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May 25, 2012, 10.30 AM IST | Source: Moneycontrol.com

Buying Bonds: Go through the checklist

Bonds are fixed income instruments in which payment is made by the issuer to the subscriber on a fixed schedule, even though the amount may vary.

By Vivek Sharma, Financial Planner and Trainer

Bonds are fixed income instruments in which payment is made by the issuer to the subscriber on a fixed schedule, even though the amount may vary. Depending on the terms of the bonds, the issuer pays a pre-defined amount after a specified period. In between the subscriber may also received periodic payments from the issuer which is called as,’ Coupon’. Bonds are issued by governments, financial institutions, banks etc. These institutions issue bonds because they need capital for certain reasons. Investors prefer to invest in bonds because these instruments generally offer secure and steady cash flows. 

How should an investor decide to invest in a bond? What are the parameters on which bond can be evaluated? Let us look at these parameters one by one:

1) Coupon: The first and the most important parameter to evaluate a bond is the rate of return being offered by the bond. The rate of interest offered by the issuer of the bond is called as,’Coupon’. An investor must first check the coupon being offered on a bond issued by a company. Higher the coupon higher is the return. However, there are some inherent risks in higher coupon bonds. A company offering higher coupon on bond may be credit hungry and hence the investor need to be careful with such bonds. It is pertinent to note that coupon and rate of interest are used as inter-changeable concepts in the financial market by investors.

2) Payment Frequency: Payment frequency shows how many times in a given year the coupon is being paid by the company. If a company pays Rs. 8 as coupon once a year and pays Rs. 4 as coupon semi-annually ,the second option becomes better for the investor as Rs. 4 received after six months can be reinvested and higher return can be generated on the same. If an investor receives Rs. 4 semi-annually, it becomes equivalent to Rs. 8.16 per annum which is higher than Rs. 8 received per annum. So higher the payment frequency for a given coupon better it is for the investor.

3) Credit Rating: Credit rating of a bond is a third party assessment of the quality of bond in terms of its credit performance. Some of the leading credit rating agencies in India are CRISIL, ICRA, and Fitch in India. Watch out for credit rating of bonds before you make investments. An investor who is risk averse should go for a high credit rated bonds. Risk savvy investors can select lower credit rating bonds. Generally bonds issued by government agencies command a higher credit rating because of low probability of default. Credit rating of bonds is also changed from time to time so the investor needs to be careful about it.

4) Tradability or Listing on stock exchange: A bond which is tradable on the stock exchange has higher liquidity and provides an exit route to investors. Any investor needing money can sell his investment on stock market and come out of his investment if the need arises. Other things remaining constant, an investor should go for a bond which is available for trading on stock exchange.

5) Bonds with call and put option: A call option in a bond gives the issuer right to recall bond before maturity, while put option gives an investor right to redeem bond before maturity. An investor should check if options are available with bonds or not. A high coupon bond having call option makes it easier for the issuer to call back bonds before maturity which may impact expected cash flow of the investor.

6) Tax Benefits: Some of the bonds offer tax benefit under certain sections of Income Tax act. Till last financial year, investment in infrastructure bonds upto Rs.20000 was eligible for tax benefit under section 80CCF. The tax benefit on bonds increases effective rate of return. Hence, an investors needs to check whether there are any tax benefits available for the bond selected by him.

7) Maturity: An investor needs to select a bond which matches his requirement of funds. So if an investor needs money after ten years, the investor can select bonds having maturity of ten years. The significance of maturity lies in the fact that investment in bonds must be aligned to the goals set by an investor in terms of time horizon.

Before buying any bond it is important to evaluate bonds on above mentioned parameters. The bonds cannot be bought only on the basis of return offered. Like other investment options, the bonds also must pass the test of return, risk, liquidity and tax benefits. Be a watchful investor and buy those bonds which pass the test of these parameters.

The author can be contacted at viveksharma95@rediffmail.com .

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