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How beginners should evaluate bonds and debt instruments?

Equity research and the evaluation of equities are much talked about. However, despite a lot of investments going into banks, debentures and FDs, there is very limited research and work that is done on these debt instruments. How to evaluate investment in bonds? Let us look at it from the perspective of bond and debt instruments and also debt funds. Let us take a very basic approach as investing in bonds for beginners.

A bond or debenture is a fixed return instrument. You invest in a bond with a face value and you are paid interest on the face value of the bond. The face value is what you get when you redeem the bonds. Bonds have to pay the interest on time at regular intervals and the redemption of the bond has to done promptly once the bond matures. Bonds are assured return instruments and hence are less risky compared to equity trading. Here is what you need to look at while evaluating bond and debt instruments.

Returns on pre tax basis
Here you look at the interest that you earn on the bonds. For example if the bond has a face value of Rs.1000 and it is paying 9% interest per annum, then you get Rs.90 as interest each year on the bonds. Normally, issuers of bonds will pay this interest either semi annually or annually and you can opt for the scheme that suits you best. There are other measures of return but we shall dwell on them at a later stage in this article. There are two kinds of returns that you will earn in bonds. If you hold the bond then you earn the regular interest that is paid. If the bond is listed, then bond prices gain when interest rates go down. That will result in profits and you can book profits and exit the bond in the secondary market.

Returns on post tax basis
Pre tax returns can be quite misleading and hence you need to look at post tax returns to get a clear picture of what you actually take home. Bonds and bank FDs have to pay tax on interest at par with other income. So if you are in the 30% tax bracket then your tax payable on the interest will be 30%. Effectively, your 9% bond will earn you only 6.3% (9% - 30%) in post tax terms. When you redeem the bonds at par then there is no tax payable. However, if you sell the bond at a profit then that is treated as capital gains. In case of bonds, it is STCG if held for less than 3 years and LTCG if held for more than that. In case of STCG tax is payable at the peak rate while in case of LTCG it is payable at 20% on capital gains with the benefit of indexation.


Default risk of the bond

Normally, default risk is the risk of the issuer defaulting on the bonds. Government bonds and bonds issued by large financial institutions backed by the government are free of default risk. However, as you go down the credit quality line, the risk of default increases. Recently, we have had cases of IL&FS, a fairly large and reputed company defaulting on its bonds. Other than government backed bonds, al other bonds have some degree of default risk built into it. Credit rating by organizations like CRISIL, CARE and ICRA are meant to measure the credit rating of these bonds and debentures and they are mandatory as per the law.

Interest rate risk of the bond
Rate risk is the risk of the bond price going against you when the rates move up. Normally, bond prices appreciate if rates go down and bond prices go down if rates go up. The extent of the impact on price depends on the duration of the bond. For example, long duration bonds are more vulnerable to shifts in interest rates compared to short duration bonds. That is why bond funds tend to shift from long duration debt to short duration debt when the interest rates are expected to rise in the near future.

Understanding different types of yields
As a bond investor, there are 3 types of yields that you must be familiar with. They are enumerated as under:

Interest yield is the rate of interest that the bond pays on the face value of the bond. For example, if the bond with a face value of Rs.1000 pays 9% as interest rate then the interest yield will be 9%. Interest yield is always with reference to the face value.

Current Yield is another measure where the Interest income of the bond is dividend by the market price of the bond. For example if the 9% bond with face value of Rs.1000 is quoting at Rs.992 then the current yield of the bond is 9.07% (9/992). Current yield is normally compared to the earnings yield of equity and is used to decide whether fund managers should allocate funds to equity or to debt.

The most important type of yield you need to know is Yield to Maturity (YTM), which is the yield that you will earn till maturity. The YTM not only factors the market price of the bond but also the time value of the interest payments. For example, Getting Rs.90 at the end of year 1 is more valuable than getting Rs.90 at the end of year 2. YTM is the most popular measure for analytical purposes.

A better grasp of some basics of bonds and debentures will help you to better appreciate debt as a product and its role in your portfolio.

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