Bonds

  

WHAT ARE BONDS AND DEBENTURES?

Every business entity or a company needs money to fulfill their immediate and short term cash requirements for managing their day to day operations and cash flow to ensure smooth functioning of its business operations.

The funds can be used for buying raw materials, payment of salaries, opening new branches, upgrading technology to increase efficiency etc.

 There are 2 most common methods that large corporations and business houses use to raise money –

• Equity
• Debt

BONDS are secured debt instruments that are issued by government agencies, PSUs, large private corporations, etc. and are backed by collateral. In case of bonds, an asset is pledged as the security by the borrowing entity so that if the issuer fails to pay the sum, the bondholder’s money can be recovered by selling an underlying asset.

Debentures on the other hand are also a debt instrument but unsecured which are issued by private entities only.

The primary difference between bonds and debentures is security where debentures are very risky as they are unsecured and are not backed by any asset. Its credentials and credit rating is all that forms the basis of raising money. Hence, in case a company issuing debentures defaults on making payments, the debenture holders will not be able to recover their dues as easily as bondholders.

In simple words, instead of reaching out to banks, a company would approach the general public to borrow money for a specific period and promise to pay you interest. It helps them to obtain funds faster and at a cheaper rate.

Debentures are freely transferable but having a debenture does not make you a shareholder and does not give you the right to vote in the general meetings of the company.

 

TYPES OF DEBENTURES

1. Secured Debentures – Secured debentures are secured with fixed assets of the company. This means that a company has to raise all deposits against the asset which should be free from any encumbrance and in case, the company goes bankrupt and fails to repay the loan taken from the investor, its assets will be sold to repay the liability of the investor. Hence, secured debenture offers lower interest as compared to unsecured ones due to its level of safety. However, this option shall be exercised only if the company goes into liquidation.

 

2. Unsecured Debentures – As the name suggests, these types of debentures are not secured against any company asset. This means there is no obligation on the company to repay the amount to the investor when debentures come due. Such debentures usually offer a higher coupon rate for the higher risk involved.

 

3. Redeemable debentures – These debentures are issued for a fixed period. The principal amount of such debentures is paid off to the debenture holders on the expiry of such a period. These can be redeemed by annual drawings or by purchasing from the open market.

 

4. Non-redeemable debentures – These are the debentures which cannot be redeemed in the lifetime of the company. Such debentures are paid back only when the company goes into liquidation.

 

5. Convertible Debentures – As the name suggests, these types of debentures can be converted either into equity shares or any other security on maturity. These debentures are either fully convertible or partly convertible depending upon the terms and conditions of the debentures.

So, after the specified time, these debentures are converted into shares (stocks) of the company. Until then, you will enjoy the fixed specified coupon (interest rate) on such debentures. After that, your earnings will depend on price appreciation of the stock or the dividend income you receive (if the company declares it).

 

6. Non Convertible Debentures – The debentures which cannot be converted into any other securities or shares are called as non-convertible debentures. This type of debenture offers a higher rate of interest in comparison to convertible debenture.

 

 

IMPORTANT POINTS TO NOTE ABOUT BONDS AND DEBENTURES

The following are some of the important features of BONDS that every investor must know.

1. Investor’s profile – It is best suited to investors who want to lock-in funds for a specific tenure. It is not suitable for long term investing beyond 5 years due to no equity participation.

 

2. Risk – Bonds are considered to be a moderate risk-moderate returns investment product. It is comparatively safer than equities since the money is lent to companies in the form of loans. Bonds of companies with poor credit ratings offer higher returns as they are riskier as compared to AAA-rated companies.

 

3. Liquidity – Bonds are considered low on liquidity as the amount invested can only be liquidated on maturity. However, accessing funds during emergencies is possible as they are listed on a stock exchange and can be sold in the secondary market for which investors need to find a buyer.

 

4. Taxation – Income earned from bonds is considered as “Income from capital gains” and if held for more than 36 months qualifies for indexation benefits. However, it does not provide tax benefits.

 

5. Volatile – Returns from bonds are market-linked which makes them volatile. However, being a debt instrument, the interest rate it offers is pre-determined due to which its returns are indicative.

 

6. Time horizon – Bonds are available with different maturities and are suitable for investors having a time horizon of 1 to 3 years.

 

7. Regular Income – Bonds do not provide any regular income as the interest earned gets accrued and paid with the principal on maturity.

 

8. Returns – Since it is market-linked, its returns are not fixed. However, one can expect the average returns in the range of 4% to 13% depending on the quality of bonds and duration.

 

9. Asset class – Bonds are a pure debt product.

 

10. Cost – Bonds involve the cost of investment in the form of expense ratio if invested through mutual funds.

 

11. Loan facility – In case of emergencies, investors can avail loan against bonds and debentures.

 

 

WHO CAN AND CANNOT INVEST IN BONDS?

