Factors To Consider Before Investing In Bonds

Introduction

Investing in bonds can be exciting and tricky. Remember that bonds are debt instruments and create the relationship of a creditor and the debtor where the investor is the creditor. You have a wide option of investments in the bond category. There are infrastructure tax free bonds, corporate bonds, NBFC bonds, government bonds and even treasury bills (purely for short-term under 1 year)

While we understand bonds as a product, the actual investment process can be quite complex. Today, you can buy government bonds and treasury bonds by opening a retail direct account with the RBI. It is quite a simple process. You can also apply for most corporate bonds and directly get these bonds into your demat account. Let us also look at some of the key factors to consider before investing in bonds?

Things to consider before investing in bonds

Before investing in any bonds, here is what you need to quickly consider.

1) Check whether the bond is secured or unsecured. Typically, this does not apply to G-Secs but only to corporate bonds. A secured bond is backed by charge on assets of the company. The rates may be slightly lower but they are safer than unsecured bonds.

2) Check for secondary market liquidity. Most corporate bonds are either liquid or the traders are limited. In case you don’t intend to hold for the full tenure, you must have adequate exit options on the table.

3) Check out if the coupon rate or the rate of interest is competitive. There will be minor differences, but the coupon cannot be off the market. Remember that bonds with coupons lower than the market tend to trade at a discount.

4) What is the credit rating of the bond. This is perhaps the most important criteria. Typically, the AAA bonds are the safest bonds with very low chance of default. However, the yields are also lower on highly rated bonds compared to lower rated bonds. Many investors deliberately go down the rating curve for higher yields, but that can be a dangerous strategy.

5) Does the bond have a callability clause. Most long term bonds have a callability clause in that if the market interest rates fall sharply then the issuer will call back the bond after a specific period and redeem the bonds forcibly. In case you are counting on such high yields for long term financial planning, you could be in trouble.

6) Look at post tax yields. Bond interest is fully taxable in the hands of the investor. However, there are tax free infrastructure bonds like the ones issued by REC and PFC where the interest is entirely tax free.

Best Long Term Bond Funds

Here is a list of the best performing long term government securities funds, ranked on 5 year returns.

Data Source: Morningstar India

While the table above presents returns for 1 year, 3 year and 5 years, the funds are ranked based on five year returns, to give a longer term perspective for investors.

Best bond funds to invest

Here is a list of the best performing long term corporate bond funds, ranked on 5 year returns.

Data Source: Morningstar India

While the table above presents returns for 1 year, 3 year and 5 years, the funds are ranked based on five year returns, to give a longer term perspective for investors.

Conclusion

Bonds are an interesting addition to your portfolio, and you can get higher yields on the bonds, provided you are willing to go down the rating curve. That comes with risks.