Want to buy bonds instead of debt funds? This is what you need to know

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After the series of credit problems in debt mutual funds, many investors would like to know more about buying bonds directly instead of debt mutual funds. To do this, knowledge of basics and familiarity with bond terminology is essential. Therefore I have requested an expert to discuss the basics of how to go about buying bonds and the essentials that an investor needs to know.

The expert for personal and professional reasons wishes to remain anonymous. He is, however, eager to help out investors and based on the feedback for this article is ready to write a second part. Kindly keep in mind that the risk and reward parameters of buying bonds directly quite different from that of debt mutual funds. So do not proceed unless you are appreciative of the pros and cons.

Want to buy bonds instead of debt funds? This is what you need to know

What is a Bond?

A bond is simply a loan between the issuer (borrower) and the bondholder (lender). When you purchase a bond, you are lending money to any entity known as the issuer. In return, you receive a bond and issuer pays fixed interest on the amount of money you lend.

Characteristics of Bonds

 Face Value: A bond issued at a face value to the bondholder. For example, Rs 1000 per bond.

Maturity Date: Term to maturity of a bond changes every day from the date of issue of the bond until its maturity. The issuer has to repay the principal amount on the maturity date.

Principal Amount: Total amount invested by the bondholder in a bond issue is the principal amount. For example, you invest Rs 10,000 and you get total 10 bonds with face value worth of Rs 1000 each.

Coupon Rate: The coupon is the interest rate that the issuer pays to the security holder. It refers to the periodic interest payments that are made by the issuer of the bond to the bondholder and are expressed as a percentage of the face value. For example, just like your Bank F D payments.

Types of Bonds

There are various types of bonds available in the market.

  • Fixed Rate Bonds: Has a coupon or interest rate fixed till the maturity of a bond.
  • Floating Rate Bonds: Also, known as floaters where the interest rate is linked to reference rate such as MIBOR (Mumbai Interbank Offered Rate).
  • Zero-Coupon Bonds: It does not pay periodic interest or coupon rate but is effectively rolled up to maturity and the bondholder receives the full principal amount at the redemption date.
  • Convertible Bonds: This bond lets a bondholder exchange a bond to a number of shares of the issuer’s common stock.
  • Inflation-indexed Bonds: Inflation-indexed bonds are bonds in which the principal amount and the interest payments are indexed to inflation
  • Perpetual Bonds: These bonds are also often called perpetuities or ‘Perps’. They have no maturity.

Where and how to find bonds

There is a wide variety of individual bonds to choose from in creating a portfolio that matches your investment needs and expectations. An individual can purchase bonds in two ways

Primary Market: If you are interested in purchasing a bond when it is first issued, you should look for various bonds being issued by companies currently or forthcoming bond issues.

Primary Sources: Lead Managers, Newspapers Ads, Financial Market Portals

Secondary Market: Bonds are bought and sold by brokers and institutions in the secondary market and mostly through over-the-counter (OTC), although most corporate bonds are also listed on BSE and NSE.

Secondary Sources: Brokers, Dealers, Stock Exchanges, Banks, etc

How to buy /sell Bonds?

  1. Open a demat account: A number of online brokers offer very basic functionality to buy / sell bonds.
  2. Get connected to Securities firms, brokers, dealers that trade in bonds as more than likely you will need the help of broker or dealer in executing and getting best possible returns or investment opportunity through them.
  3. Which broker or dealer to approach?: Get in touch with Full-Service Brokers that help clients develop investment goals, research and recommend investment opportunities for individual clients and also execute sale or purchase of bonds for a client’s portfolio.
  4. Evaluate the broker or dealer to trade.
  5. Check for following pointers while selecting the dealer
    • Competence & Experience
    • Access to bonds that may interest you
    • Strict Compliance team
  6. Know about investor costs associated with buying or selling bonds

Factors affecting bond prices

1 Level of interest rates: Bonds prices go up when interest rates go down and vice versa. See examples here: Why you need to worry about “duration” if your mutual funds invest in bonds

2 The credit quality of issuers: Financial conditions of the issuer determine extra yield trader or investors demand for holding issuer’s bonds.

3 Liquidity of bond: Like equity shares, you could choose corporate names you follow in order to have a good liquid bond. Generally, government bonds offer the highest amount of liquidity and good companies’ bonds also fetch higher to medium liquidity.

Bond CategoryCredit QualityLiquidityExamples
GovernmentHighestHighestGovt bonds, T-bills
Public Sector EnterpriseHigh GradeMediumIRFC, REC, PFC, NTPC, NHAI
Private Sector CompaniesHigh to LowVariesShobha Ltd., Tata Steel, STFC

4 Bond Maturity: Longer maturity bonds will trade at higher yields compared to short term bonds as they have a longer time horizon that presents more uncertainty on interest rates. See above link for an example.

MaturityYieldPrice Volatility
ShortLowerLower
LongHigherHigher

5 Demand/Supply: Bonds are no different from any other asset with regards to supply and demand. During times of financial crisis, investors prefer government bonds, public sector companies’ bonds for safety. When growth picks up in the economy, investors generally prefer to invest in high yielding corporate bonds.

You as an investor need to understand tax implications for any asset class you choose to invest as any income through various asset classes can attract various kinds of taxes. In bonds too, there are certain tax considerations you need to check before investing. In bonds, there are two types of income that you earn.

6 Interest Income: When you invest in bonds, you get the interest income till the time the bond matures. Income interest from bonds and tax treatment is exactly similar to any other interest income such as interest earned through FDs. In other words, income interest from bonds or NCDs (non-convertible debentures) will be subjected to tax at normal rates by including it in “Income from other securities”.

7 Capital Gains: If you decide as a bondholder to sell the bonds/NCDs on the stock exchange, capital gains tax may also arise. If bonds are sold within a period of 12 months from the date of allotment, short term capital gain will arise and there will be a tax for the same. If you decide to sell bonds after a period of 12 months, that will result in long term capital gain or loss.

While short term capital gains on the sale of bonds would be taxed at normal rates, long term capital gains on the sale of the bond (listed security) are taxed at concessional rates u/s 112 of IT Act. Long term capital gains on listed securities are taxed at the rate of 10% without indexation or 20% with indexation whichever is lower. However, as the benefit of cost indexation is not available in case of bonds and debentures; therefore, long term capital gains from bonds/NCDs are always taxable @ 10.30 percent (including education cess of 3%) without indexation.

In recent years, tax-free bonds have gained immense popularity in India. Many public sector entities are allowed to raise funds through public issue of tax-free bonds. Interest received through tax-free bonds is fully exempted u/s 10(15) (iv) (h) of IT Act. However, the principal amount invested in these bonds cannot be claimed as deduction from the total income of the bondholder for the purpose of payment of income tax.

Advanced topics like how to use NSE’s Electronic Debt Bidding platform (NSE-EBP) for buying bonds can be taken up if there is interest. Please join me in thanking the author for his help in understanding this complex topic. Superficially it may appear that buying bonds directly is easier than buying debt mutual funds, but that is not quite the case.

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8 Comments

  1. Thanks for the article. Request to provide some more clarity and details on evaluating the broking firms for buying bonds.

  2. Thanks a lot for informative article. Next one in this series should address how to evaluate various opions available, how to make sense of data available on trading platform (like ICICI-Direct) while purchasing online, how market fluctuations can be made use of etc.

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