how to invest in bonds

A beginner’s guide to understanding Bonds

Investors looking for a fixed income with higher returns other than the regular investment option like fixed deposits, PPFs and postal savings can opt for Bonds. Bonds are debt instruments that are issued by governments, companies, banks, public utilities and other large entities to raise funds for financing their capital expenditure for a wide variety of projects and activities.

Bonds bear a predetermined rate of interest and a specific maturity period (more than one year). Bonds provide an important component of many financial plans. Most investors buy bonds for two basic reasons:

Safety and/or income. Bonds can provide some stability for your portfolio to counter the volatility of stocks while generating current or future income.

For Ex: An investor who wanted a steady income bought a bond for Rs 10,000 at a coupon rate of 8% with a maturity of 10 years., which means that he/she will receive Rs 800 per year as interest for the next 10 years. Assuming the bond pays interest bi-annually, the investor will receive Rs 400 every 6 months for the next 10 years. At the end of the maturity, he will get his principal (Rs 10,000) back.

In todays’ high interest rate environment, it would bode well to invest in bonds to lock in the yield because once the rate cycle reverses there might be higher demand for these bonds, with a scope for capital appreciation.

Types of Bonds:

Government bonds: These bonds are issued by Government to fund their projects. Also referred as G-Sec, these bonds constitute larger portion of the bond market than the corporate bonds. However, it is difficult for retail individuals to invest directly in these bonds as the minimum investment amount is very high.

Corporate bonds: These are issued by corporate houses to raise capital. However, these bonds are not as safe as government bonds as the issuing companies are subject to market volatility, industry ups and downs, etc.

Banks and other financial institution’s bonds: These are issued by banks and other big financial institutions and usually have high credit ratings. Since the Indian financial markets are very regulated, the chance of default from banks and financial institutions is quite less.

Tax-free bonds: Tax-free bonds are debt instruments that pay income which is exempt from income tax. These bonds are issued with the purpose of raising funds for infrastructure development by the government of India. These bonds are issued by entities such as the NHAI, PFC, IRFC, REC, HUDCO etc.

The key advantage of tax free bonds are: These bonds are issued by highly rated central PSU’s and are considered very safe, Interest earned is tax exempt, No cap on amount of investment eligible for tax benefits, Can be sold in secondary market without any lock-in period.

Since it is backed by the government of India, these bonds are mostly highly rated and also fully secured, which makes it a very attractive investment avenue. The income by way of interest from tax-free bonds is fully exempt from Income Tax and shall not form a part of the total income as per provisions under section 10 (15) (iv) (h) of the IT Act. Investors can park surplus funds in these tax free bonds which would give an absolute return every year upto 10/ 15/ 20 years as compared to returns available elsewhere. Most of the companies are giving an additional coupon of 0.50% to retail investors who apply during public issue.

Capital Appreciation on Tax Free bonds: Price of a bond fluctuates with the rate of interest. If the interest rates fall, then the price of the bond increases and vice versa. As the emerging economy like India improves, interest rates are likely to come down, in such a case the bonds would trade at premium and generate capital appreciation. Longer the tenure of the bond, higher the capital appreciation.

Generally, a 1% fall in interest rates will give an investor a capital appreciation of around 5-6% on a 10 year bonds, while the capital appreciation will be as high as 9-10% for a 20 year bond.

Taxation on Tax free bonds: Although the interest earned on the tax free bonds is tax-free, any capital gain from sale in the secondary market is taxable. Short-term capital gains are taxed at the normal rate, while long-term capital gains are taxed at 10% without indexation and 20% with indexation. These bonds are highly suitable for investors in higher tax brackets.

For example: Let us assume that an investors purchased a PSU bonds which were issued in Oct 13 with a face value of Rs 1,000 at a coupon rate of 8.43% for 10 years, 8.79% for 15 years and 8.92% for 20 years. Now, supposing the investor holds on to the 10-year bonds for 12 months, and the interest rates fall by half per cent in the meantime and the bond is currently trading at Rs 1030. Total returns on the bond at the end of the year will be 11.43% (interest+capital appreciation)

To Conclude: Bond market in India is gaining momentum as investors are increasingly looking for secure investment opportunities where they can be assured of a fair return with low risks. The amount invested in the bonds depend upon the age and the risk profile of the investors. Investors can also invest in bonds through Debt mutual funds.

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