How to invest in corporate bonds in India?

Bonds are considered to be one of the best defensive asset classes. That is why, many investors have a mix of both bonds and stocks. (Image: Pixabay)
Bonds are considered to be one of the best defensive asset classes. That is why, many investors have a mix of both bonds and stocks. (Image: Pixabay)

Summary

  • How bonds can fit into your portfolio.

2022 was the year of reckoning for the entire bond market. In their efforts to tame soaring inflation, the Federal Reserve and central banks across the globe implemented the most rapid series of interest rate hikes, ever!

The immediate impact?

Bonds lost in double digits. The returns they made in over a year were wiped out in a span of weeks.

For instance, the Total Bond index, which tracks the US investment grade bonds, marked 2022 as its worst year on record going back 250 years.

The good thing was this aggressive action by central banks created one of the best buying opportunities for bonds in the past two decades.

The situation is similar right now as well.

We now have positive real yields and both government and corporate bonds offer more than 8% interest rate.

The cherry on top is that if central banks, more importantly the Fed, manages to bring inflation back under control and cut rates, bond funds can possibly make a strong comeback.

Keeping that in mind, this is the perfect time to take a deep dive into the bond market and understand how to invest in corporate bonds in India.

What are bonds?

Bonds serve as a method for a company or government to raise funds for their initiatives.

By purchasing a bond, you are lending money to the issuer, who in return agrees to pay you a predetermined rate of interest throughout the bond's duration and to return the bond's principal value upon its maturity.

To simplify this, let’s consider a hypothetical example…

Suppose on the day of purchase, you give 100 to the bond issuer. Over the next 10 years, the bond issuer will give you 10 every year as the coupon payment, and at the end of 10 years, you receive the initial 100 you used to purchase the bond.

So every year, you get a fixed-income from your 100 investment. This is the reason why bonds are considered less risky than stocks.

That is if the issuer does not go bankrupt.

Also, in the event of a company filing for bankruptcy, bondholders are the first in line to get repaid. When Lehman Brothers’ filed for bankruptcy, bondholders received up to 40% of their investment back whereas the equity holders got nothing.

How bond pricing works

For a retail investor, purchasing bonds directly from a company can be challenging. Typically, bonds are traded on the secondary market once they have been issued.

The price of a bond represents the value of the income it generates through its coupon payments.

In practice, bond prices are quoted as a percentage of the bond’s face value, allowing you to quickly determine whether a bond is trading at a discount or a premium to its par value.

How to Invest in Corporate Bonds in India?

Given the attractive valuation, consistent income, and low volatility they offer, bonds might look like an attractive option to add to your portfolio.

However, you must analyse how they have performed during previous crises.

There are two types of common bonds on the market – the bonds offered by government and the bonds offered by private corporates.

Here’s a step-by-step guide on how to go about investing in corporate bonds in India:

Evaluate Risk and Return: Unlike government securities, corporate bonds carry a higher risk, depending on the financial health of the issuing company.

However, they also generally offer higher interest rates.

Usually, what investors do is look at ratings provided by agencies like CRISIL, ICRA, and CARE to assess the risk associated with these bonds.

However, the primary way to assess health of corporate bonds should be to check the health of the underlying business in terms of debt to equity, cash flows, profit margins, interest coverage ratios, and return ratios.

Buying Corporate Bonds Directly: You can buy corporate bonds directly during the issuance in the primary market or from the secondary market through a stock exchange like the BSE or NSE.

For this, you’ll require a demat account.

Buying Corporate Bond Funds: Alternatively, you can invest through mutual funds that focus on corporate bonds.

Tax Implications: Interest from corporate bonds is taxed according to your income tax slab in India. If you sell bonds in the secondary market at a profit, capital gains tax may also apply.

Impact of Bonds on Your Portfolio

Bonds are considered to be one of the best defensive asset classes. That is why, many investors have a mix of both bonds and stocks.

Some like to keep it at 60/40 with a higher allocation towards stocks. This is the most popular portfolio mix.

While many also keep 60% in bonds or 50/50, depending on their risk appetite.

An important thing to note here is that you should not expect your stocks and bonds mix portfolio to outperform a 100% stock portfolio. Bonds come to play when there is a market crash.

Some Associated Risks

Apart from interest rates, there are some more risks that investors need to consider before they decide to put money in bonds.

Credit Default Risk

Corporate bonds are dependent on the issuer’s ability to repay the debt. If the issuer defaults, you can’t really do anything about it.

A classic example of such default is the latest one for Credit Suisse. As part of its merger with UBS, Credit Suisse wrote down billions of dollars of its tier 1 bond to zero. So all the holders of this bond lost 100% of their investment.

What About Inflation?

As usual, inflation would come into play. Suppose you lock in a 2% bond for the next 10 years and inflation shoots up to 7%. In this case, you’ll lose money to inflation.

Liquidity

In case of government bonds, there’s always a ready market but for corporate bonds, low liquidity can result in losses during a crisis.

Final Words

Investors must remember that when interest rates decrease, older bonds with higher coupons issued at previous higher rates become more attractive compared to new bonds.

This allows investors with these older bonds to potentially sell them at a premium in the secondary market.

Conversely, if interest rates increase, older bonds lose value because new bonds are being issued with higher coupons, leading the older bonds to trade at a discount.

A crucial mistake to avoid is focusing solely on the current value of bonds in your portfolio. In scenarios where interest rates rise, the overall returns in your bond portfolio can actually improve.

This is because you can reinvest the payouts from coupons and matured bonds into new bonds that yield higher returns.

In conclusion, maintaining an asset allocation strategy that aligns with your risk tolerance is crucial for staying invested during market fluctuations.

Bonds provide a comforting option for investors focused on preserving capital rather than seeking high returns.

That’s it for today, we hope this guide to investing in corporate bonds was helpful.

Happy Investing!

Disclaimer:This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com

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