Bonds, as the name suggests, are debt market instruments that pay a fixed interest rate per annum or at periodic intervals and are redeemable at the end of a particular time period. Effectively, bonds are fixed income instruments that are a promissory by a private sector corporate to raise funds for its business use. Most of these bonds are traded in the secondary market and can also be held in dematerialized form by the investors. In India companies like HUDCO, ECL Finance, IIFL among others consistently raise funds through the corporate bond issue route. Here are the factors to consider before buying into private sector bonds
1. Is it backed by a reputed business group?
Unlike government bonds that are free of default risk, these private sector corporate bonds are subject to default risk. Default risk can impact you as an investor in two ways. Firstly, the company may be hit by weak financials and may be forced to default on its periodic interest payments and its principal repayment. Secondly, the bond may be listed in the bourses but the bond may be downgraded by the rating agencies which will result in the price of the bond cracking. We have seen that in the case of Amtek Auto and RCOM. In both the cases, the investor in such corporate bonds scan be exposed to risk of capital loss.
2. Don't go hunting for higher returns
Even among fund managers, it is quite common to hunt for higher returns on private bonds by going down the rating curve. For example, a AAA rated corporate bond will pay the lowest rate of interest. But if you opt for AA or A rate bonds, the yield will be higher as such companies will be more willing to pay higher rates compared to the AAA companies. While not all companies with AA rating and A rating will default, it is a risk that you need to be cautious. The risk becomes more pronounced if you do not have a secondary market liquid exit or you do not have the time to track the performance of the bond underlying the company.
3. Remember, you are at a tax disadvantage in private sector bonds
At the end of the day, your effective returns are determined by the tax treatment. When you invest in private bonds, the interest that you earn on these bonds are taxed at your peak rate of, say 30%. So, if the bond pays you 11% interest, then your effective post-tax yield on the bond is just 8.7% (11-3.3). You may be better off putting this money in a tax saving infrastructure bond, even though it may entail a longer lock-in period. For example, an infrastructure tax-free bond that pays 6.5% interest will result in an effective post tax yield of 9.3% (6.5/0.7). You are actually getting a better effective yield with much lower default risk in an infrastructure bond.
4. Debt funds may be a better investment option for you..
If stability is what you are looking at, then debt funds may be a much better option for you. There are variety of reasons for the same. Firstly, debt funds give you the benefit of interest earned on the bond as well as the capital appreciation when the interest rates come down. Secondly, debt funds create a diversified portfolio of debt instruments across the risk spectrum that substantially reduces your overall exposure risk. It is hard to achieve this kind of diversification on your own. Thirdly, debt funds are liquid and can be redeemed at short notice unlike bonds that are mostly illiquid. Also, the prices may not be reflective of the actual value of the bond due to pricing anomalies. Lastly, there is the big tax advantage in debt funds over private sector bonds. If you opt for the dividend plan of a debt fund, you can swipe out the returns of a debt funds without paying any taxes as dividends paid out by debt funds are entirely tax-free in the hands of the investor.
While private sector bonds do offer a slightly higher return compared to bank FDs, the concomitant risks are also relatively higher. One needs to be conscious of the same before investing in private sector debt.