Bonds: The Safest Investment in The Securities Market
People invest in the market mainly for two reasons, reducing investment risk and capital appreciation. Investing in the stock market does not only help in achieving those goals. As an investor, you have to look upon the various options to put your money. It’s quite important to weigh them carefully. Investment in the capital markets is generally categorized into three main categories: stocks, bonds, and cash equivalents. Stock and bonds are considered best for long term growth. Those investors, who have a higher risk appetite prefer stocks, while those who have a lesser risk appetite prefer bonds. So, common investors always feel puzzled about bonds.
A bond is basically an agreement between a government or a company to pay back a loan to the investor at a specified interest rate. It is mainly issued by governments and corporations to raise money. By buying a bond, an investor is giving the issuer a loan for a specific period of time and specific interest rates. The issuer of the bond agrees to pay you back the face value of the loan on a specific date as well as make periodic interest payments along the way. Let’s look at the different types of bonds.
- Government bonds (Central/ state)
- Municipal bond
- Corporate Bond
- Public Sector Bond
- Tax-Free bond
- Government bonds: These bonds are issued by mainly Central or State governments to raise funds. RBI issues these bonds on government’s behalf. The main purpose of these types of bonds is to finance the fiscal deficit and meet the shortfall of revenue in the government budget.
- Municipal bond: A municipal bond is mainly used to raise finance to meet funding for specific goals, such as constructing infrastructure, public drainage works.
- Corporate Bonds: These bonds are issued by corporations in order to fund their project, whether related to company expansion, merger, and acquisition or for long term plans.
- Public Sector Bond: These are mainly issued by public sector companies for meeting their growth and expansion needs.
- Tax-Free bonds: There are certain government enterprises such as the National Highway Association of India, Indian Railways Finance Corporations, HUDCO, Rural Electrification Corporation, which raise funds for a particular purpose. The interest earned on these bond funds is completely tax-free.
Types of Bond Market:
There are mainly two types of the bond market in India.
- Primary market: In this market, the entity that needs to borrow money invites the general public or investment banks to purchase their bonds. These bonds are issued for a fixed tenure at a pre-specified interest rate.
- Secondary Market: In this market, the investor who had purchased the bond previously, sells their bonds to other investors who wish to buy the same.
Advantages of investing in bonds:
- Lowest Volatility: Bonds have the lowest level of volatility in all the securities. So, it is generally considered safer investment than stocks. In day to day term, it has the lowest level of volatility compared to stocks. The interest payments on bonds are sometimes higher than the general level of dividend payment.
- Liquidity: Bonds are often liquid. So, it is often fairly easy for an institution to sell a large quantity of bonds without affecting the price much which is sometimes difficult in case of equities.
- Legal protection: Bondholders also enjoy a measure of legal protection in most of the countries, as the government hardly defaults on its obligation. More so, if a company goes bankrupt, its bondholders often receive money backs, whereas the company stocks may end up valueless.
Disadvantages of Investing in bond:
There are certain risks associated with an investment in bonds, which may act as a disadvantage. Let’s look at each of them: –
- Interest rate risk: Bond price is inversely proportional to the interest rate. So, if the interest rate rises, then the price value of the bond will fall immediately.
- Inflation risk: Inflation adversely impacts the bond rate of returns. For instance, if an investor buys a bond at a set interest of 6%, so the real value of your investment is determined by how much inflation eats your yield. If inflation is 2%, the real pay-out is 4%, but in case if the inflation increases to 3% then the real pay-out will decrease to 3%.
- Repayment Risk: This is one of the most common risks associated with the bond. A bond poses a reinvestment risk to investors if the proceeds from the bond or future cash flow will need to be reinvested in security with a lower yield than the bond originally provided.
*Disclaimer: investment in securities market are subject to market risks, read all the related documents carefully before investing