Yields, coupons, defaults, duration… bond lingo tends to leave the 'aam aadmi' flummoxed more than anything else. Wasn't bond investing meant to be simple? If an aspiring bond market investor is what you are, here's what you need to know before you get started - minus the frills.
The BasicsA bond is really nothing but a loan. The issuer of the bond borrows money from the bondholder, who is the lender in this case. The interest (coupon) rate fixed for the bond depends primarily on the prevailing market rates and the creditworthiness of the borrower.
A borrower with high creditworthiness will be able to borrow money at lower interest rates, whereas a borrower with a questionable financial condition will in all likelihood need to offer lenders the lure of a significantly higher return, in order to compensate them for the additional risk they'll be taking on.
Various kinds of bonds exist, but they can be clubbed into three basic categories - Government bonds (or GILT's as they are called) have the lowest risk of default and the highest liquidity. However, they also provide the lowest return.
Bonds issued by PSU's (such as IRFC, REC, NTPC & NHAI) come next in the credit rating pecking order, have fairly high liquidity, and offer slightly higher returns than GILT's.
Private Sector companies (for instance, TATA Steel, Edelwiess Housing Finance, Shriram Transport Finance) offer higher returns, but their credit qualities vary depending on the financial strength of the issuer.
As a thumb rule, shorter maturity bonds (say for instance, 6 months) will offer a lower return to investors compared to longer maturity bonds (say 10 years). Longer maturity bonds also exhibit significantly higher price fluctuations, so be careful in buying them if your intention is to liquidate them prior to maturity.
Bonds can be bought in the primary market or the secondary market. Newspapers, Financial Portals (and most recently, Metro Trains!) regularly advertise these issues. They will typically display the rate of return, maturity date and 'credit rating' very prominently, as these three things matter the most when it comes to making an informed decision.
Sunil Jhaveri, Chairman, MSJ Capital has a different view on how retail investors should invest into the Bond Markets. "Ideally, retail investors should not invest in Corporate Bonds directly. This will have concentration & credit risk in case of default by the issuer. They should invest in Accrual Schemes through the MF route to take advantage of Diversification benefit, professional advise & capital gains tax benefit", he says.
How to interpret Credit RatingAll investments carry risks - there are no free lunches in the investing world! However, the quantum of risk that is acceptable varies from individual to individual, and credit ratings allow an investor to make informed decisions while investing into a bond.
A credit rating is issued by a rating agency of repute (such as CRISIL, ICRA or CARE) after a careful evaluation of the issuer's ability to service their interest and repay principal at maturity. A high credit rating (AAA) is a stamp of approval about the company's creditworthiness, whereas a poor rating (D) indicates that the bond is expected to default soon - so you need to have a very good reason to even give it a second thought!
Bonds with higher ratings will provide a lower return, and vice versa. The various ratings (ranked in decreasing order of creditworthiness) for long term debt instruments are AAA,AA,A,BBB,BB,B,C and D.
If you're risk averse, stick to a portfolio of AAA or AA rated corporate bonds, GILT's and PSU issues. If you can stomach more risk, you could consider bonds all the way down to BBB, at most.
Retail investors are advised to stay away from bonds that are rated BB, C or D - even if they are offering a higher rate of return. For instance, Jaiprakash Associates Ltd has a bond rating of CARE 'D'. Even if their bond issues are offering a higher rate of return compared to other bonds, they are best avoided.
Jhaveri of MSJ Capital believes that the interpretation of credit ratings is a task best left to a professional fund manager. "Once retail investors invest through MF route, they should not bother too much about credit ratings as they are depending on Expert Advice. Credit ratings & interpretation is a very complex matter, beyond the comprehension of any investor", he says.
Where do they fit in?Bonds fit into a well-diversified, well planned out portfolio of investments. One should not over-invest into bonds to the extent that they ignore higher risk; higher return asset classes such as equities altogether.
Although it's a very rough estimate, it could be said that one should invest up to their age in percentage terms into bonds, and the remainder into higher return asset classes. For instance, a 30 year old should have up to 30 per cent of his or her liquid assets in bonds, and not more. A more thorough risk profiling exercise will yield a much more accurate estimate of your ideal asset allocation.
Associated RisksThere are several types of risks associated with bond investing; however, there are two kinds that really stand out. Interest Rate risk is the risk of your bonds falling in value if prevailing interest rates were to be increased by the RBI (which usually happens in inflationary scenarios). Bond Prices are inversely correlated with prevailing interest rate changes.
However, if you're planning to hold a bond until it's maturity, the above stated becomes a moot point. If you're not planning to sell your bond, its prevailing market price has no bearing.
The second risk (called credit risk or default risk interchangeable) you need to be aware of it the risk that the borrower will fail to repay interest and/or principal in a timely manner. The level of credit risk can be ascertained from the rating of the bond.
A few final pointsBonds can be a useful alternative to leaving money idle in savings accounts or even fixed deposits. You'll need to open a demat account to buy or sell them. Preferably, perform a background check on the competence, experience and compliance team of the broker you're going to invest with.
Keep your eyes open when it comes to brokerage rates, so you don't get overcharged. Also, do bear in mind that incomes arising from bonds (other than tax free bonds) are clubbed with your income for the year and taxed accordingly. Retail investors are advised not to trade actively in bonds, but rather to buy moderate to high rated bonds, accrue interest, and hold them until maturity. Alternatively, as Jhaveri advises, they could opt for the hassle free experience of investing into Bond Funds instead.