Indian citizens including residents and non-resident Indians can invest in this scheme.

 

 

WHERE DOES BONDS INVEST YOUR MONEY?

A company requires funds for day to day operations and managing their cash flow. For this, they issue bonds and debentures to raise funds from the public and in return, they promise to pay them interest.

It is a kind of loan that a company takes from the general public where post maturity, you end up earning some interest plus the company returns your principal amount.

Interest that is offered to debenture holders is usually fixed and paid on specific dates which are defined at the time of subscription. Since this is considered as loans given by the public to a company, the company usually clear all dues of debenture holders before declaring dividends to equity shareholders. Hence, the returns you expect is more or less secured.

 

 

CALL AND PUT OPTIONS

There is one more variant in case of debentures and they are usually called “CALL” or “PUT” Option Debentures.

A “CALL” option means that a company has an option to ask the investor to surrender the debenture after a certain period. In such a situation, the company will pay back the principal to you.

Usually, companies exercise this option if interest rates go down, and the company can get funds at lower rates from the market. In such a situation, instead of paying you a higher interest rate, companies can exercise this call option and go for a cheaper loan.

On the other hand, a” PUT” option means that the investor has an option to surrender the debenture if he wants to, and get back his principal.

Suppose if interest rates go up and the interest you are receiving from your debenture is lesser than the current coupon rate, then you can exercise this option and get back your money to invest somewhere else. A put option gives a lot of flexibility to investors if interest rates go up, and they can get better rates from the market.

Do remember that such CALL and PUT options are available to investors after holding the debentures for the minimum specified period. Also, companies give you time to accept or exercise such options and within that period you have to exercise it.

 

 

FUND ACCESSIBILITY AND LOCK-IN APPLICABLE FOR BONDS

Debentures are like closed-ended funds which can only be liquidated only at the time of maturity. However, it is traded in a stock exchange. So in case, someone needs to liquidate that before maturity, they can sell it in the secondary market. In case, any capital gain arises, the tax will be applicable.

 

 

WHAT ARE THE BENEFITS OF INVESTING IN BONDS?

BONDS offer the following benefits to its investors.

1. Better returns than Fixed Deposits – Bonds and debentures usually offer higher interest rates as compared to bank fixed deposits because it is market-linked.

 

2. Tax-efficient – Returns generated out of the sale of debentures are termed as “Income from capital gains” which are taxed at a lower rate. Also, the long term gains qualify for indexation benefits.

 

3. Safety – Bonds and secured debentures protect your principal investment.

 

4. No TDS – Debentures do not attract TDS if held in Demat format. Hence it has an edge over bank fixed deposits.

 

5. Flexibility to earn better returns – Convertible debentures allows you to convert debentures into shares of the company and generate better returns.

 

6. Predictable Returns – Though returns in debentures are predefined, its returns are somewhat indicative.

 

 

WHAT ARE THE LIMITATIONS OF INVESTING IN BONDS?

BONDS has the following limitations.

1. Low Liquidity – Debentures are issued for a specific period and it cannot be liquidated before maturity. Though they are listed on the stock exchange, they are very thinly traded and are difficult to liquidate.

 

2. Limited Earning – Since it has no participation in equities, investors lose the opportunity to earn more during the market upswing.

 

3. Not 100% safe – Though debentures offer a comparatively higher level of safety as compared to equity mutual funds, it is not 100% safe as it is exposed to credit risk. If the company you have invested your money in run into losses, they can not only default on the payment of your interest but also the principal.

 

 

WHO SHOULD CONSIDER INVESTING IN BONDS?

BONDS is best suited to the following investors:

1. Moderate risk-takers - Bonds are a great investment for individuals with moderate risk appetite who wish to earn decent inflation-adjusted returns to manage their current and future financial needs must consider this option.

 

2. Investors with high equity exposure - Investors who are overboard on equities and want to create a debt portfolio can consider investing in bonds and debentures to diversify their investment portfolio and create a retirement corpus.

 

3. Senior citizens - Individuals above 60 years of age, having a low-risk appetite can invest a small part of their savings in bonds for 3 to 5 years or more to earn better post-tax returns than FD out of their retirement fund to beat inflation.

 

4. Investors seeking predictable returns – Investors looking for better returns than FIXED DEPOSITs and have an appetite to take some level of risk related to interest rate fluctuations can consider investing in Bonds.

 

 

WHO SHOULD AVOID INVESTING IN BONDS?

BONDS may not be the best investment for the following investors:

1. Risk-takers - Young investors especially below 35 years of age with higher risk appetite can earn much better returns by investing in equity mutual funds or direct equities.

 

2. High-income individuals - Investors who fall under a higher tax slab of 20% or above as the entire interest earned is added to their taxable income and taxed accordingly.

