What are bonds?
A bond is a debt security issued by a government, municipality, or corporation. It is essentially a loan that an investor makes to the issuer in exchange for periodic interest payments and the return of the bond's face value when it matures. When an investor buys a bond, they are lending money to the issuer in exchange for the promise of regular interest payments and the return of the bond's face value at maturity. The issuer of the bond uses the proceeds from the bond sale to finance its operations or capital projects. The bond's value can fluctuate based on interest rate changes and the creditworthiness of the issuer. When interest rates rise, the price of existing bonds fall, and when rates fall, the bond prices will increase.
Risk of Investing In bonds
The main risks of investing in bonds include
1. Interest Rate Risk
Interest rate risk is the potential for a bond's value to fall in the secondary market due to competition from newer bonds at more attractive rates. Interest rate risk is the potential for a bond’s value to fall in the secondary market due to competition from newer bonds at more attractive rates. Rising interest rates are a key risk for bond investors. Generally, rising interest rates will result in falling bond prices, reflecting the ability of investors to obtain an attractive rate of interest on their money elsewhere. Conversely, falling interest rates will result in rising bond prices, and falling yields.
2. Credit Risk
Credit Risk is the risk that the issuer will be unable or unwilling to make further income and/or principal payments. ILFS defaulting on its payment to issuer is an example of credit risk default.
3. Inflation Risk
Inflation Risk is the risk of the bond’s value being eroded by inflation if the interest payments are fixed. If you lock in for 5 year FD at 6% and if inflation is 7%, your value of money is being eroded.
4. Reinvestment Risk
Reinvestment Risk is the risk that investors may have to reinvest their coupon income and their principal at maturity at lower prevailing rates if interest rates are declining. Keeping your interest income idle at bank savings rate is an example of re-investment risk.
5. Liquidity Risk
Liquidity Risk is the risk that investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value.
6. Underlying Ratings
Underlying Ratings refer to the ratings assigned to issuers by rating agencies such as CRISIL, ICRA, which assess the credit worthiness of issuers and assign a credit rating based on their ability to repay its obligations. If the credit rating of an issuer is downgraded (from A to BBB), the price of the bond will fall accordingly.
Warren Buffet on investing in bonds
Warren Buffett is one of the most successful investors of all time, and he has a lot to say about investing in bonds. Buffett believes that bonds are an important part of a diversified portfolio, but he cautions against investing in them when interest rates are low. He notes that when interest rates are low, it is more difficult to find attractive returns on bonds, and suggests investing in stocks instead.
Buffett also recommends investing in bonds with shorter maturities, as they are less likely to be affected by interest rate changes. Additionally, Buffett believes that bonds should only make up a small portion of a portfolio, and suggests investing in stocks and other asset classes for greater returns.
Type of bonds instruments available to invest in India
Different types of bonds that you can invest in India include:
1. Capital Gains Bonds
2. Government Securities
3. Corporate Bonds
4. Inflation-Linked Bonds
5. Convertible Bonds
6. Fixed-Rate Bonds
7. Zero-Coupon Bonds
8. Floating Rate Savings Bond
9. Sovereign Gold Bond
10. Tax-Free Bonds.
Taxation on Bonds in India
In India, different bonds have distinct tax rules. Regular taxable bonds are taxed on capital gains and interest earned. Capital gains are profits earned by an investor at the time of maturity, while interest is added to the individual’s gross total income and taxed accordingly. Tax-free bonds are not taxed on the interest earned, but returns earned from such bonds upon maturity or sale may be categorized under long term capital gains or short term capital gains depending on the holding period. Tax-saving bonds help individuals save taxes by investing in these bonds, and zero coupon bonds are not taxed on interest, but capital gains may be taxed as per the applicable tax slab rate.
Who should invest in bonds?
Bonds are a good investment for those looking to generate a steady income stream, preserve capital, and diversify their portfolios. Investors who are nearing retirement, have short-term goals, or need a steady income may find bonds to be an attractive option. Additionally, investors who are wary of the stock market may also find bonds to be a good option as they tend to be less volatile than stocks.
That being said, it's always important to do your own research, and consult a financial advisor if you have any doubts. An investment that is suitable for one person might not be suitable for another, depending on the person's individual circumstances.
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