Learn about bond funds

Had an interesting experience when I went to the local branch of my bank recently. Want to share that experience with you.

As I walked in I was slightly intimidated by the long line of people waiting to get things done. Hassled clerks and equally hassled customers do not a good Saturday morning make!

Thought again, as I always do whenever I walk into this branch that life would have been so much easier if everything was online like the Quantum invest online section where you can invest directly without any paperwork...

Anyway I digress, as I walked in I heard the branch manager speaking with a customer trying to sell him a bond fund. The customer then asked the branch manager what exactly a bond was, how do bonds work and why should he invest in a bond fund.

The branch manager`s response was standard - "I will ask the concerned Sales person to get in touch with you, as I too don`t know too much in detail about bonds!"

Hence thought that if the layman does not know much about bonds, maybe I should write to you, our reader, clarifying 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 steady income and preserving wealth 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 three 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.
Capital Gains/Losses - Changes in market level interest rates lead to increase or decrease in bond prices. Bond prices rise when market interest rates fall and vice versa.

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 be liquidated 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.

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 rates of between 8.5% - 9.0% 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 and safe bond issuances.

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

*The figures used are for illustrative purpose only. Actual figures may differ.

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 attractive annualized yields of around 9 % in the 5 to 10 years bucket, and in the 20 to 30 years bucket, papers are available at an annualised yield of 9.30 to 9.40 levels. The corporate bond yields are trading at an yield of 9.80 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 only negative for bonds at present is high CPI inflation. The expectation is RBI will keep interest rates on hold, to bring down inflation expectations and not raise Repo rates further from these levels. 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 currently.

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.