The very first thing that comes to the minds of people when we talk
about investments is investing in stock markets. It is true that share
markets are exciting and the news about people gaining wealth and
becoming rich overnight are quite common. Bonds, though are considered
by many as a good investment option, do not carry the same appeal. The
lingo itself sounds arcane to a normal person and many consider these
boring; that holds true during the days of exciting bull markets.
But,
bonds are known for their security and safety and many investors make
sure to have bonds in their portfolio. So, what are bonds, and how to
invest in them and what the risks involved when you invest in bonds? Let
's get an answer to all the above questions.
Did you ever borrow
money? Yes, most of us have borrowed money at some stage in our lives.
Similarly, companies need money for expansion and government too needs
funds for social programs and infrastructure. In many cases, the money
required is more than that can be issued by the banks as a loan. Hence,
these entities issue bonds to the public markets. A number of investors
thus helps raise the money by lending a portion of the funds that are
needed. In simpler terms, bonds are similar to loans for which the
investor is a lender. The company or the entity that sells the bonds is
known as the issuer. Bonds can be treated as IOUs that are given by the
issuer to the lender, who in this case is the investor.
No one
would lend money for nothing and hence the issuer of the bonds pays that
extra for using the funds in the form of interest. The interest on the
bonds is paid at a fixed rate and predetermined schedule. The interest
rate when it comes to bonds is often called as 'Coupon '. The amount
that is being borrowed is called as the face value, and the day the
amount has to be repaid is known as the maturity date. Bonds are the
fixed income securities as the investor knows the amount of cash he/she
would get back when they hold it until maturity. Bonds are less risky
when compared to stocks, but they also come with low returns.
Why investing in bonds is important?
Bonds
investment provides an income stream that is easily predictable and in
many cases, bonds pay the interest twice in a year. If the bondholder
holds the bond till the day of maturity, the investor gets the entire
principal amount and hence, these are considered as an ideal way to
preserve one 's capital.Bonds can also provide the offset exposure to
the extreme volatile shareholdings one might have. By investing in
bonds, one can expect a steady stream of income even before the maturity
in the form of interests.
Calculating the yield and the bond prices
A
number of investors find it confusing when it comes to the bond prices
and the return one can get via bond investments. A number of novice
investors will be surprised to learn that the bond prices change day to
day, similar to any other security that is traded publicly.
The
yield is the returns one can expect from their investment made in
bonds. The simplest way to calculate this is by using the formula; yield
is equal to the coupon amount divided by the price. When the bond is
bought at par, the yield can be equal to the rate of interest. Thus, the
yield changes with the bond price.
Another yield that
is often calculated by investors is the returns that they get upon the
maturity of the bond. This is a more advanced calculation which will
provide the total yield one can expect if the bond is held until the
date of maturity.
Different types of bonds:-
Bonds can be mainly classified into,
Government bonds: These
are the bonds that are issued by the government directly. These are
secured as they are back by the Government of India. These bonds
generally have a low rate of interest.
Corporate bonds: Corporate bonds are issued by the private companies. These companies issue both secured and non-secured bonds.
Tax saving bonds: The
tax saving bonds are issued in India by the government itself to
provide tax savings to individuals. Along with the interest, the holder
would also receive a tax benefit.
Bank and Financial institution bonds: These
bonds are issued by various banks or financial institutions. A number
of bonds that are available in this segment are from this
sector.Investors can buy these bonds by opening an account with a
broker. It is also advisable to check with your financial advisor before
making your investment in bonds and to know which one to choose from.
What are tax-free bonds and how they work
Tax free bonds have been the flavour for high net worth investors for
the last few years. Towards the end of the financial year, there are
large infrastructure players like the IRFC, IREDA, REC and PFC that are
permitted to raise funds through the issue of tax-free bonds. These
tax-free bonds are a way of the government subsiding the raising of
infrastructure capital. In fact, tax-free bonds come in two basic types.
Let us understand them a little better.
Firstly, there are the
Section 54EC bonds where you can get a tax break by investing the
proceeds of your sale in these Section 54EC bonds. For example, if you
sold your property which you had bought in 2007 for Rs.55 lakhs at
Rs.1.20 crore in 2017, then you can avoid paying the capital gains on
these bonds by reinvesting the entire Rs.1.20 crore in Section 54EC
bonds. The benefit under Section 54EC will be available in the form of
making your capital gains tax-free. The interest earned on Section 54EC
bonds will be fully taxable in the hands of the investors. Secondly,
there are the tax-free bonds wherein the interest paid on the bonds at
regular intervals is entirely tax-free in the hands of the investor. So a
6% tax-free bond will have an effective pre-tax return of 8.57%
assuming that you are in the 30% tax bracket. Most tax-free bonds are
fairly attractive when compared to normal taxable bonds and bank FDs in
terms of effective pre-tax returns.
