By Hemanth Gorur
Conservative investors in India flock to fixed deposits when in doubt. However, term deposits have lost their luster lately. Interest rates have fallen and risk averse investors appear to have no options.
Bonds are a good alternative in such cases, but you need to know how they work before you invest. Let’s take a look.
How bonds work
Simply put, bonds are the opposite of loans. When you take out a loan, you borrow money from someone, so you become a borrower. When you take out a surety bond, you lend someone money, so you become a lender.
Bonds are issued with a “face value”. This is what you receive when the bond matures. Along with this, you receive interest on the amount you invested in the bond. This guaranteed interest payment is called the “coupon rate”. The “yield to maturity”, on the other hand, is the effective interest rate you get when you equate the bond’s coupon payments, the amount received at maturity and any accrued interest at the current price of the bond. ‘obligation.
Bonds are generally long-term instruments. The period for which the obligation is taken is called the “term to maturity”.
Types of bond issuers and associated risks
There are mainly two types of risk associated with bonds: default risk and interest rate risk. Default risk is the probability that the bond issuer will not repay the amount invested in the bond. This mainly depends on the type of issuer and its creditworthiness.
Bonds can be issued by government, government agencies, public sector companies, financial institutions, and legal persons. Government-issued bonds are the safest because there is little or no risk of default. The risk of default of any bond can be measured by the ratings of bonds issued by rating agencies such as CRISIL, ICRA or CARE.
The other type of risk associated with bonds is interest rate risk. Bond prices can fluctuate based on market movements and economic trends. When interest rates fall in the market, bond prices rise. This is because investors may flock to stable investments like bonds because they don’t get good returns from traditional risk-free investments like deposits. This increases the demand for bonds. However, it also lowers the yield to maturity since the investor has paid a premium on the current price of the bond. This entails an interest rate risk.
Investing in bonds vs bond funds
Since bonds are long-term investments, maturity value is only realized if the bond is held to maturity. If you want to exit earlier, you can trade the bond in secondary markets, but this requires knowledge of the bond markets and a keen eye on interest rate movements.
Another way is to invest in bond funds. Bond funds are mutual funds that invest in different bonds depending on the theme of the fund. This avoids having to analyze bond price movements or market rates. Thus, bond funds are a very defensive investment, as bonds themselves are virtually free from default risk if the issuer has a high credit rating, and the diversification offered by the bond fund eliminates much of the risk of default. interest rate.
However, a caveat is in order here. There is a human element in the management of bond funds: the fund manager. It is advisable to invest in bond funds managed by fund managers who have been in the business for a long time and who have a track record of consistently profitable returns from managed funds.
Bonds can be your choice when interest rates fall. But, as with all investments, carefully assess the instrument and the markets before investing.
Bonds are issued by PSUs, government, government agencies, financial institutions and legal persons
The risk of default of any bond can be measured by the ratings of bonds issued by CRISIL, ICRA or CARE.
Bond funds are a very defensive investment, as bonds themselves are virtually free from the risk of default if the issuer has a high credit rating.
The diversification offered by the bond fund eliminates much of the interest rate risk of individual bonds
The writer is the founder, Hermoneytalks.com
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