Things to consider before investing in bonds directly

With debt funds roiled in trust issues, you may be looking for fixed-income products beyond debt funds. Typically, there are two primary criteria that retail investors seek from debt investments—safety and returns that are better than what a bank fixed deposit (FD) gives. One option to populate this part of the portfolio is investing in corporate bonds. But do they make the cut and does it makes sense for you to invest in them directly? We evaluate the options for you.

What works

Just as the interest on bank FDs is known at the time of making the deposit, the coupon or interest rate on a bond is usually known at the time of buying.

Bonds and debentures, typically, offer better returns than FDs and you can tie into these higher returns for the tenor of the bond. Many of the bonds may be secured against the assets of the issuer as an additional security. Since all bonds that are offered to the public have to be listed on a stock exchange, you can sell them on the stock market if you need funds before maturity. Any capital gain realized on selling the bonds in the stock markets is treated as long-term capital gain (LTCG) if you hold the bonds for at least one year before sale; also, you will get the benefit of indexation while calculating LTCG tax. This is unlike debt funds which has to be held for three years before the gain can be treated as LTCG.

Apart from subscribing to bonds in the initial public offerings (IPO), you can buy them in the secondary markets at the current market yield. For example, a bond issued by L&T Finance Ltd on 17 September 2009 with a coupon of 10.24% is currently available in the secondary market at a yield of 10.07%. If you buy the bonds now, you will get the same coupon of 10.24% but will pay slightly more than the face value of1,000 per bond which brings down the effective yield to 10.07% (bond prices and yields are inversely related).

You can build a diversified portfolio of bonds by buying through the primary and secondary markets. The face value of many bonds is 1,000 and the market lot on the NSE in the capital market segment is typically one bond. Diversifying across issuers and sectors will help reduce the risk of default by any one issuer.

What doesn’t

Unlike bank FDs and government-sponsored schemes that are guaranteed, bonds do not guarantee that the coupon will be received or that the principal will be returned on maturity. Some bonds may be secured, but in the event of a default selling the assets and receiving the principal and other dues is a long legal process.

So, as an investor, you should not only be able to evaluate the risk of default at the time of making the investment but also continuously monitor any change in the circumstances of the issuer which may reduce its credit-worthiness.

While the credit rating helps evaluate the level of risk of default at the time of investing, any subsequent deterioration in the ability of the issuer to service the debt is not captured by rating agencies in a timely way. The recent downgrades in the debt papers of the Essel group and others demonstrate this. Typically, retail investors are the last to know of any distress and by that time the price of the bond would have sunk making it difficult to exit.

Though it is possible to reduce the risk of default by diversifying the bond portfolio across different issuers, the extent of diversification will be constrained by the availability of suitable bonds since there are few IPOs and the secondary market is illiquid. “Investors may not be savvy enough to trade in bonds on the secondary market. What is available on the screen is the price of the bond. To determine the corresponding yield for a given price may not be possible for most investors,” said Joydeep Sen, founder, The funds available for investment may also be limited and the efficiency with which individual investors can track and monitor a large number of companies is likely to be low.

Another risk is decline in the bond’s market price in response to changes in interest rates. When interest rates go up, the prices of existing bonds come down. You may make a loss if you have to sell the bonds in such a market.

What you should do

If you are looking for a debt product, other than an FD, that gives a predictable and certain return, you may consider bonds, provided there are adequate safeguards built in, particularly in the current context of slowing economic growth and tight liquidity conditions.

Consider bonds from issuers such as banks and public sector units; among private sector bonds, consider those with the highest credit rating. “For safer credit it is a good time to buy and hold bonds. By this I mean that it should be bonds with AAA and equivalent credit rating along with good parentage,” said Roopali Prabhu, director, investment products at Sanctum Wealth Management, a Mumbai-based wealth management firm. Sen advises being cautious in considering issuers in sectors that are currently seen as fragile, such as non-banking finance companies (NBFCs).

If you are considering bonds to hold funds as goals come closer, then select the ones that mature before the time when you need to fund the goal, so that the targeted maturity amount is received from the issuer and you do not have to risk selling it in the secondary market at a lower price. It goes without saying that it is important to monitor the credit-worthiness of the issuer till the principal is repaid.

The interest income on bonds is taxed at the marginal rate of tax applicable to the investor. Even if you choose the cumulative option, where the interest is received on maturity along with the principal, it is taxed as interest income and not capital gains. “In a bond most of the return comes from the coupon and only a small portion from capital gains. If you are in the highest tax bracket, you will be paying 30% on the larger interest income portion and only a small portion of the total return will be eligible for 10% capital gains tax,” said Sen. “If you have a hold-to-maturity view and the bond is rated AAA or AA from a reputed business house, you can consider bonds. If you want liquidity and tax efficiency over a three-year period, then a debt fund is better,” he added.

The return from a debt mutual fund can be structured as LTCG by choosing the growth option and taxed at 20% along with indexation benefit. A view that Prabhu agrees with. “If you have at least a three-year horizon then invest through mutual funds because in the same amount of money, you are able to get more efficient diversification and expertise. Be aware of the price risk in some categories of mutual funds, but if you hold for the tenure recommended for a scheme based on its portfolio, you should be okay,” she said.


Author: Roky