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Understanding Bonds and Their Risks

IndianMoney.com Research Team | Posted On Tuesday, April 23,2019, 06:01 PM

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Understanding Bonds and Their Risks

 

 

Bonds are basic debt securities that are traded in the capital market. It is an instrument through which the entities borrow capital from the buyer of the bond. Issuing bonds help the entity to raise capital for business development at cheaper rates than banks and lending institutions. The bond issuer is obliged to repurchase it within the specified period by paying the buyer the agreed interest. The government also issues bonds to raise money for government projects.

Benefits and Risks of Bonds

Some of the main benefits of bonds are as follows:

  • Bonds have a certain advantage over other types of securities. In bonds, the volatility is lower than other kinds of equities and stocks. Bonds are generally considered to be safe investment options than other risk-bearing financial products. The day to day risk is less on bonds than shares and equities that have price fluctuations due to share market performance. Also, the interest payment on bonds is higher than the general level of dividend payments.
  •  One of the key features of bonds is that they are highly liquid. It is easier for an entity to sell large quantities of stock without much difference in the price which may not be the case for equities. Bonds are a more attractive investment option for investors as they provide certainty of fixed interest payment twice a year and a fixed lump sum amount on maturity.
  • Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company’s equity stock often ends up valueless. Furthermore, bonds come with indentures and covenants.An indenture is a formal debt agreement that establishes the terms of a bond issue. Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing.
  • There are also different types of bonds available to suit the different needs of investors, including fixed rate bonds, floating rate bonds, zero coupon bonds, convertible bonds, and inflation-linked bonds.

SEE ALSO: Comparison between Stocks and Bonds

Disadvantages of Bonds

  • Bonds are subjected to various other risks namely call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk and yield curve risk.
  • Any price change in bonds will in return affect the mutual fund portfolios which hold these funds as debt products. In case the value of the bonds in a trading portfolio falls, then the value of the trading portfolio also falls.
  • Bonds are generally issued by institutions that have strong credit ratings. However, the prices of the bonds depend on the credit rating of the issuer. Therefore an unanticipated downgrade in the credit ratings of the user will cause the market price of the bonds to fall, which in turn affects the mutual fund holdings of these bonds and holders of the individual bonds.
  • Some bonds are callable, which means, even though the company has agreed to make payments plus interest toward the debt for a certain period of time,it can choose to pay off the bond early. This creates reinvestment risk, meaning the investor is forced to find a new place for investing his money. As a consequence, the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.
  • There are chances that the bondholders may lose all their bonds if the company goes bankrupt. In such cases, the company will first try to pay the bank lenders, deposit holders and trade creditors. Bondholders will be paid after all such payments are settled. In case of a bankruptcy involving reorganisation and recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through the exchange for a smaller number of newly issued bonds.
  • Fixed rate bonds are subjected to interest rate risk, meaning, their market prices will decrease in value when the general prevailing rates rise.

An Inverse Relationship: Interest Rate Risk

Interest rate risk defines the possibility of change in the price of a bond due to a change in prevailing interest rates. The prices of the bonds are inversely related to the interest rate. When the rate of interest is higher, the prices of the bonds go down and vice-versa. In normal circumstances when the market interest rate level rises, the bond market value usually drops. However, the interest risk effect on the market value of bonds may be deemed as a negligible factor. This is because the bondholders are entailed to receive the entire face value of the bonds at the time of maturity. So any short term changes in the market value of the bonds caused due to interest rate fluctuations do not make much difference.

Types of Bonds:

There are various types of bonds that bring differentkinds of risk and tax implications to the investor’s portfolio. The bonds are available in various forms and each has a different set of benefits. The different types of bonds generally fall under these categories:

Corporate Bonds: a corporate bond is a debt security issued by a corporation to raise funds from the investors. Such bonds are generally bought by investors as these companies have high credit ratings. The backing of these bonds is usually the payment ability of the company, with the money that is earned by them through their investments. In some cases, the physical assets of the company can be used as collateral for these bonds.

  • Risk Considerations: The primary risk associated with these types of bonds is credit risk, interest risk and market risk. Also, some corporate bonds can be demanded for redemption purpose by the issuer. In these cases, the bond is repaid before the specified tenure and the principal is repaid before the maturity date. This creates reinvestment risk and investors have to find new bonds/ financial options to park their money. As a consequence, the investors may not be able to find a good deal as such instances take place when interest rates are declining.
  • Tax considerations: The holder of the corporate bonds fund must pay Short Term Capital Gains Tax or STCG based on their tax slabs for holding bonds for less than 3 years. On the other hand, Section 112 of the Income Tax Act mandates 20% of Long Term Capital Gains Tax applicable for long term investments. This is applicable to individuals who hold the bonds for more than 3 years.

SEE ALSO: Corporate Bonds

Government Bonds: Government bonds are bonds issued by the central government and are supervised by the Reserve Bank of India. Government bonds are sold to investors through auctions. Bonds are issued by the government to raise money to fund projects related to public welfare and infrastructural development. The government would pay a regular and fixed interest rate to the investors who buy the bonds. The face value of the bonds will be paid to the investors on the maturity date. 

  • Risk consideration: these types of bonds carry the lowest amount of risk and are the safest types of bonds as they are issued by the government. Such bonds carry low credit risk as they have a sovereign guarantee. However, the only risk carried by these bonds is the inflation risk. The chances are that that returns received by the investors will be comparatively low and the returns are not inflation beating.
  • Tax considerations: the interest income received from treasury bonds is fully taxable. Gains on sale or redemption of government bonds are also liable to taxes.

Government Agency Bonds: agency debt is also known as agency bonds. It is a type of government security, usually in the form of bonds issued by government-sponsored agencies. The offerings of these agencies are backed but not guaranteed by the government.

  • Risk Consideration: agency bonds carry the lowest credit risk due to their association with government-backed entities. But because these bonds are not directly issued by the government they are not necessarily the safest and low-risk investment options. Agency bonds also have the risk of running in to default although the chances are very low. Due to these associated risks, these bonds generally offer a higher yield than government bonds.
  • Tax Consideration: Government agency bonds are fully taxable. Gains on sale or redemption of government bonds are also liable to taxes.

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