In his famous book 'The Ascent of Money,' Niall Ferguson states that the birth of the bonds market is the second greatest revolution in the ascent of money after the creation of credit by banks.
The bonds market is the largest securities market globally, providing investors with virtually limitless investment options. Bonds were once viewed as means of earning interest while preserving capital but have evolved into a USD 100 trillion global marketplaces that offer many potential benefits to investment portfolios, including attractive returns.
So let us look into what bonds are and why they are a vital component of a well-balanced portfolio.
Let's get started.
What are bonds?
A bond is essentially a loan that the bond-purchaser/bond-holder makes to the bond-issuer. Every business entity (governments, municipalities, and companies) needs capital to run their businesses. One of the means of raising money is through the issue of bonds.
A person buying government bonds is lending the government money. Similarly, a person purchasing a corporate bond is lending that corporation money. As it happens in any loan, bonds pay periodic interest and repay the principal amount on maturity.
So, what sets bonds aside?
Bonds are called fixed-income securities because they generate cash flows at a fixed rate. In an individual investor's portfolio, bonds have two main functions:
- Generating a steady stream of income.
- Since the principal amount of the bonds is returned at maturity, bonds often become capital preservation tools for the risk-averse investors.
- Hedging against economic slowdown - economic slowdown slows the growth, which brings down the inflation making bond income more attractive to investors.
For a detailed discussion on the bonds, their features, the benefits they provide, and the risks associated with bonds, head over to our previous article (Everything about bonds) on the same.
So, let's analyze why having bonds as a part of the investment portfolio is essential.
Types of bonds to consider as an investment option
Investors these days have the option to invest in several types of bonds. They also have different ways of holding these bonds. Different types of bonds serve different investment needs, and investors can choose a combination of different kinds of bonds to diversify their portfolios.
- Government/Sovereign Bonds, Municipal Bonds and Agency Bonds: Government bonds are the debt instruments issued by India's central and state governments to fund their infrastructure development activities or quench a liquidity crisis. Municipal bonds are issued by municipalities and government-affiliated entities like the PSUs issue agency bonds. Investment in these bonds is considered to be the safest because the governments being the bond-issuers rarely default on their obligations.
- Corporate Bonds: Companies issue corporate bonds as debt financing from investors rather than from the banks. By lending money to companies, investors also enjoy higher yields compared to other bond types.
Bonds – A perfect defence against volatility
They say, if you plan to invest, you have to plan for risk as well. Market volatility is exciting for some investors, but for most, it is a cause for anxiety. So how do you battle volatility?
Well, by finding a balance between stocks (equity) and bonds (debts) in your investment portfolio. Investing in bonds (debts) is safer than stocks (equity) because the debtholders have a priority over the shareholders in the company's payment run. Bonds, therefore, become a safe haven for investors to invest their money.
Stocks provide opportunities to earn higher returns but also come with inherent risks associated with them. On the other hand, bonds offer a reasonably reliable and steady income stream and are therefore more suitable for risk-averse investors. Investors can achieve risk-mitigated returns from their investment portfolios through a combination of bonds and stocks.
Next big question – How much to invest in bonds?
There are no rules set in stone on how much an investor should invest in bonds. However, you'll often come across an old axiom that requires an investor to subtract his/her age from 100 to formulate the allocation of the available funds between stocks, bonds, and cash. The resulting figure from the subtraction represents the amount to be invested in the stocks, and the balance spread between bonds and cash. So, an investor of 25 years of age will invest 75% in stocks and 25% bonds, while an investor of 75 years of age will invest 25% in stocks and 75% in bonds.
*Please note that this is just a guideline.*
Choosing an optimum allocation of funds between stocks and bonds involves considering several factors like the timeline of investment, risk-appetite and risk-tolerance, investment goals, market perception, and the investor's level of income and expenditure.
Why are bonds so attractive? – You get a targeted amount at maturity
Stocks are subject to market risks and price fluctuations. Mutual funds also come with the disclaimer – mutual fund investments are subject to market risk. Investors don't know how much gains they're going to reap when they square off their investments in stocks and mutual funds because the risk and market forces are in the play and affect every transaction.
Bonds are subject to market risk, as well.
As discussed earlier, bonds are debt instruments. Bond-holders are lending their money to bond-issuers in lieu of periodic interest payments. As it happens in every loan settlement, the borrower returns the principal amount to the lender after a fixed period. The bond-issuers also payback the principal amount borrowed through bonds on maturity.
Bonds are fixed-income securities because of the following two characteristics:
- Periodic interest payments (coupon payments on fixed rates known as the coupon rates)
- Payback of the principal amount on the maturity
Therefore, as it happens to other asset classes where the prices may rise or drop when they're sold, it does not apply to the maturity proceeds of bonds (well, unless the bond-issuer defaults).
Tempted to invest in bonds but don't know how to?
So, are you tempted to invest in bonds after our discussion above? But you don't know where to begin? Let us introduce you to THE FIXED INCOME - Click here to know more.
THE FIXED INCOME is an online platform for investing in bonds and fixed income securities. It is backed by the SEBI registered Tipsons group.
THE FIXED INCOME website offers various categories of bonds like high return bonds (higher investment grade), sovereign bonds (risk-free), tax-free bonds (issued by PSUs), and other multi-asset portfolio products like FDs, and zero-coupon bonds (ZCB).
The website has been so beautifully designed that any novice investor will find his/her way around it. The products are well categorized. There are impeccably written FAQs for help. The site hosts excellent educational material. It is like shopping on Amazon! You like a product (bond), you add it to the cart and purchase it. It's that easy.
So, if you're planning to create a well-balanced portfolio and looking to invest in bonds, do head over to THE FIXED INCOME.
They say that the difference between men and investment bonds is that bonds mature. So, what are you waiting for? Invest in bonds – mitigate your risks and create a diversified and a well-balanced portfolio.
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