In this article we will take a closer look at what are bonds (also known as debentures in many parts of the world); and how you can use them to improve your portfolio either to increase return or to reduce risk.
Bonds / debentures are a common way to invest your money when the equity market is too volatile. However, many investors are still not sure what bonds / debentures are and how they work. Let’s delve deeper into the functioning of a bond and how you can use to improve your portfolio. In simple terms, a bond is a loan given to a company or the government by the investors, who receive a fixed amount on it on a regular basis, called as interest.
Various companies and governments issue bonds / debentures to the public; for different purposes like funding new projects or meeting their daily ongoing expenses. Many investors put money in bonds / debentures with the expectation that they will not lose the principal amount which they’ve invested; and also earn additional money in the form of interest. Generally speaking, bonds / debentures are viewed as less risky in comparison to stocks; and people oftentimes use them for the diversification of their portfolio.
To illustrate, let’s take an example of the below bond
Face value = $1000
Coupon Rate = 10% per annum
Tenure = 10 years
The above bond would cost $1000 for an investor to purchase at the time of its issue, and would annually pay the investor an amount of $100 for 10 years; in the form of coupon or interest. At the end of 10 years, the investor will get back his initial investment (principal amount) of $1000.
Typically, bonds / debentures carry two most important types of risk – Interest Rate Risk and the Default Risk. Let’s discuss these two risks in detail.
Interest Rate Risk
Now, our above example may seem simple from a valuation perspective. But, in reality, the interest rates of different and new bonds / debentures keep on varying and therefore, the opportunity cost of holding on to your existing bond keeps on fluctuating. To illustrate this, we can extend our example.
Suppose you purchased the above bond in 2020, but next year in 2021, the same company came out with a new bond issue, having the same terms but a higher coupon rate of 12% per annum. As an investor, you would want to sell your existing bond and purchase the new one. However, since market prices get adjusted quickly to new information; the market value of your existing bond would go below the face value and you wouldn’t be able to recover the full principal amount on selling it in the open market. On the contrary, if the new bond issue had a lower rate of interest, then the value of your existing bond would have gone up and you could’ve sold it for a higher amount of money.
Credit Rating (and Risk of Default)
We can see from the above illustration that the value of a bond depends on the interest rate fluctuations in the market. This is just one aspect to trading in bonds / debentures; another aspect is the credit rating of a company. Since bonds / debentures are essentially a loan given out to someone, you need to be sure that the borrower will be able to repay the loan at the end of the term; or as per the repayment schedule. For this, there is the concept of credit ratings of bond issuers. Every company or agency that issues bonds / debentures has to mandatorily get their credit rating evaluated by an independent agency; like CRISIL, CARE, etc.
The higher the credit rating of the borrower, the more likely it is that they will be able to repay the full money as per the repayment structure. You might have seen wordings like AAA, AA+, A-, etc. on the bond names; these are the credit ratings of the issuers. Since a bond with a higher rating is more likely to pay back the money; many people consider it a safer and more secure than a bond with a lower rating. Accordingly, these bonds / debentures carry a lower rate of interest than bonds / debentures with lower ratings.
As with everything, there is a risk-return ratio for every bond that an investor can purchase from the market. Lower the credit rating of the issuer, higher is the risk, and higher is the return. Therefore, you might see that 2 different issuers may issue bonds / debentures to the same set of investors, at the same time, but at different interest rates. The difference is most likely because of the difference in their ratings. The better credit rating bond would generally carry lower interest rate, so safer investors would invest their money in that; and vice versa.
Risk of Default
The risk that the issuer will not be able to pay back the principal amount of the bond is known as the Default Risk. Therefore, an issuer with AAA rating has a lower default risk than an issuer with a AA rating. Generally, government bonds / debentures are considered safer than their corporate counterparts; they are stable bond issuers and usually issue bonds / debentures with a lower interest rate. On the other hand, corporate bonds / debentures would carry a higher risk of default, as companies can go bankrupt. This is a reason why corporate bonds / debentures would typically have a relatively high interest rate than government bonds / debentures.
Investors may use a combination of bonds / debentures and stocks to reach their investment goals. Because bonds / debentures move in different way from stocks; they are generally able to help in protecting, or even increasing portfolio returns. If a person only invests his or her money in bonds / debentures; then they are most likely making a lower return on their investment; as compared to if they had invested a part of their money in the stock market as well. On the contrary, if an investor is putting all of his or her money only in stocks; then they are exposing themselves to a lot of risk; equity markets are quite volatile by nature with large fluctuations; and bonds / debentures can help reduce the overall portfolio risk for an investor.
This article showed you a generalized way that many investors may use bonds / debentures and just a couple of most important risks that you need to consider before investing your money in bonds / debentures. As is the case with any investment avenue, bonds / debentures are a complex tool, and there are various use cases and risks for them.
Before you invest in bonds / debentures, you must gauge the financial strength of the issuer of the bond. There are multiple credit rating agencies that assign rankings to different bonds / debentures. Each agency often uses their own criteria for measuring the risk associated with the bonds / debentures. It’s always a good idea to compare ratings of different rating agencies when considering a particular bond. It is also important to understand that ratings are never 100% accurate or precise, and you need to conduct your own research on the issuer to understand whether you should invest in their bond or not.
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