You work hard to earn money, then think hard on spending it wisely. And now you have to stress harder to save or invest it profitably. That’s adulting! But don’t worry, once you learn how to invest in bonds, you can balance risk and returns like a pro.
In your desire to invest your savings in a profitable deal, you look for options like buying stocks, investing in FDs or RDs. But you will be surprised to know that there is another smart investment option, better than the traditional FD and can give high returns without the stress of market fluctuations.
Bonds, a reliable counterpart to the more volatile stock market, give you a steady, passive income. Interesting right? Let us understand the nuances of bond yields, credit ratings, and interest rate sensitivity in this blog. Whether you’re a seasoned investor or you want to know how to invest in bonds as a beginner, this guide will help you understand the bond market and harness its potential for your financial security.
What Are Bonds?
A bond is a debt security, which the lender uses to provide funds to the bond issuer for a certain amount of time. The bond issuer raises money from lenders and promises to pay back the amount borrowed at the end of the bond period, along with the interest paid at regular promised intervals.
So, when you buy a bond, you are lending money to the issuer, which can be any corporation or government. The bond issue:
- Pays interest at a specified rate during the life of the bond
- It repays the principal amount, also known as the face value of the bond, when it “matures,” or at the expiry of the bond period.
So, businesses or the government issue bonds to fulfil their financial requirements, and people invest in those bonds because they are a safer option than other capital market securities.
How Do Bonds Work?
Unlike stocks, which represent an ownership in a company, bonds are typically a loan, that you are lending to the issuer. The issuer can be the following:
- Governments
- Municipalities
- Corporations
The following are the key terms used in bonds:
1. Principal Amount (Face Value):
This is the amount you invest or lend to the issuer of the bond. You get this amount back when the bond matures.
2.Coupon rate:
This is the interest rate that is agreed between the bond issuer and investor. The interest is paid as per this rate at regular time intervals, as decided in the bond.
3. Maturity Date:
On this date, the issuer will repay you the principal amount.
4. Bond yield:
Bond yield is the total amount anticipated on a bond until it matures. Yield reflects the bond’s current market price.
The following are the steps showing how bonds work:
STEP1: Whenever the government or corporations need to borrow money, they issue bonds, which are a financial instrument that acts like a promise of repayment of the borrowed amount to the lender with an interest rate and other details.
STEP2: The investors buy/invest in such bonds.
STEP3: As soon as the issuer receives the funds they need, they start making regular interest payouts, called coupons, to the bond holders.
STEP4. On the date of bond maturity, the issuer repays the principal amount to the bond holders.
These bonds can be bought or sold in the trade market before their maturity date. Their prices fluctuate on the basis of various factors like varied interest rates, market demands, etc. However, bonds are generally less risky than stocks.
NOTE: The price of the bond and interest rate have an inverse relationship. When interest rates go up, bond prices tend to fall, and vice versa.
Different Types of Bonds
Credit agencies rate different types of bonds to determine their credibility and to help assess the likelihood that investors will be repaid. These bond ratings are grouped into two major categories:
- Investment Grade (Top rated):
- High Yield (Low rated):
There are 3 main types of bonds:
a. CORPORATE BONDS:
These are debt instruments issued by a company to raise capital for business expansion, growth, research and development. The interest you earn from these bonds is taxable, and these bonds generally yield higher returns than any other types of bonds.
b. GOVERNMENT BONDS:
Government bonds in India are the safest as these bonds fall under the broad category of government securities (G-Sec) and are primarily long-term investment tools issued for periods ranging from 5 to 40 years. Most G-Secs were initially issued for large investors, such as companies and commercial banks. However, eventually, GOI made government securities available to smaller investors, such as individual investors, cooperative banks, etc.
The Government Bond interest rates can either be fixed or floating and are disbursed on a semi-annual basis. The different types of Government bonds are discussed below.
1. Fixed-rate bonds
As the name suggests, these bonds come with a fixed rate of interest which remains constant throughout the tenure of investment irrespective of fluctuating market rates. The interest coupon is given in the nomenclature like, “Rate of Interest on the face value+ Issuer+ Date of maturity”. For example, 7% GOI 2021 means the bond coupon rate is 7% issued by the GOI and the bond matures in the year 2021.
