The Secret to Growing Your Wealth
Why Bond Investments are the Way to Go
For those who read the word ‘Bond’ and thought of a thrilling, action-packed journey, here’s a spoiler - it is unlikely to be one.
But here’s what you can expect - predictability, stability or assurance - the nomenclature could vary, but the idea is simple - you know what you are in for, and you will like it that way!
This is perhaps the greatest strength of bonds - simple, reliable instruments with no frills attached.
What are we talking about? Let’s delve right in!
A bond represents a loan given by an investor to the borrower who plans to use these funds for operational purposes. The borrower could be corporate, a state entity or, more often than not, a central government.
Yes, governments borrow too! Government securities - or bonds used for borrowing by the government, is in fact, one of the most common around the world and considered the most secure too!
Why do governments borrow, you may ask? Well, for the same reason that the rest of us do - their expenses are more than the revenue they earn, or they spend more than what they earn.
This is how borrowing through bonds works - the borrower issues bonds worth a certain amount, which are then subscribed to or bought by investors. The borrower promises to pay the lender - here the investor - a fixed return for the amount borrowed throughout the loan, while agreeing to return the principal on a pre-decided date.
Now, what’s in it for you as investors?
- Predictable Cash Flows
The borrower will pay interest, generally referred to as a coupon, on pre-decided intervals, which means that as investors, you know exactly when you will be getting funds. And because the rate of interest is also known, you also know the exact amount you will be getting.
This can be very helpful to meet your planned expenses, like children’s education, your annual vacation or even in your retirement period - when you must have assured and timely cash flows. -
Diversification
Equities are generally believed to be the asset classes outperforming others if one were to remain invested over the long term. Gold, on the other hand, is often seen as a hedge against inflation. The value of the real estate is generally believed to steadily rise over the years.
And yet, it is often advised that one must not put all the eggs in a single basket. Spreading your investments across asset classes can help investors to offset an adverse phase in a single asset class, which would otherwise drag the entire portfolio.
Investing in bonds for diversification can also be helpful in instances where prices in other classes are volatile, as bonds offer stable returns. -
Assured Returns
Investment in most asset classes - equities, commodities or real estate - is associated with several risk factors, which impact their prices. Unlike bonds, none of these come with assured returns.
Bonds, on the other hand, have fixed returns, which makes it easy for an investor to plan expenses based on the corpus their investments will generate. -
Preserving Capital
Your initial investment in most asset classes may or may not grow. In fact, in adverse market situations, investors may end up losing the amount they invested as well. This is not the case with bonds, which are fixed-income instruments. Not only are the returns on bonds assured, but the capital or the amount that you have invested in these instruments also remains intact. -
Tax Benefits
Investing in certain categories of bonds offers the unique benefit of indexation - which takes into account inflation throughout the investment, and this helps in bringing down the tax liability of an investor on the gains they have made on the investment - or capital gains.
How is this done? When an investor is redeeming their investment, their cost of acquisition or the initial cost of investment is adjusted for inflation. This generally raises the cost of acquisition or the value of the initial investment, and thus, lowers the number of capital gains on which you would be paying taxes.
Let’s understand this better with an example. If you bought a bond at 100 rupees five years ago, and its value is now 160 rupees, you have made a gain of about 60 rupees. But if you take into account indexation, the cost of the bond could be 125 rupees instead of 100 rupees, which means that your tax liability will be only 35 rupees as compared to 60 rupees earlier.
When looking to build their portfolio, investors are often confused about where they should invest, especially in their initial years. While equities can help generate inflation-beating returns over the long term, bonds are essential for those looking for a steady income and capital preservation. It also comes in handy when looking to diversify the portfolio.
Thrills are great - on a joyride at an amusement park. As for your investments are concerned, bonds are what will give you joy.
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