5 Things to look at before buying bonds6 min read . Updated: 05 Apr 2009, 09:10 PM IST
5 Things to look at before buying bonds
5 Things to look at before buying bonds
Encouraged by the present mood of retail investors, companies such as State Bank of India (SBI), Future Capital Holding, India Infrastructure Finance and Mahindra and Mahindra Financial Services too have planned bond offers.
Bonds are currently offering an annual interest rate (coupon rate) in the range of 8-11% and the yield (total return on bonds if unsold before maturity) on them is at least 9%, which is equal to or higher than the rates offered by bank deposits.
Krishnan Sitaraman, head, fund services and fixed income research, Crisil, says: “The yield at present is 250-300 basis points higher than that of government securities, compared to an average of 100 basis points in the past 10 years. This will go down and simultaneously, the value of corporate bonds will increase. These corporate bonds look like a proposition that people could invest (in) more going forward."
However, the high returns also bring along a slew of risks. Here’s what you should look at before buying:
Default in payment by the issuer is one of the major risks you face. The default could be in the form of untimely payment of coupons or non-payment of the principal at the time of maturity (face value). The chances of a default can be assessed by the rating assigned to the bond by authorized agencies on the basis of a rating scale. The higher end of the scale indicates better credit quality (the company’s ability to pay), lowering the chances of default. The lower end indicates poor quality and higher chances of default.
Apart from that, agencies also consider another risk before assigning a rating. This risk arises when the industry in which the issuer operates undergoes a sudden rough phase. The increased risk profile of the industry increases the yield (interest) demanded by the investors from new bond issues in that industry. This, in turn, pulls up the yield even of the old issues and brings down their prices.
Look beyond ratings
Ratings do not account for all the risks associated with bonds. New risks could arise after you have purchased the bond.
For example, if an issuer decides to go for acquisition or any other restructuring, the debt burden on the issuer will increase. This will affect the issuer’s ability to service the existing bond liability, thereby increasing the risk profile of the bond that you are holding. This, in turn, will reduce the price of the bond.
Companies operating in industries such as metals and telecommunications, that are evolving or going through a consolidation phase, are potentially risky.
In some cases, rating agencies may be late in updating the company’s credit profile. For example, the downgrading of companies in sectors such as real estate happened much after the signs of financial strain actually started showing.
Avoid investing in the bonds of companies where revenue shows a declining trend and the debt burden is increasing.
Consider your liquidity requirement before investing in corporate bonds and match your investment horizon with the bond’s maturity period, which is generally 5-10 years.
Premature selling of bonds will expose you to volatility in interest rates. For example, when interest rates go up, new bonds start offering higher rates than that of existing bonds. If you want to sell your existing bond in such a scenario, you will have to sell for a lower price in order to compensate the buyer for the lower coupon on your bond.
Another factor that you need to consider if you plan to exit your investment before maturity is the liquidity of bonds. Says Milind Gadkari, group head, financial sector ratings, CARE Ratings: “Even though these securities are listed on exchanges, they may not be liquid and this only prevents retail investors from entering bonds. And selling illiquid bonds in the market will fetch you less value."
Avoid complex bonds
Additional features, such as call and put options, may expose you to new risks.
For example, a call option allows the issuer to buy back the bonds before maturity after a certain specified period mentioned by the company. This may go against you in a declining interest rate environment. When the interest rate falls, the issuer still pays you the coupon rate fixed earlier, which is higher than the existing market rate. The issuer, therefore, may decide to buy back high coupon-paying bonds from you and may issue new bonds with low coupon rates. In the process, you are left with the money that can only be invested at the prevailing low rate. At the same time, a put option, where you can sell the bonds back to the company before they mature, can be profitable to you in a similar scenario.
Some bonds allow you to convert them into company shares. But this increases volatility in prices and it is better to stay away from them.
There is no thumb rule to decide the exact return that a particular bond will fetch. But you can compare instruments with a similar rating in the market to reach a reasonable figure. Yield on a particular bond can also depend on the industry in which the company operates and the market’s attitude towards that industry. Says Sitaraman: “There will be finer differences in yields. A finance entity with ‘AAA’ rating will get a higher yield than a manufacturing one with the same rating. The market is more comfortable with manufacturing companies and it will buy their bonds at a lower yield than those of finance entities."
The call and put feature should also be considered. Since the call option gives additional rights to the issuer, investors are compensated by way of extra coupon rate compared to similar rated non-callable bonds. Putable (or put) bonds give more rights to investors. So, their coupon rate is less than that of non-putable bonds.
A bond glossary you can use to brush up your investment basics:
Convertible bonds: These can be converted into a particular number of company shares at a particular time.
Coupon rate: The interest received on the principal amount invested. It is generally paid annually or semi-annually.
Current yield: The annual rate of return on the bond’s price.
Face value: Also known as par value, this is the maturity amount that the bond issuer agrees to pay the investor.
Interest-rate risk: The risk of change in the price of a bond due to interest rate fluctuations. Interest rate and bond prices are inversely related.
Yield to maturity: The rate of return that you get if you hold the bond till maturity. The return includes coupon payments as well as maturity value.
• Hunt for quality convertible bonds: Those from good companies fetch regular dividends. You may even get equity later.
• Buy high dividend yield stocks: Stocks with regular dividend-paying history give you tax-free dividends every year and capital appreciation.
• Invest in large-cap FMCG and pharma stocks: With a more predictable earnings stream, they involve lower risk.
• Secure tax-saving investments: Keep investing in ELSS funds with a large-cap focus or for greater security, invest in PPF up to its limit of Rs70,000 per year to get effective post-tax returns of over 11%.
• Invest in the Index: Invest funds you don’t need soon in index-based funds, ETFs such as Nifty BeES or even index funds. You will get growth from large-cap stocks as well as the benefit from their eventual turnaround.