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Should you buy bonds directly?

Debt mutual funds invest in individual corporate bonds giving investors a wide variety of choices. If you are thinking that it may be simpler to just subscribe to a debenture issue from one of the corporates then here is what you need to know and keep in mind.

Equities and bonds, that’s what we learn about in finance classes. In reality, at least in the Indian context, its equities and fixed deposits. Very few individual investors venture into direct investments in corporate bonds. 

While fixed deposits are the go-to choice for the low-risk part, stable return part of a portfolio, investing in bonds can help make it more diverse and tax-efficient. There are two ways to get exposure to bond investing, through a mutual fund or directly. 

Debt mutual funds invest in individual corporate bonds giving investors a wide variety of choices. If you are thinking that it may be simpler to just subscribe to a debenture issue from one of the corporates then here is what you need to know and keep in mind. 

Do you know credit risk?

All bonds carry credit risk and default risk. Credit rating agencies like CRISIL, CARE and ICRA, among others rate a bond issue from a corporate according to their assessment of the company’s financial ability to pay interest on time and repay the capital. For example, a AAA-rated bond is of the highest quality and D rated bond is of junk quality. 

Credit risk refers to the change in this rating over the period that the bond is in existence and default risk is, of course, the chance that you don’t get your interest payment and your money back.

When you are buying bonds directly, be sure to check the published credit rating. This is not foolproof, as we have seen over the last 2-3 years, even AAA-rated bonds can get downgraded and default. For example, individual investors in DHFL’s bond issue are now stuck as the NBFC finds it doesn’t have the capital to repay its lenders; its issuances originally were rated AAA.

The current AAA bond yield is around 4%-5% on average depending on the tenure; as the rating moves lower, there is a premium on yield that investors seek and hence, the yield is higher. 

If the bond is not listed, selling may or may not materialise, depending on whether you find a buyer and what price they are willing to pay.

Can you sell, when you want to?

Buying a bond is only one part of the transaction, the second is getting your money back. You can do this either by selling in the secondary market on exchanges or wait for maturity. If you need the money sooner than envisaged you may look to sell the bond. 

However, this is easier to do if it is listed. The tax advantage of 20% capital gains tax along with indexation also applies only to listed bonds. However, not all bonds get listed and post listing too, there may be issues with the liquidity and trading volume of bonds. Low liquidity and trading volume might mean you have to settle for a lower than the expected price on sale. 

If the bond is not listed, selling may or may not materialise, depending on whether you find a buyer and what price they are willing to pay.

Some of these hurdles are overcome in debt mutual funds which invest in bonds. There’s the tax advantage for three years plus holding period remains,  and at the same time, you can sell the fund anytime you want. Checking credit risk is the job of a fund manager and you get the advantage of a diversified portfolio rather than being stuck with one or two bond issues. 

Funds usually invest in listed securities which also helps them take advantage of price rise during periods of falling interest rates. 

Be mindful in your direct bond exposure and if you are not able to invest very large amounts with thorough credit checks, it’s best to rely on debt mutual funds. 

 

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