Bond with the Bonds

Posted On Monday, Apr 06, 2015

Bonds are one of the important parts of your Fixed Income portfolio. They contribute an element of stability to almost any portfolio. However since most investors do not know much about bonds; in today's article I would like to clarify what bonds are and why you, as an investor, should have an allocation to bonds...

What are Bonds?

Bonds, as an asset class, can play an important role in your asset allocation by diversifying risk, generating regular income and potential capital appreciation across economic and market cycles.

Bonds belong to the category of fixed income instruments. Fixed Income instruments, unlike equities (where the dividend income tends to fluctuate), generate regular income through coupon payments and have fixed maturity periods.

Bonds generate income through below sources:-

Coupon Income - It is the periodic interest income that accrues from a bond throughout its term.

Re-Investment Income - The coupon income so received from the bond can be re-invested to generate further income.

How do bonds differ from other fixed income instruments?

Bonds are issued by central and state governments, corporates, banks and financial institutions, municipalities etc. and are actively traded in the institutional (wholesale) market.

The ability of bonds to trade before the maturity period and gain from market movements distinguishes it from traditional non-tradable fixed income instruments like fixed deposits and postal savings and also retirement savings like PF& PPF

Returns form fixed income instruments and bonds are sensitive to the following factors

Price Risk - If not held till maturity, an increase in market interest rates leads to lower bond prices and thus lower returns and vice versa. Longer the maturity; greater the risk

Inflation - A period of high inflation reduces the purchasing power of the income earned from a fixed income instrument. A continued higher inflation also leads to higher interest rates further lowering bond returns due to the fall in bond prices.

Default Risk - Bonds, other than those issued/guaranteed by the central government, are exposed to the risk of default (failure to repay the interest and principal). The higher the perceived default risk from an instrument, the higher would be the relative yield on that bond.

Impact of economic changes on Bond Total returns - The table below indicates impact on bond returns on changes in individual economic factors, other things being constant.

Table I - Economic parameters and Bond Returns

Factors/Impact on Bond ReturnsPOSITIVE for Bond PricesNEGATIVE for Bond Prices
Economic GrowthWeakStrong
Global Interest RatesLowerHigher
Crude OilLowerHigher
Fiscal DeficitsLowerHigher

Source: Quantum AMC

The above table is for explanatory purpose. The economic parameters vis a vis Bond returns may change from time to time.

For instance, expectations of weak economic growth is positive for bonds, as it will lead the central banks to cut and keep interest rates low and thus resulting in higher bond prices for existing bonds and vice versa.

Case for allocation to bonds

In India, the retail investor is largely exposed to fixed income instruments through government run assured return schemes like NSC; PPF and of course bank fixed deposits.

Unlike equities, bond markets are institutional in nature and thus have had minimal direct retail participation.

But In the last 3-5 years, there have been numerous instances of companies raising money by public issuances of bonds. The most popular amongst them though have been the 'TAX-FREE' bond issuances in the last 2 years. With general interest rates remaining high; the coupon rates on offer on these tax free bonds has resulted in investors queuing up to invest.

For those who are in the 30% tax bracket; tax free coupon bonds are proving more attractive than fully taxable fixed deposits. The demand has been so high that these bonds are currently trading at significant premiums in the secondary market. And Despite these bonds having maturity of more than 10 years; the investor interest suggests that Indian investors have appetite for appropriately priced bond issuances.

The table below compares the different options for an investor in medium to longer tenor fixed income instruments.

 Debt Mutual FundRetail Corporate BondsTax Free BondsBank Fixed DepositsPPF
Average Returns*
The figures used ae for illustrative purpose only. Actual figures may differ.
7% - 10%, dependent on
yield movement
8.5-10.5%.6.50-7 %8.0-8.50% -8.70% for 2014-15, changes every year; linked to 10 year government bond
RiskLow to medium market risk

Default Risk High

market risk : Low to medium
Low Default risk in PSU issuances; market risk : Low to mediumLowLow
LiquidityHigh, As daily redemption
of units possible
Listed on exchanges,
but volumes  not
very high
Listed on exchanges,
but volumes not
very high
High, subject to prepayment penalty
Low, Loan and
withdrawal after initial term
Taxability20% capital gains tax after indexationTax on interest and capital gainNo tax on interest,
but capital gains on sale
will be taxed
Interest is taxed
as normal income
No Tax
AccessibilityDirectly through mutual fund
website or through
mutual fund distributor
Buying /selling on exchange post primary issueBuying /selling on exchange post primary issueEasyAvailable with
designated banks or Post office

So, although availability of retail and tax free bonds have increased the choice but as can be deduced from the table for a retail investor, debt mutual fund schemes which in turn invest in bonds offer one of the best means of asset allocation from the liquidity, taxability and accessibility angles.

In the current scenario, the government securities are trading at annualized yields of around 7.7-7.90% in the 5 to 10 years bucket, and in the 20 to 30 years bucket, papers are available at an annualised yield of 7.80- to 7.95 levels. The corporate bond yields are trading at an yield of 8.30 levels in the ten year bucket. If you apply the different criteria, which investors should use before purchase of bonds these levels are attractive. The economic factors like low GDP growth, Banking liquidity, Rupee relative strength, nature demand from investors are attractive. The expectation is RBI may keep interest rates on hold, and wait for the monsoon scenario to become clear before cutting interest rates again. The investor’s downside is limited in this base case scenario and investors can expect good accruals and some capital gains if he invests in bonds wisely considering the bond market conditions from time to time.

Do let us know whether you have any further questions regarding bonds. Do not hesitate to call us at 1800-22-3863 in case of clarifications!

And always remember to consult your investment advisor before making any investments.

Disclaimer, Statutory Details & Risk Factors:

The views expressed here in this article / video are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering / communicating any indicative yield on investments made in the scheme(s). The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the reader. The article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date. Readers of this article should rely on information/data arising out of their own investigations and advised to seek independent professional advice and arrive at an informed decision before making any investments.

Mutual fund investments are subject to market risks read all scheme related documents carefully.

Please visit – to read scheme specific risk factors. Investors in the Scheme(s) are not being offered a guaranteed or assured rate of return and there can be no assurance that the schemes objective will be achieved and the NAV of the scheme(s) may go up and down depending upon the factors and forces affecting securities market. Investment in mutual fund units involves investment risk such as trading volumes, settlement risk, liquidity risk, default risk including possible loss of capital. Past performance of the sponsor / AMC / Mutual Fund does not indicate the future performance of the Scheme(s). Statutory Details: Quantum Mutual Fund (the Fund) has been constituted as a Trust under the Indian Trusts Act, 1882. Sponsor: Quantum Advisors Private Limited. (liability of Sponsor limited to Rs. 1,00,000/-) Trustee: Quantum Trustee Company Private Limited. Investment Manager: Quantum Asset Management Company Private Limited. The Sponsor, Trustee and Investment Manager are incorporated under the Companies Act, 1956.

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