 

3. Investors with short term liquidity needs – Bonds and debentures can only be liquidated at the time of maturity. And in case someone needs to liquidate it before maturity, they need to sell it in the secondary market. Hence, anyone looking forward to liquidating their investment before maturity may not be able to do so.

 

 

A PIECE OF ADVICE

THINGS YOU SHOULD DO WHILE INVESTING IN BONDS

BOND investors must follow the below suggestions while investing to maximize the value of their investment.

1. Perform due diligence – Never invest in any debentures before verifying the credentials of the company and checking their credit rating. Usually, companies with low ratings try to lure investors with attractive rates. But don’t fall in the trap as they are very risky. One should thoroughly study the risks involved in such instruments.

Also, investors should be aware that though debentures in a way are considered as s, they do not guarantee returns. Thus, returns it generates completely depends on the performance of the company and various macroeconomic factors.

 

2. Consider risk involved – One should always assess their risk appetite before investing in these instruments. Unsecured debentures with low rated companies are considered as a high risk – high return debt investment. And someone with moderate income, sole bread earner of the family, low on savings, high on loans tend to have a very low-risk appetite as even a minor loss may derail their financial life. Such individuals should be very careful while investing in this option.

 

3. Always diversify – The safest way of investing is to diversify your risk across various sectors or companies. Concentration on one particular company can be very risky and may result in loss of capital as well.

 

3. Know what you are agreeing to – Coupon rates should be thoroughly verified at the time of buying debentures as different companies may offer different coupon rates and the one with a higher rate and decent credit rating should be considered.

 

4. Update nomination details – Updating nominee details with the respective company is very important. In case of an investor’s death, the family members should not end up running from pillar to post when they need that money the most to claim your investment proceeds.

 

5. Always prefer bonds over debentures – Unless there is a major difference in the offered rate, always prefer bonds over debentures. This will only keep your money more secure in the long term.

 

 

THINGS YOU SHOULD AVOID DOING WHILE INVESTING IN BONDS

BOND investors must avoid taking the following actions while investing to protect their investment from losing its value.

1. Investing during increasing interest rate scenario – Bond prices are inversely related to market interest rates. It means that the bond prices start to fall when market rates increases and vice-versa.  This happens because bonds issued at a coupon rate of 6% per annum loses its value if market rates go up to 7% per annum as new bonds are now available at a 1% higher coupon rate.

 

2. You can foresee the need for funds before maturity and still investing – Bonds and debentures can only be liquidated on maturity. Hence, anyone looking forward to liquidating their investment before maturity may find it difficult to do so. They need to look for the buyer for selling their investment in the secondary market.

 

3. Investing by solely relying upon the past track record – Though past performance is one of the very important aspects while choosing a company, it should not be the only deciding factor as the glorious performance in the past can be a result of various factors which may or may not exist in future.

 

4. Do not get influenced by anyone but financial experts – A confused investor always has a tendency of reaching out to their friends and relatives for suggestions while making critical investment decisions. That happens irrespective of the knowledge and the level of understanding the friend has about the domain. It is as good as asking a truck driver, how to fly an airplane. Such advices in most cases are based on their individual experiences and hardly on calculations or facts and figures. Hence, instead of blindly following the financial advice of a random friend, investors must act wisely and take assistance of a well qualified financial planner who has sound knowledge about the domain.

 

 

WHAT ARE THE RISKS INVOLVED IN BONDS?

BOND investors should be mindful of following risks involved in this investment:

1. Credit risk – The biggest risk involved in “Debentures” is credit risk. It means they do not guarantee payment of fixed interest on maturity. And unsecured debentures do not even guarantee repayment of your principal. This depends purely on the performance of the company in which you invest. However, when the company does well and make profits, then debenture holders are entitled to get their dues before equity shareholders.

It is imperative to always check the credit ratings of any company before taking a leap. There are credit rating agencies like CRISIL, CARE, ICRA and Fitch who rate companies based on various parameters including their financial health, past track record and debt repayment capacity.

Though it is a very effective tool to find out the credibility of any company, it is not 100% foolproof and a AAA-rated company can also default on interest and principal payment.

Also, one should diversify its investment portfolio across different companies of various sectors and different maturity.

 

2. Interest rate risk – When you buy a bond, you are committed to receiving a fixed rate of return (ROR) for a set period. However, interest rates are subject to change due to various market forces. Should the market rate rise from the date of the bond's purchase, its price will fall as new instruments will be available at a higher rate so the demand for the prevailing instrument will fall. The bond will then trade at a discount to offset the lower return that an investor will make on the bond. Similarly, if the market rate decreases, the value of the existing instrument will go up and it will start trading at a premium. Hence, this factor should be considered while investing in such instruments.