Do Section 54EC bonds make investment sense?
Prima
facie, these bonds are heavily in demand from HNIs who find this a good
way of saving their capital gains tax. However, there are a few basic
things you need to remember about investing in these bonds. The yields
on such bonds are much lower than on normal bonds and bank FDs to factor
in the tax benefit. Hence it will only make sense if you actually
capital gains you need to save tax on. Secondly, to be eligible for a
tax break under Section 54EC, you need to invest the entire proceeds and
not just the capital gains. That has an opportunity-cost in the form of
alternate investment opportunities foregone. So, these bonds are not
exactly effective unless capital gains constitute a major chunk of your
overall sales proceeds.
A better way to approach this would be
calculating your actual capital gains tax payable after adjusting for
the indexing benefits of long term holding. If after considering
indexing, your total tax payable is less than 10% of the proceeds then
it makes sense for you to pay off the tax and invest the proceeds in
more wealth creating investments. Alternatively, you can also get the
same benefit under Section 54 if you reinvest the proceeds in acquiring
another property. Considering the lock-in period involved and the
opportunity cost of investing the entire proceeds, the tax saving bond
may have limited utility from an investor’s perspective.
Are tax-free bonds a good investment option?
As
discussed earlier, these tax-free bonds entail an investment in an
infrastructure driven company which will be eligible to earn tax-free
interest. Prima facie, the effective returns are higher than taxable
bonds if you consider the impact of taxation. But the lock-in period can
be quite a deterrent as your bonds are literally idle in your demat
account or in your vault. The key question is whether the lock in period
is justified considering that this asset does not exactly create wealth
over the long term. The value of the bond remains virtually unchanged. A
better choice would be to stick to traditional bonds and FDs that would
not have the hassle of lock-in periods and can also be monetized at
short notice in a much easier manner.
Why not look at debt funds as a better option..
Debt
is intended to meet your basic needs for stability and assured returns.
A better choice will be opt for debt funds instead. It proffers quite a
few advantages. Firstly, the dividends that you opt for will be
entirely tax-free in your hands. Secondly, debt funds are liquid and you
can monetize your debt funds at very short notice and realize funds in
less than 2 days. Thirdly, investors do worry about default risk and
interest rate risk. We will look at interest rate risk separately, but
default risk can be overcome by focusing on G-Sec funds that are
entirely risk-free. Lastly, let us come to the aspect of interest rate
risk. In the current economic context, the rates have held a downward
trajectory and therefore rates should work in favour of debt funds. When
rates fall in the market, debt funds see an appreciation in their NAV
and therefore investors earn the interest plus the capital gains. That
is a benefit that is not available in case of even tax-free bonds.
To
conclude, while it is easy to get carried away by the apparent
attractiveness of tax-saving bonds, you need to get the arithmetic
right. Evaluate the options and then take a final call on investing in
these tax-free bonds!
The Benefits of Investing in Bonds
The very first thing that comes to the minds of people when we talk about investments is investing in stock markets. It is true that share markets are exciting and the news about people gaining wealth and becoming rich overnight are quite common. Bonds, though are considered by many as a good investment option, do not carry the same appeal. The lingo itself sounds arcane to a normal person and many consider these boring; that holds true during the days of exciting bull markets.
But, bonds are known for their security and safety and many investors make sure to have bonds in their portfolio. So, what are bonds, and how to invest in them and what the risks involved when you invest in bonds? Let 's get an answer to all the above questions.Did you ever borrow money? Yes, most of us have borrowed money at some stage in our lives. Similarly, companies need money for expansion and government too needs funds for social programs and infrastructure. In many cases, the money required is more than that can be issued by the banks as a loan. Hence, these entities issue bonds to the public markets. A number of investors thus helps raise the money by lending a portion of the funds that are needed. In simpler terms, bonds are similar to loans for which the investor is a lender. The company or the entity that sells the bonds is known as the issuer. Bonds can be treated as IOUs that are given by the issuer to the lender, who in this case is the investor.
No one would lend money for nothing and hence the issuer of the bonds pays that extra for using the funds in the form of interest. The interest on the bonds is paid at a fixed rate and predetermined schedule. The interest rate when it comes to bonds is often called as 'Coupon '. The amount that is being borrowed is called as the face value, and the day the amount has to be repaid is known as the maturity date. Bonds are the fixed income securities as the investor knows the amount of cash he/she would get back when they hold it until maturity. Bonds are less risky when compared to stocks, but they also come with low returns.