2. Floating Rate Bonds (FRBs)
The FRBs are subject to periodic changes in the rate of interest. The change in rates is declared beforehand during the issuance of such bonds. For example, if an FRB comes with a pre-announced interval of 6 months; it means that interest rates on it would be re-set every six months throughout the tenure.
One more variant to FRBs is where the rate of interest is derived from 2 components: a base rate and a fixed spread. This fixed spread is decided through auction and remains constant throughout the maturity tenure.
3. Sovereign Gold Bonds (SGBs):
The Central Government issues sovereign Gold Bonds, wherein investors can invest in gold for an extended period through such bonds, without the stress of handling physical gold. The interest earned on such bonds is exempted from tax.
The price of SGBs are linked with gold’s prices. The nominal value of SGBs is derived by calculating the simple average of closing prices of 99.99% purity gold, three days preceding such bonds’ issuance. SGBs are also denominated in terms of one gram of gold.
As per RBI regulations, there are pre-defined limits set to SGB possession for different entities. Individuals and Hindu Undivided Families can only hold up to 4 kg of Sovereign Gold Bonds in a financial year. Trusts and other relevant entities can hold up to 20 kg in a financial year. Interest at 2.50% is disbursed periodically on such SGBs and has a fixed maturity period of 8 years unless stated otherwise. On top of that, no tax is levied on interest earnings through such SGBs.
Investors seeking liquidity from such bonds need to wait for the first five years to redeem them. However, redemption shall only be done on the date of subsequent interest disbursal. For example, Mr Mukesh invested in an SGB on 2nd November 2014, and interest will be given on 2nd December 2014 and every six months from thereon. Now, if he has to withdraw it on 2nd
Assuming that Mr A invested in an SGB on 1st April 2014, interest disbursals are set on 1st May 2014 and every six months from thereon. In case he decides to withdraw it on 1st September 2019, he shall need to wait till 1st October 2019(interest disbursal date) to receive the redemption amount.
4. Inflation-Indexed Bonds
These bonds are indexed as per the Consumer Price Index (CPI) or Wholesale Price Index (WPI). The principal and interest earned on such bonds are adjusted according to the inflation. This unique type of bond ensures that real returns remain constant, and the investors are safeguarded against the inflation rates.
c. MUNICIPAL BONDS:
Issued by a city or state, these types of bonds intend to raise money for a public project for example, schools, roads, or hospitals. The interest you earn from these bonds is not taxable. Municipal bonds are further divided into two types:
1. General Obligation:
This type of bonds is used by the municipality to fund projects that do not produce income, for example building parks, gardens, etc. These bonds are credible and are backed by the government, so the issuer will be doing the repayment without fail.
2. Revenue:
These bonds pay back investors according to the income created by those funds. For example, is the state government requires funds to build a nre highway, the bonds will be paid from the funds generated by the tolls. These bonds are exempted from federal taxes only.
Benefits of Investing in Bonds
Bonds help in preserving earnings by getting a timely, predictable return. More than that, they are like a steady, passive income from interest payments prior to maturity. The interest from most of municipal and government bonds is also exempt from income tax. Along with this, the following are the benefits of investing in bonds:
1. Assured Repayment:
Most of the bonds comply with SEBI , thus, they are safe and secure form of investment. Due to their stability of funds and promise of assured returns, bonds, especially government bonds, are a premium choice of investment with high yield. Since the issuing authority is the government, so there is a guarantee of repayment as per the stipulated terms.
2. Higher returns than FD:
A traditional Fixed Deposit income ranges 7-8%, while a good choice of bonds might leave you with return rate upto 15% per annum.
3. Adjustment against inflation:
The best part is that, bonds offer protection against the market ups and downs. In inflation-indexed bonds and capital-indexed bonds, the principal amount invested is adjusted against inflation. This provides an edge to the investors as investing in such funds increases the real value of deposited funds.
4. Regular income on diverse portfolio:
It is a strong investment option to balance risk and returns. As per RBI, the interest accrued on Government bonds are disbursed every six months to the investors. This provides them with a steady, stable source of income.