 

3. Inflation risk– Returns on “Bonds” and “Debentures” are not in line with inflation. So, a rise in inflation can lead to negative returns from such instruments as your purchasing power reduces. For instance, If you hold a bond paying 6% interest and inflation reaches 7%, your return is negative (-1%), when adjusted with inflation. You’ll still get your principal back when your bond matures, but it will be less valuable. Inflation risk increases the longer you hold a bond.

 

4. Liquidity Risk – Bonds and debentures can only be liquidated at the time of maturity. And in case someone needs to liquidate it before maturity, they need to sell it in the secondary market. Hence, anyone looking forward to liquidating their investment before maturity may find it difficult to do so.

 

5. Concentration risk – Bonds and debentures are being issued by one company due to which the fate of investors is dependant on the performance of that particular company. This increases their exposure to risk due to over-concentration on one particular company.

Investing in can help investors mitigate risk and also earn decent returns.

 

 

HOW TO SELECT THE BEST BONDS?

BOND investors must follow the below instructions before signing up for the product to ensure the safety and growth of their investment.

1. Get to the roots of the company – Before investing, find out as much information possible about the track record and the past performance of the company. One should religiously study the financial statements of the company like profit and loss statement, cash flow statement and balance sheet. The company which is low on debt and high on operating income is usually preferred. To find out all this information, one can always download and refer to DRHP (Draft red herring prospectus) from the SEBI website. Also, search on google if any frauds are being reported on the company or litigations pending against them.

 

2. Performance – Performance is one of the most critical parameters to assess the worth of the company. How long the company has been in existence, where does it stand against its competitors in terms of market share, ROI, etc. If the company has been in business for a while and still failed to acquire a sizeable market share or generate minimum returns as per the industry standards and in comparison to fellow competitors then the reason for underperformance should not be ignored.

 

3. Know about the promoters of the company – Promoters are like the heart and brain of the company and they are the ones who run the show. It is very important to learn about their background like their qualifications, past performance, work experience, expertise in their line of business, a character like have they indulged in any unethical activity or do they have any criminal charge against them, etc. Also, their personal financial health should not be ignored.

 

4. Study the products or services they sell – Your returns from the investment will be largely influenced by the profits the company will make in the future. Hence, it is important that the product they are selling is in great demand and has a huge market share. E.g. In this computer age, a company selling typewriters will not have great demand and hence not scalable and should be avoided.

 

5. Innovation, marketing and technology – Are they in pace with their competitors? Are they using innovative marketing tactics to reduce the cost of operation? Do they have the latest technology to increase the efficiency of business operations? These are the questions one should explore about the company.

 

6. Study their competitors – Where does the company stand against its competitors in terms of profits, market share, turnover, etc.

 

7. How strong is their client base – Having a great clientele is one of the strongest contributors to the company’s growth. Getting repeat orders from the same set of clients indicate that the company is successful in producing or procuring quality products at competitive rates and maintaining a healthy relationship with clients.

 

 

TAXATION RULES FOR BONDS

BONDS offer 2 types of income to its investors

1. Capital Gains – Bonds get listed on stock exchanges where investors can sell it before maturity. Any profits made through selling it in the secondary market is termed as capital gains.

If sold within one year of purchase, it will be termed as short term and will be added to your total taxable income and taxed as per applicable slab.

However, if the investment is sold after a year, then any profit made will be treated as long term and will be taxed at the rate of 10.30% without indexation.

 

2. Interest Income – Any interest earned out of debentures is added to the investor’s total taxable income and taxed as per the applicable slab.

 

 

DOES ANY OTHER PRODUCT OFFER BETTER PROSPECTS THAN BONDS?

A Bond can be beaten by the following products on various grounds.

1. From a safety point of view – Bank fixed deposit is safer as compared to debentures as the returns fixed deposit generates are fixed. Also, it carries a relatively lower risk of loss of principal if booked with reputed banks. Fixed deposits are however most tax-inefficient options which can further lower your post-tax returns.

 

2. From the returns point of view – Balanced funds generate better returns as they partially participate in the equity market too.

Equity mutual funds, on the other hand, generate even better returns in the long run however, it carries a higher risk as well, as they invest directly in the stocks of various companies.

If someone is looking for even better returns and has a high-risk appetite then they can invest in or of various companies.

 

4. From a liquidity point of view – Bonds and debentures come with a pre-defined maturity period and are highly illiquid. Hence, if someone is expecting any major expense soon can consider investing in liquid funds or ultra short term funds which not only generates decent returns but also offer high liquidity.

 

 

HOW TO INVEST AND DOCUMENTS NEEDED

You need to have the usual trading and a Demat account to buy a non-convertible debenture (NCD). The process to buy a NCD is the same as that for a share. You log into your trading account or ask your broker to buy you an NCD on your behalf. How you buy and the brokerage is the same as that for shares.