A lot has been discussed about investing in bond mutual funds. Here is what you need to know about how to invest in bonds or debentures.
Q: Is investing in bonds more difficult than doing so in equity shares
A: Arguably, investing in bonds is simpler than doing so in equities, because there is a defined maturity. That is, the issuer of the debt instrument commits to pay back the invested amount on a specified date. In equities, there is no maturity, so the issuer would not repay you. Therefore, you have to sell it in the secondary market when you need to. The selling price of your equity shares depends on someone else, i.e., the purchaser at that point of time, over which you have no control.
Q: Sounds good. But is there any catch?
A: As you are dependent on the issuer of the bond for getting back your money, the credit-worthiness of the issuer is of paramount importance. It is possible to sell a bond in the secondary market prior to maturity, but if there is any deterioration in the quality of the issuer, the purchaser would consequently pay a lower price. Obviously you would want to buy bonds or debentures issued by a good-quality issuer. But how do you ascertain the quality of the issuer? The answer to that is the credit rating given to the instrument. Credit rating agencies give their opinion on the credit-worthiness of issuers, as AAA, AA etc. Professional investors such as fund managers or corporate treasury managers do their own research about the fundamental quality of the issuer, but not every investor will have the bandwidth do so.
If you do not have the bandwidth to research the bond issuer, you may add your bit to it: the general standing or goodwill of the issuer. There are certain business groups perceived to be of good standing. You may go for bonds of issuers with a combination of high credit rating (AAA / AA) and where you have the confidence on the standing of the business group.
Q: Okay, I buy bonds of good quality. But what about the returns?
A: Your return on a bond is defined when you buy it. There is a coupon or interest, usually payable every year, which is usually a percentage of the face value of the bond. For example, if the face value of the bond is Rs 100 and the coupon/interest rate is 8 per cent, you will get Rs 8 every year. There may be a small exception to this: if your purchase price is higher or lower than the face value, your return will consequently be a little lower or higher. The reason for this phenomenon is that the interest is payable on the face value, and your purchase price has no role in that. When a bond is issued in the primary market, most of the times, it is issued at face value and your return is the same as the coupon/interest rate. If you purchase the bond in the secondary market, depending on your purchase price being lower or higher than the face value, your return will be a little higher or lower than the interest rate.
Q: So do I always get a fixed return on a bond?
A: If you hold the bond till maturity, then your return is fixed. But if you sell the bond before maturity, the price depends on market conditions at that point of time. If your sale price is higher than your purchase price, your return is accordingly higher and vice versa. One issue about investing in bonds is that the secondary market lacks liquidity, at least for retail lots. The bond market is less liquid than the equity market, which means if you want to sell before maturity, you may not get the right price.
Q: What is the way out then?
A: There is reasonable liquidity for highly rated bonds of leading issuers. But for lower-rated bonds (less than AA), this is an issue. The way to go about it as a retail investor is to buy the bond of the tenure you can hold for. That is, if you are buying, say, a five-year maturity bond, you ideally hold it for five years and don’t need to sell it earlier. For purchase of bonds, primary issuances of bonds are suitable for you as you can purchase in lot sizes suitable for you. In the wholesale secondary debt market, trades take place in large lots only. Most of the primary bond issuances have various maturities – three years, five years, seven years, etc. Hence, you can pick the one that suits you.
Q: What do I need to invest in bonds?
A: As long as you have a demat account, you can purchase bonds/debentures in a primary issuance, by filling up the application form provided by the manager to the issue/sub-broker to the lead manager. For a secondary market trade, you need to go through a broker.