Bonds are typically issued by governments and corporations to raise money. They usually offer a fixed rate of interest to an investor. Unlike a shareholder, a bondholder is not an owner of the entity whose bonds he has invested in.
This is because a bond is like a loan contract. When an entity raises money through bonds, it is just like raising money through a loan on which it has to pay a certain interest to the bondholder. So, if you are thinking of opening a trading account, you need to know the risks and rewards of bond investing.
Types of risks in bonds
1. Credit risk
There are several types of risks in bonds. Bond investors are exposed to ‘credit risk’, which means the risk of a bond issuer not being able to pay either the interest or principal amount when it falls due.
To deal with this, investors should check the credit ratings of a bond before investing in it. Such ratings are issued by credit rating agencies like Crisil, Moody’s, and Standard & Poor’s.
Some agencies provide ratings in this format AAA, BBB, etc., while other agencies use this format Aaa, Baa, etc. In most cases, if a bond has a lower rating than BBB, it shows that it has a significant credit risk. Therefore, investors should avoid such a bond.
2. Interest rate risk
Bond investors should also be concerned about ‘interest rate risk’. There is an inverse relationship between bond prices and interest rates. If interest rates increase, bond prices decline. Conversely, when interest rates decline, bond prices rise. Suppose an investor invests in a bond with a face value of Rs. 100 and a coupon rate of 5%.
However, a few months later, interest rates increase to 6%. In this case, the price of this bond will fall below its face value of Rs. 100.
This is because other bonds are offering a higher rate of interest than 5%. If this investor were to sell the bond, he would incur a loss. However, if he decides not to sell the bond and hold it till maturity, he will not be incurring any loss because he will be repaid the face value of the bond by the issuer.
Benefits of investing in bonds
Steady source of income: A bond, in most cases, offers a fixed rate of interest. As a result, an investor is assured of getting that interest.
Compared to an investment in a stock, the income is steadier here because companies do not offer an interest on their shares. Moreover, they are under no obligation to pay dividends. So, the only way to earn money through shares is by selling them.
And, if the stock market is not conducive, an investor may not be able to sell his shares at the right price.
Diversification:
Investors can diversify their portfolio by investing in bonds. In India, many salaried individuals invest in mutual funds (mostly equities) and bank fixed deposits (FDs).
They can diversify their portfolio by investing a certain portion of their funds in bonds. They can either directly invest in a bond or invest in a mutual fund that has significant investments in bonds.
While making bond investments, investors should check their credit ratings and the interest being offered. If a bond is offering a higher rate of interest than bank FDs, that alone should not be the criteria to invest in that bond.
In such a case, investors should also check the credit rating of that bond. If the rating is high enough and it offers a higher rate of interest than bank FDs, then investors can consider investing in that bond.
Conclusion
Investments in debenture bonds come with both risks and rewards. It is for a discerning investor to carefully analyse these aspects before making an investment. If he finds it difficult to actively invest in debenture bonds on his own, he can also invest in mutual funds focusing on such instruments.
