative—are available and there is no ceiling on the investment amount. These bonds are non-transferable and, hence, non-tradable on the secondary market.
• Investors desirous of investing gains of long-term capital assets like land, house, property, etc, within six months of sale of these assets find a valuable financial instrument in Capital Gains Bonds. These bonds enjoy tax exemption facilities for transferring such gains with a condition of a three-year lock-in period. The facility is available for an invested amount with a limit of ₹ 5,000,000.
• Corporate Bonds are issued by large public and private companies for various purposes such as building a new plant, expanding the business or for purchasing machinery and equipment. These bonds are risky compared to the bonds discussed above, as an investor may lose all his investment in the event of the company going bankrupt. But they provide higher returns than government bonds.
• Sovereign Gold Bonds denominated in terms of gold grams, with a maturity of eight years, were issued in March 2016. This new instrument on stock exchanges has gained popularity. Recently, it is quoting at a premium of 11 per cent over the issue price. These bonds provide the benefit of the gold price, obviate the need to hold gold in physical form, and offer tax benefit in addition to 2.5 per cent interest.
• If an investor does not want to directly invest in bonds and yet wants to diversify the portfolio with bonds, an option is available in the form of debt mutual funds that invest in bonds. Dynamic Bond Funds, Long-Term Income Funds and Gilt Funds gain more during periods of falling interest rates.

Bond price and yields

It is important for an investor to understand the relationship between bond price, interest rate and yield. The bond price is indicative of the present cash inflows from it, discounted by the market yield. If a bond is not traded, its price and yield will remain unchanged. In case of a traded bond, if it is purchased at a lower price, the return (yield) from it will increase and vice versa.

So, when interest rates start falling, bond prices start increasing in the secondary market and vice versa. In periods of a fall in bond prices, both the mutual funds and individual investors who want to cash out of the market by selling the bonds suffer a loss. On the other hand, cash-surplus investors can benefit by buying bonds when prices are low and selling them when prices rise; this allows them to earn capital gains, which is the difference between the buy and sell price.

Are they risk-free?

Like other financial instruments, bonds offer a mix of safety and risk. Highly rated bonds bought at an attractive coupon offer the same safety and fixed income as FDs over a long period. Bonds that are traded in the secondary market are exposed to the same risk as stocks owing to volatility in the market and the attendant risk.

Look at the benefit of tax-free bonds that offer a reasonable interest coupon of 8 per cent over a longer period. An investor that parks surplus funds in these bonds will be freed of the worry of paying any tax over the interest income and will get a fixed income for a long time. On the other hand, an investor who invests in bonds that default on interest and the principal payment suffers a high risk.

A sudden downgrading of a bond adversely affects the bond price. Debt mutual funds history is a standing testimony to the losses suffered owing to such downgrading of bonds. Individual investors suffer in such periods of volatility too.

Caution is the byword

Risk is inherent in financial investments and instruments. It is foolhardy to think that bonds are an exception to this feature of inbuilt risk owing to changes in the financial environment. However, risk levels vary and some risks never materialise. In addition to being fixed income-earning instruments, bonds offer a wide avenue to diversify an investment portfolio by carefully comparing the risks, expected returns and liquidity aspects. The Indian bond market is a strong one, and has witnessed significant expansion in recent years.

No one wants to be a loser or bystander in the financial world. But a winner works to succeed. Silvers who have planned their investment portfolio with an eagle’s eye, patience, study and foresight can find bonds to be a useful financial instrument.

The author is an economist based in Mumbai

Photograph by iStock
Featured in Harmony — Celebrate Age Magazine
September 2016