Know Your Bond
Things You Didn't Know
Recently the chief investment officer at the wealth management unit of a global financial powerhouse told clients to stay patient and collect coupon income.
Coupon income is the interest that an investor gets as interest paid by the issuer of bonds.
Bonds, one of the many fixed-income securities, are finding fresh attention now.
Rising interest rates have made investing in fixed-income instruments, such as corporate bonds, non-convertible debentures, market-linked debentures, govt securities or gilts, debt mutual funds, and floating rate bonds interesting and attractive.
The certainty of a predictable income stream from interest payments and near protection of principal have made these debt, or fixed income, instruments much sought after during these times of uncertainty.
There is a compelling reason for having bonds as an investment at all times and not just during times of uncertainty. But, that is for another time.
For now, interest rates will stay high, because controlling inflation is topmost on RBI’s agenda. Interest rate is one of the monetary policy tools used by central banks around the world to combat it.
For now, let us revisit the basics of investing in bonds. An instrument that offers a stream of fixed income even in volatile market conditions.
The basics are just that. Basic. Bearing this in mind will serve investors as a guidepost for selecting their bond investments based on their risk profile.
These are the aspects that you should consider while investing in bonds and other debt instruments.
A) Credit quality: A non-negotiable factor one should consider while investing in bonds is credit quality. More so, if you are extremely particular about the quality of the borrower.
One of the most important things to look for when investing in fixed-income instruments is the credit quality of the issuer.
Credit quality refers to the ability of the issuer to make timely interest and principal payments on the bond.
Various factors affect the credit quality of companies.
Generally, the higher the credit quality of the issuer, the lower the risk of default and the lower the yield on the bond.
Look at the credit rating of an issuer before investing in a bond. Also, keep an eye out for rating upgrades and rating downgrades of bonds as they reflect developments that impact the ability of the bond issuer to honour the covenants mentioned in the bond.
Credit rating is an assessment of a bond issuer's defaulting probability on payment of interest and principal. It is not a recommendation to buy, sell or hold a bond or debt instrument.
Investors must consider ratings as the main input in making an investment decision.
In India, the RBI has made it mandatory for all bond issuers to get a credit rating for their instrument.
The ratings are provided by credit rating agencies such as CRISIL Ltd, CARE Ratings Ltd, and ICRA Ltd.
B) Interest rate:The prevailing interest rate has a bearing on the coupon or the rate that the bond issuer will pay, to a buyer.
A hike in the key policy rates by RBI, the central bank of India, impacts the yield of the bond.
But, bonds bought in the primary will not get impacted by as the interest payable on it won’t change and the principal will get redeemed on maturity.
If interest rates rise, the price of existing bonds tends to fall in the secondary market. This is because new issuances are at a higher interest rate.
One must consider the likelihood of interest rate changes when investing in fixed-income instruments, particularly for longer-term bonds.
C) Maturity: The length of time that a borrower, or the bond issuer, takes to repay the principal is referred to as maturity.
The longer the time that a borrower takes to repay the principal, the yield tends to be higher. But, the risk also tends to be higher. It is important to consider your investment horizon and risk tolerance when choosing the maturity of a bond
D) Inflation: Inflation is when prices of goods and services rise in an economy. A rise in prices reduces the purchasing power of the income generated by a bond or bond fund.
Inflation erodes the value of future cash flows, which can reduce the value of a bond.
If inflation continues to rise beyond the RBI’s tolerance band and tends to be stubborn without any sign of softening, the central bank can raise the repo rate – the key policy rate for the economy.
The RBI has already raised the repo rate by 225 basis points, or 2.25% percentage points, in 2022 as it looks to control.
It appears that inflation will stay high in 2023. The central bank too thinks so.
The RBI said in December that “inflation may be slightly down, but it is certainly not out. If anything, it has broadened and become stubborn, especially at its core.”
It is important to consider the potential for inflation when investing in fixed-income instruments and choose instruments with yields that are higher than the expected rate of inflation.
E) Diversification is the practice of spreading investments across a variety of assets to reduce risk. It is important to diversify a fixed-income portfolio by including a mix of bond types and issuers.
Investors can buy a mix of short-medium and long-term fixed-income securities to diversify their investment portfolio.
This can help to reduce the impact of any one bond or issuer defaulting on its payments, or the impact of a hike in interest rates.
F) Tax liability: The tax treatment of fixed-income instruments can vary depending on the type of instrument and the investor's tax bracket.
The tax incidence on various fixed-income securities such as 54-EC bonds, REITs or Real Estate Investment Trusts, InvITs – Infrastructure Investment Trusts, Pass-Through Certificates, Sovereign Gold Bonds, and Market Linked Debentures could vary.
It is important to consider the tax implications of investing in fixed-income instruments and choose instruments that are tax-efficient for your situation.
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