Benefits of Bond Investments

Benefits of Bond Investments

One can argue that bonds fall lower on the return scale compared to equities and equity mutual funds. However, bonds investment still offers some very distinct advantages. The bond market offers a wide variety of bond options to invest in and they could range in quality, maturity and issuer profile. For instance, tax free bonds can offer you advantages in terms of interest tax breaks, capital gains tax breaks or purely give an investment tax break. Similarly convertible bonds have the qualities of equity and also of debt.

If equities are higher on the return scale, they are also higher on the risk scale. Having too much of equity in your portfolio is not only riskier, but can also lead to capital depletion. That is where bonds step in. One of the key benefits of bonds is that they can give predictable, regular and steady income. Let us look at some of the key benefits of investing in bonds.

Bonds can provide steady income flows

It is not that equity does not provide income. It does provide income in the form of dividends, but these dividends are not assured. For instance, if the company has lower profits or if they have capex plans, the company can either reduce the dividend or skip dividends altogether. However, in the case of bonds, the income in the form of coupon interest is a fixed commitment. Unless the company goes bankrupt, there cannot be any default in interest payment. Of course, in case of government bonds, interest and principal repayment is guaranteed by the government. This benefits is not available to that extent in any other asset class.

That is what makes the bond investment very suitable to senior citizens relying on regular income to run their households and pay bills. Also, if your age is advanced, you need to be invested in assets that can give you gradual and steady income over time. Bonds fit that bill as they are low on risk and the pay outs are in the form of a commitment. Most importantly, a strong bond portfolio can provide decent yields with substantially lower level of volatility than equities. This makes bonds a good option for those who need to live off of their investment income. Even when younger people create their portfolio, some portion of their money must be invested in such steady bond investments.

Investors can diversify their risk with bonds

We know it does not make sense to put all your eggs in one basket. For instance, if you put 90% of your funds in equities and the index falls by 30% due to recession fears, your portfolio is sharply lower. That is something you cannot afford. Hence when you invest, you must have a good measure of bonds in your portfolio. The best of investors in the world also diversify because markets are unpredictable by default. You cannot say for sure that equities or real estate or gold would perform well in the coming one year. When your portfolio is shrouded in such high levels of uncertainty, the best option is to add bonds that reduces the overall risk by diversifying. Since bonds offer steady returns, your portfolios returns don’t get impacted. On the other hand, these bonds offset the volatility of equities, gold and other commodities. Bonds are a great way to reduce portfolio risk for investors.

Preserve capital with bonds

When you invest capital, one thing is how much of returns you earn on that principal amount. But a more important question is whether you are able to preserve the capital that you bring to the table. For instance, when you invest money in a government bond with face value of Rs10,000 with 6% coupon interest, the principal is Rs10,000. In a bond, the principal is absolutely safe and you can be confident of getting back that principal. Just as returns are guaranteed in the form of interest, the principal preservation is also guaranteed in of bonds.

You must look at this point in contrast to equities. Let us look at a practical situation. Had you invested in the IPO of Paytm and bought 1,000 shares at the IPO price of Rs2,150 per share. Your investment would have been worth Rs21.50 lakh. However, the current market price of Paytm stands at around Rs685, so your capital at today’s valuations is worth Rs6.85 lakhs only. In short your capital is depleted by Rs14.65 lakhs. We are not even talking about whether we will get dividends on Paytm stock. Your capital itself is substantially depleted. That is the problem that bonds solve.

Bonds offer a wide choice

This is an oft ignored aspect of investing in bonds. These bonds offer you a wide choice in terms of maturities, credit ratings, issuer profile, bond features etc. For instance, in terms of maturity, you have bonds ranging from 91-day treasury bills to 30 year bonds. Similarly, if you look at credit rating, there are the blue-chip government bonds to bonds of mid-cap and small cap companies with ratings of “A” or “AA”. Also, bonds offer variety in terms of issuer profile. There are bonds issued by the centre, state governments, municipal bonds, institution bonds, bank bonds, corporate bonds, NBFC bonds etc. Lastly, you can also get variety in terms of bond features. For example, there are convertible bonds, callable bonds, puttable bonds and the list can go on. The moral of the story is that there is adequate choice even in bonds.

Bonds can play a key role in portfolio planning

When you plan to achieve long term goals like retirement, education of your child etc, you need to think in terms of returns and risk. As your milestones approach in the financial plan, you reach a stage where you must convert equities into fixed instruments to avoid last minute volatility. Apart from these advantages, there is another important merit in bonds.

Bonds can be used for maturity matching. For instance, if you have a known liability maturing after 7 years. Normally, you can buy bonds or bond funds but there is interest rate risk if the rates go up in the market. To avoid that risk, one can perfectly plan by matching duration of the bond with the maturity of the liability. Hence if there is liability after 8 years, match with a bond with duration of 8 years. That can offset interest risk totally.

Finally, you also get tax advantages in bonds

For most bonds, the interest is fully taxable in the hands of the investor. However, there are some unique tax advantages in bonds.

a) Government backed financial institutions like PFC, REC, NHAI and IRFC issue tax-free infrastructure bonds where the interest is fully tax free. Interest rate may be just about 5.5%, but it is fully tax free and hence HNIs are favour this product.

b) Then there are sovereign gold bonds of the government where the capital gains is totally tax free if held for a period of 8 years.

c) There are some special bonds, that provide tax break based on the amount invested subject to upper ceiling limits.

d) One final point to remember is that if bonds are held for over 3 years, they classify as long time capital gains and are taxed at a concessional rate. There is the added benefit of indexing available on long term gains on bonds, which enhances effective gains.

To sum it up, bonds offer stability, diversification, steady income and a good portfolio fit.