Bonds are debt instruments where the lender lends money to a bond issuer. The bond issuer guarantees to repay the sum borrowed at the end of the bond tenure, plus interest at regular intervals. A private or public company, a bank, a non-banking financial company, or the government can issue a bond. Bonds are low-risk investment options that offer good diversity. Bonds add income and diversification to an investment portfolio while carrying a lower risk than equities. This article covers how to invest in bonds in India, things to consider before investing in bonds, and the risks associated.
How to Invest in Bonds?
Bonds are a type of secured investment that provide safe returns during the investment tenure. When you invest in bonds, you’re generating a secondary source of income for yourself as well as a well-balanced investment portfolio that will protect you from stock market volatility. Bonds also help to diversify and reduce risk in your portfolio.
You can buy bonds in both the primary market and secondary market.
- Primary Bond Market: Primary bond market is where the bond issuer and the investor deal with each other.
- Secondary Bond Market: In a secondary bond market, investors can trade bonds that have been issued and purchased through the primary market.
Earlier, investing in bonds was a time-consuming and complicated process. Investors had to choose from the limited bond options available with the broker, submit various documents, and sign papers before getting the bonds. One would either receive a bond certificate or hold them in their demat account. The entire procedure would take about a week.
However, with the advancement of technology, this procedure has become fully paperless and extremely fast.
In the primary bond market, you must fill out a form and submit it along with the relevant documents, and the bond will reflect in your demat account after allotment. On the other hand, in a secondary market, you can easily buy or sell the bonds that are available.
Following are the three ways to invest in bonds:
1. Buying Bonds Through a Broker
You can buy bonds through most brokers in the same way that you buy stocks. However, fees may vary widely, and researching all of the possibilities can be challenging. Since each company may have dozens of bond options. Furthermore, you will have to analyse the bond issuer to ensure they will be able to repay their obligations.
2. Buying Bond Mutual Funds and ETFs
Investing in bonds through mutual funds or ETFs saves a great deal of effort. When you buy a bond mutual fund or an exchange-traded fund (ETF), you don’t have to decide which bonds to buy. Instead, the fund or ETF provider selects them for you and typically categorises them by kind or duration. Thus, making bond investing easy for you.
3. Buying Bonds Through RBI Retail Direct
Individual Investors can invest in Government Securities through the Retail Direct scheme. Under this system, you can register for a Gilt Securities Account with the RBI called ‘Retail Direct Gilt (RDG)’. RDG account holders can participate in the primary issuance of CG / SG / T-bill / SGB.
What are the Tips for Investing in Bonds?
Following are the tips to consider before investing in bonds:
- Bond Maturity : The bond maturity date is the day on which you will receive back your investment amount. Therefore, it is important to know how long your money will be locked up in the bond before you invest in it.
- Bond Rating : You can determine the creditworthiness of a bond by its rating. A lower rating indicates a higher chance of default and capital loss. The highest rating for a bond is AAA. Bonds with a credit rating of C or lower are considered to be low-quality or junk bonds, and these have the highest chance of default.
- Bond Yield : Bond yield is the return you can expect from your bond investment. Bonds with high ratings often have a lower yield. While bonds with low ratings have a higher yield. Since bonds with low ratings are riskier than bonds with high ratings, the returns are higher. The high yield compensates for the high risk. Thus, you should consider the bond ratings and also the bond yield while choosing a bond for investment.
- Bond Issuer : The track record and credibility of the bond issuer are very important. Thus, knowing a company’s history can help you decide whether or not to invest in its bonds.
- Investment Objective : Bonds are good investment options for diversification. Thus, assess your investment objectives and asset allocation strategies before investing in bonds. In addition, there are a variety of bonds available. Hence, pick a bond that best fits your investment portfolio, depending on your investment objective.
- Risk Tolerance Level : Your risk tolerance levels greatly impact which type of bond to choose. If you have a high-risk tolerance, you may consider investing in bonds with low ratings. On the other hand, a bond with high credit ratings is more suitable if your risk tolerance level is low. Bonds with a lower credit rating offer a higher yield to compensate for the high risk. Thus, consider your risk tolerance levels before investing in a bond.
- Macroeconomic Risks : Bonds lose value as interest rates go up. The risk of interest rates changing before the bond’s maturity date is known as interest rate risk. It is impossible to predict the interest rate movements. Thus you should avoid trying to time the markets. Instead, concentrate on your long-term investment goals. Bonds are also highly sensitive to inflation.
- Bond Prospectus : Reading the bond’s prospectus is very important. It gives you an understanding of portfolio allocation. If you’re going to invest in a bond fund, it is advisable for you to understand the fee structure, and what types of bonds it invests in. The fund’s name may only imply part of the allocation. For example, government bond funds can sometimes hold non-government bonds as well.
- Broker : If you’re buying individual bonds, choose a platform or broker that has been in the bond market for a long time. Also, understand the fees and commission associated with your bond investments. Have a clear breakdown of all the associated costs.
What are the Risks Associated with Bond Investments?
Following are the risks associated with bond investments.
- Interest Rate Risk: Interest rates and bond prices are inversely proportional. Bond prices fall when interest rates rise. Thus, the bonds you hold may lose value when interest rates rise. Bond market price volatility is often because of interest rate changes.
- Credit/ Default Risk: It is the risk of the bond issuer defaulting on their debt obligation. It is also known as financial risk or business risk.
- Liquidity Risk: Liquidity risk refers to the probability of not being able to sell/ liquidate your bond investment. In other words, there is the possibility that you will not be able to find buyers when you wish to sell or liquidate your bond investments.
- Inflation Risk: Inflation refers to the rate at which the prices of goods and services increase over time. Thus, if the bond return is lower in comparison to the inflation percentage, you may lose your purchasing power. In other words, your returns are lower than the inflation rate.