What are Bonds? How does Investing in Bonds work?
When it comes to investment possibilities, investors frequently have a wide range of options. Hundreds of investment possibilities are available, such as stocks, bonds, gold, and real estate. Depending on many characteristics, including the time frame of the investment, the investor’s risk tolerance, and the expected return, the investor may select one or more of these possibilities. For example, investors who can tolerate more risk might put their money into stocks. Real estate is a possibility for those with a longer time horizon. And bonds are a good option for individuals looking for safer products.
Amongst all the options mentioned above, bonds are considered one of the safest investment options. Let’s have a look at what exactly are bonds and how to invest in bonds.
What are bonds?
Bonds are financial products through which an investor can lend money to a Company, Government, or any other entity, for a specific period and investors expect interest payments in return. The said interest rate on bonds is termed as “coupon”.
To put it simply, a company or government borrows from investors through Bonds. As the entity has borrowed money from investors, it is listed as liabilities on a company’s balance sheet as a debt.
The coupon rate and the bond prices are inversely proportional. That is, when the rate of interest increases the bond prices decrease and when the rate of interest decreases, the bond price increases.
Investing in Bonds
Why invest in bonds?
Investing in bonds is a good method to diversify your portfolio. One can use bond interest as a complement to their primary source of income. If a person has a limited tolerance for risk and wants to avoid taking on too much with their investing, bonds might be a great choice.
Bonds provide a consistent stream of income, making them a safer investment alternative than stocks. Their income is also easier to forecast. Usually, bonds pay interest once or twice a year. They function as a means of capital preservation since, at bond maturity, bondholders get the principal amount.
How to invest in bonds?
An investor has two options to invest in Bonds. The first one is through the primary market and another option is from the secondary market.
Primary bond market
Investors can purchase bonds when they are newly issued by the Company/ Government either through a public issue or private placement.
Secondary bond market
The secondary bond market is the marketplace where investors can buy and sell bonds just like stocks. In contrast to the primary market, where the investor buys directly from the borrower, in the secondary market one buys from or sells to another investor.
What are the Types of Bonds?
Broadly, the bonds can be categorized into a few types mentioned below:
Corporate bonds are issued by a corporation or a Company to raise money for ongoing company operations, mergers and acquisitions, expansion of business, etc. Investors can purchase the same from the primary market when it is initially issued or from the secondary market where it is traded. The price and yield of the bond are dependent on supply and demand, current interest rates, and liquidity. The yield (returns) an investor gets on a bond, depends on the bond’s price and coupon.
Local governments or affiliated agencies issue municipal bonds to fund public infrastructure projects. The municipal corporations provide returns on these bonds either from property tax or professional tax collected or other specific projects’ revenues.
Government Bonds are issued by the Central or State Governments. These bonds are issued to fund the state or central government’s expenditures.
They are also known as government securities (G-Sec) in India, where they are primarily long-term investment instruments with maturities of up to 40 years. Government bonds often have lower yields than other bonds with the highest level of security. Cautionary investors might choose these bonds because of their lowest level of risk.
Also Read – What are Bonds & debentures?
How to buy bonds?
There are 3 options available for investors to buy Bonds:
Debt Mutual Funds
These mutual funds belong to a type of debt funds that make investments in fixed-income and bond securities. Within this, gilt mutual funds particularly invest in government bonds whereas corporate bond funds largely put money into business bonds. Other debt mutual funds that invest in bonds issued by banks, state-run businesses, private corporations, and governments include target maturity funds, banking and PSU funds, and short-term debt funds.
Investor needs a D-mat account and a trading account with a brokerage company to purchase bonds as Direct investment. Once you have them, you can choose to buy and sell bonds.
RBI Retail Direct
This platform launched by the Reserve Bank of India (RBI) allows investors to invest in government bonds.
Factors to keep in mind before investing in bonds
As compared to stocks and other investment options, bonds are typically considered a safer investment. However, the Bonds are not immune to risk, and no investment strategy is. Therefore, investors must keep some factors in mind before start investing.
Every investor has different preferences when it comes to investments. As a result, an investor has to ensure that the risk, return, liquidity, and tax savings they anticipate from bonds match the real levels of these factors and to make informed decisions.
Risk and return
Bonds are not completely risk-free, despite being a safer alternative. Hence, an investor may be able to increase the return on their investment by alternative means if they are willing to take on greater risk. Thus, before making a choice, they ought to evaluate the return on bonds against those from other sources.
An investor must do their research and look at the ratings of bonds before investing, as a higher rating indicates a lower risk and vice versa.
While everyone wants to see greater returns, not every investor has the same level of risk tolerance. Although bonds have a lower risk than stocks, they are still not completely risk-free.
An investor should decide how much of their portfolio to allocate to stocks and bonds based on their desired rate of return and level of risk tolerance. It is usually advised to divide the risk among many asset types.