Risks Involved in Bond Investments
The following are the risks associated with investing in bonds:
1. Credit Risk:
If the company or government that issued the bond fails to pay you back the interest or the original money you lent them, there rises a credit risk. Due to unforeseen conditions they might go bankrupt or have serious financial problems. But, this might happen in very rare cases. To mitigate this risk, you must choose high-yielding bonds with the help of experts who can tell you the best bonds to invest in.
2. Risk of Interest rate:
If interest rates in the market go up, the value of your existing bond might go down. Let us explain why:
- If you hold the bond until it matures, you’ll get your money back along with the interest. But if you need to sell it before it matures, you might get less money than you paid for it.
- New bonds issued with higher interest rates will be more attractive to investors, thus lowering the price of older, lower interest bonds.
3. Risk of Inflation:
If the market inflation goes up, then the interest earned on your investment will not look sufficient. In a way, your money loses some of its buying power.
4. Liquidity Troubles:
You might have trouble finding someone to buy your bond when you want to sell it, or you might have trouble buying the bond that you want. This means it might take some time to turn your bond into cash.
5. Call Risk:
When the interest rates fall, the company or government that issued the bond might decide to pay it off early. They can then issue new bonds at a lower interest rate, saving themselves money. This means you get your money back sooner than you expected, and you might not be able to reinvest it at the same high interest rate.
How to Invest in Bonds?
If you are worried about where to start and how do you invest in bonds, then keep in mind the following simple tips:
- Know your bond’s maturity date so that you can calculate your money returns.
- Always check the bond’s rating or credit score.
- Do not invest before researching the issuer of the bond.
- Take help from top financing apps like Stashfin that help you understand your risk tolerance level.
- Do not forget to consider the economic factors like interest rates and inflation.
- Always believe in diversification of your portfolio. Invest in multiple bonds and other entities with the help of a financial advisor.
- Read the fund details carefully.
- Enquire about all the costs involved at the time of entry till the time of maturity.
How to Build a Bond Portfolio?
Now that you know how to start investing in bonds as a beginner, Stashfin gives a great opportunity to invest in India’s most trusted Corporate and Government bonds with ease and at the click of a button. You can choose from a wide range of Corporate Bonds with high returns and favourable tenures. You can see the credit rating of each of the listed bonds, indicating that these bonds have been issued by reliable, trustworthy companies with extremely low or no risk of default.
Conclusion
Investment is always a wise habit, but knowing where to invest requires research, planning, and courage. If you’re considering investing in the best bonds, it’s essential to evaluate key variables such as your risk appetite, investment goals, current portfolio, and market trends. Alongside these, always assess the issuer’s credibility and the bond’s credit rating to ensure liquidity and timely repayment.
Interestingly, just as choosing the right Personal Loan Tenure can impact your monthly budget and financial stability, selecting the right bond with the correct maturity timeline is equally important for your long-term investment strategy.
Frequently Asked Questions
1. What Is the Difference Between Bonds and Stocks?
The following are the key differences between bonds and stocks:
Stocks:
- Represent equity in a company.
- They can get you high returns via price appreciation and dividends.
- Come with risk of losses due to market volatility.
- Gives variable income.
Bonds:
- Represent a loan to an issue.s
- They give more stable returns with predictable fixed-interest payments.
- Market volatility does not affect income form bonds, but there is a risk of interest rate fall.
- You get creditor rights, not ownership.
2. Are Bonds a Safe Investment?
Yes, bonds are a safer investment option than shares. However, no investment is absolutely guaranteed, but in the case of bonds, issuer promises to pay the coupon over the life of the bond, and to repay the original investment at maturity.
3. How Can I Buy Bonds?
Stocks are traded on a centralized market, which means that they are bought and sold at one price, unlike stocks. Bonds are traded over the counter, meaning that you must buy them from brokers.
4. What Is a Bond Yield?
Bond yield is the annual return an investor expects from a bond investment. It is a percentage that is derived from the bond’s price, coupon payments, and maturity value. Bond yields are indicators of the economy and inflation. They can also help investors compare different bonds.
