Investing in bonds & debt instruments
One of my most popular post has been on parking short term cash from last year. I have always believed that any successful investor should invest a portion of his portfolio in debt.
I will be writing on debt in three parts to do justice to this asset class. Today’s post is part -1
When investing in debt securities you are effectively lending money to businesses or governments or banks. Returns typically comprise interest and changes in the market value of the security.
Today we are going to cover
a) What is the risk of investing in debt instruments
b) What feasible options are available to retail investors to invest in debt instruments
There are few risks which we should be aware of
1. Loss of entire capital – Also know as credit risk or default risk. In unfortunate circumstances if the businesses or governments or banks are unable to return what you have lent them. To guard against this most of the debt instruments are rated by independent agencies,an investor should carefully understand what each ratings account for.
2. Loss on account of reduction in price of security – IFprice of the debt instrument goes down, you may face loss. This is also called price risk. Debt instruments carry this risk as interest rates keeps changing.
3. Notional loss of profit – You have earned some interest but you are unable to put that money for same return as interest rates have gone down. This is called re-investment risk.
Once you understand risks, lets look at what options are available for retail investors to invest in debt instruments
1. Fixed deposits – Straight forward most of us know, provides investors with a higher rate of interest than a regular savings account until the given maturity date. Banks today are offering interest for various terms and amounts (15 days – 5 years). These are less risky with almost no credit risk, however your money will locked as they are not tradable instruments
Tankrich Tip – Use ratekhoj or any other aggregators to find best rates
Typical pretax annual return – 9-10%
2. Corporate deposits – Very similar in nature to fixed deposits, However big difference is here you are giving money to a corporate. Again various terms and amounts are available. These are much more risky with higher credit risk, also many of the corporate bonds are available only to High Net worth Individuals.
Typical pretax annual return – 9-12%
3. Non convertible debentures / Corporate bonds – Debentures are long-term financial instruments which acknowledge a debt obligation towards the issuer. Some debentures have a feature of convertibility into shares after a certain point of time at the discretion of the owner. The debentures which can’t be converted into shares or equities are called non-convertible debentures (or NCDs). What separates NCD to other corporate debt is that they are listed on BSE or NSE providing very good liquidity to investors. They have credit risk and investors should really understand credit rating for NCDs . Most important feature is that they have monthly, quarterly and yearly payment of interest options.
Typical pretax annual return – 10-12%
4. Zero coupon bonds – These bonds are issued below maturity price and redeemed at face value e.g bonds will be issued at Rs20 to be redeemed at Rs100 20 years later, they provide no interest income, however you can trade in them as many of them are listed on NSE or BSE, again many of the corporate bonds are available only to High Net worth Individuals.
Typical pretax annual return – 8-9%
5. Tax – Free bonds – Very popular these days, issued by stipulated government companies, with almost next to nil credit risk coming with backing of government they are rated AAA. No tax on interest, good liquidity as they are listed on NSE or BSE. However almost all of them have once in year interest payment option.
Typical pretax annual return – 11-13%
Apart from these there are mutual funds which invest in debt instruments, one can invest in them to gain indirect exposure to debt markets.
In the next post, I will tell you how to find which of above suits you best
Sources – The Economic times , Investopedia website , mlc.com.au