Bond categories for making investments

Bond categories for making investments

Look at the credit rating, goodwill of the business group issuing the instrument and post-tax returns

We have discussed about investing in bonds earlier. Now, we will go into the types of bonds available in the secondary market that you can invest in. This clarity is required for taking a suitable investment decision.

To start with, let’s talk of the category that comes to our mind when we think of bonds. Let’s call it ‘conventional,’ i.e., regular bonds. These bonds are defined by a maturity date, coupon (i.e., interest) rate and face value (i.e., nominal value). The maturity is usually a single date, which is called bullet maturity, or it may be spread over multiple pre-defined dates, which is known as staggered maturity. The dates for coupon payment are defined as well. On maturity, the face value of the bond is paid back to the investor; if there is a premium on redemption, which is rare, maturity will happen accordingly. There are certain zero coupon bonds – there isn’t any regular coupon pay-out for such instruments; the difference between the issue price and maturity price is the equivalent of interest.

Factors associated with bond purchase

There is a credit rating, which gives you a perspective on the credit quality or the default risk of the bond. Usually, bonds have credit ratings across the range – AAA and below. Investment grade is defined as BBB. Other features may include put and/or call option(s). A call option is a choice that an issuer has of calling back the bond; i.e., redeeming it before maturity, on a pre-defined date. A put option allows an investor to put or redeem the bond with the issuer, prior to maturity, on a pre-defined date. In a way, put and/or call option(s) effectively reduce the maturity of the bond, against the stated maturity date.

The price of a bond in the secondary market would vary depending on demand-supply, interest rate movement in the economy, credit rating/credit perception of the bond, etc. The coupon rate is always payable on the face value of the bond. When the interest rate in the economy moves up, bonds of the same issuer/similar quality bonds are available at a higher interest rate.

To adjust to this, the market price of the bond – for trades in the secondary market – will adjust lower, so that the buyer gets an equivalent return. Similarly, when interest rates are moving down, the holder of the bond will command a price premium, i.e., a price higher than the face value, and the buyer gets a return commensurate with the prevailing rates. In other words, the buyer of the bonds pays a price higher or lower than the face value, to buy the defined coupon, according to prevailing market rates.

Categories you can consider

Apart from conventional bonds, there are certain other types of bonds you can invest in. The basic features remain same as discussed above; some features are different to make it a different category. One such category is tax-free bonds; the unique feature here is, the coupons are free of tax. In conventional bonds, the coupons are taxable at your marginal slab rate. In a tax-free bond, you save as much as 30 per cent (or more if you pay higher surcharge and cess) of the coupon payment and your effective return is that much higher. The issuers of tax-free bonds are certain defined PSUs, and these bonds are rated AAA. Hence, this category offers a combination of good credit quality (i.e., AAA rated PSUs) and tax efficiency.

Then there are certain perpetual bonds. Usually, bonds have a defined maturity date, as discussed earlier. There are certain bonds that don’t have an ‘expiry date,’ so to say. Theoretically, as long as the company issuing the bond remains in existence, the investor will get the coupon, and may be used for passing a legacy to next generation. However, the way the bond market looks at perpetual bonds is that, in most cases, there is a call option, and it is expected that the issuer would call back the bond on that date, though it is not a legal obligation.

Within the broad class of perpetual bonds, there is one category called Bank Additional Tier I (AT1) Perpetual bonds. As per capital requirement norms, a certain part of the capital of banks has to be raised through issuance of AT1 Perpetual bonds. The current norms, under the Basel III framework, stipulate a five-year call option in these bonds, i.e., five years from the date of issuance. The bond market assumes that these will be called back on the call date, and are traded in the secondary market on that basis.

There may be certain other minor variants such as bonds guaranteed by a State Government, and Infrastructure Debt Fund bonds. So, how do you compare various bonds on offer? Look at the credit rating, goodwill of the business group issuing the instrument, post-tax returns and compare accordingly. There are several maturities available. Hence, you can buy many bonds and spread out the maturities as per your requirements.

Happy Investing

Source: Wiseinvestor.in