What are bonds? Why to invest in Bonds?

As 31st March looms closer, the scramble to set our finances, particularly the tax planning starts to take precedence over all other activities, including the ongoing World Cup. After cheering for our favourite team, we are back at our laptops/tablets to figure out which is the best place to save taxes, and invest for the future. While many pundits and websites will tell you to invest in Tax Saving Funds or ELSS , many more will tell you to ensure that you have allocated your assets properly and have an appropriate exposure to Equity, Fixed Income and Gold. While enough has been said about equities in this environment of rising markets, it is also important to look at fixed Income and one important component of fixed income – Bonds.

What are bonds?

Investopedia summarizes what a bond is beautifully, here is what it says:

“Just as people need money, so do companies and governments. A company needs funds to expand into new markets, while governments need money for everything from infrastructure to social programs. The problem large organizations run into is that they typically need far more money than the average bank can provide. The solution is to raise money by issuing bonds to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer.

Of course, nobody would loan his or her hard-earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date.”

Bonds come under the fixed-income category since you know the exact amount of cash you'll get back if you hold the security until maturity.

How your investment in bonds pays
Bonds which generate fixed income may be issued by Governments (state and central), companies, banks and financial institutions. Bonds generate returns through two sources.

	1.	Bonds pay periodic interest throughout its term; these are termed as coupons. Unlike equities (where the dividend income tends to fluctuate), the coupon rate of bonds are fixed. These coupons can be reinvested back and allowed to earn more returns, like you can do in a regular FD.
	2.	Bonds also generate returns through capital gain/loss. When there is change in the market interest rates the trading price of existing bonds tends to change accordingly. Typically when market interest rates fall, bond prices move up, leading to capital gains. Conversely, when interest rates rise, bond prices fall, resulting in a loss.

Bonds can be traded and sold before maturity and thus you can gain from market movements. This is what distinguishes a market-traded bond from other fixed income instruments such as fixed deposits, postal savings and retirement savings such as PF and PPF.

4 factors that affect bond returns
Returns from fixed income instruments and bonds are sensitive to four factors.

	i.	Change in key interest rates
		An increase or decrease in the key interest rates (which usually is linked to changes in the RBI’s monetary policies) can cause a fall or rise in bond prices and its returns. The returns of bonds with a longer maturity period are more sensitive to interest rate changes.
	ii.	Inflation
		Continued higher inflation leads to higher interest rates, further lowering bond prices.
	iii.	Credit risk
		Bonds other than those issued/guaranteed by the Central Government are exposed to the risk of default by the borrower (i.e. the risk that the borrower may fail to repay the interest and principal). The higher the perceived default risk from an instrument, the higher would be the relative yield on that bond.
	iv.	Other economic indicators
		Other economic factors such as GDP growth, fiscal deficit, currency rates and crude oil prices also have an impact on bond returns. For instance, a weak rupee, rising oil prices and widening deficit may hurt bond returns. But expectation of weak economic growth is actually positive for bonds, as then the central bank may cut interest rates, sparking a rally in bond prices.

Why invest in bonds
In India, the retail investor is largely exposed to fixed income instruments through government-run assured return schemes such as NSC, PPF and of course bank fixed deposits.

Unlike equities, bond markets are institutional in nature and thus have had minimal direct retail participation.

But the last three-five years have seen many companies raise money by public issuances of bonds, particularly tax-free bonds. With general interest rates remaining high, the coupon rates on these tax-free bonds have made them an attractive option. For investors in the higher tax brackets tax-free bonds may be more attractive, than fixed deposits offering similar interest rates, because of their inherent tax benefits. Despite their having maturity of over 10 years, investor interest indicates appetite for appropriately priced bond issuances.

Debt mutual fund schemes that invest in bonds are also good for asset allocation. Remember prudent asset allocation is a key to long term wealth creation. Different asset classes can perform differently under similar market conditions. You can also consult a financial advisor before taking any major investment related decision.

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