Fixed deposit instruments have always been considered as safe haven assets i.e they have generally found a place in an investor's portfolio during unpredictable times. However, investors who give little weight to the benefits that bonds have to offer are undoubtedly missing out on a lot of opportunities.

While investments in general are made with the expectation of some kind of return, bonds tend to offer the most reliable return stream when compared to the other asset classes. A diversified bond portfolio has potential to provide fairly decent yields with a far lower level of volatility than equity markets and a far higher return than fixed deposits .Bonds are ideal for investors who look for competitive returns for a comparatively lesser degree of risk.

How Bonds Work?

Let's start with an example. Let's say your friend needs some financial help and he asks you for lending him Rs. 10 lacs for 5 years. He promises to return the money with 10% interest p.a., payable after 5 years, also called as the date of maturity. This is how bonds work. An investment in a bond is similar to lending money to the issuer. So, in bonds market parlance, your friend becomes the issuer, you become the investor/bondholder and 10% interest p.a. becomes the coupon rate.

Through bonds, issuers raise funds for their business operations. Issuers could be a corporate entity or the government. If the issuer is corporate, the bond is called a Corporate Bond.

Simply put, a bond is a loan given by the investor to the issuer. The company that issues the bond is known as the issuer and the investors who invest in the bond are known as the bondholders. Once the bondholder buys the issuer's bond, the issuer promises to pay the bondholder a coupon, which is the interest paid on the invested amount, expressed as a percentage on the bond's face value. The company pays the interest to the bondholders till the time of maturity of the bond, following which the entire principal is returned to the bond holder.

Types of Bond Payments and the risk associated

Now, let's go back to the above example, Your friend may agree to pay you the entire interest amount along with the principal directly on the date of maturity or pay the interest annually, semi-annually or quarterly. Similarly, the issuer of the bond may promise to pay the bondholder the entire interest and principal on the date of maturity of the bond. Such a bond is known as a Zero-coupon bond. Alternatively, the bondholder could opt for a regular coupon paying bond, with an option of coupon payments made annually, semi-annually or quarterly till the maturity of the bond.

The lesser the frequency of coupon payments, the higher is the risk to the bondholder since regular payments safeguard the bondholder's investment with every coupon payment. Therefore, for the same issuer offering the same duration of bonds, a zero-coupon bond will attract a higher yield than the annual coupon paying bond, which in turn will attract a higher yield than a semi-annually coupon paying bond and so on.

However, Zero Coupon bonds provide a higher rate of returns due to the higher risk associated with them. So an investor with a relatively higher risk tolerance could certainly opt for a Zero-Coupon bond.In annually, semi-annually and quarterly the risk tolerance considerably decreases in line with the number of coupon payments made till the maturity date.

How to analyse a Bond's Safety?

Let's return to our example. Imagine your friend works with the government. He has a highly stable job and a regular income. His chances of defaulting on the loan would be far less due to the security of a stable job, which means less risk for your investment.

However, if your friend works in a relatively new private firm, his job may not be as stable as in the previous case with perhaps irregular income streams depending on his company's performance. In this case, the ability of the issuer (your friend) to repay the loan gets affected due to the risk associated with the issuer.

Likewise, companies are judged on their ability to repay back their loans. This evaluation is done by the Credit Rating agencies, whose job is to assess an entity's financial health. Based on their financial health, the issuer could be categorised in different buckets (AAA rated, AA rated, and so on) by the credit rating agencies. In Bondskart, we only allow A to AAA rated bonds for purchase, as this reduces the risk of our clients by a certain degree. Naturally, the issuer with the highest rating will be able to attract investment with a lower yield. A relatively low rated company will have to offer high yields to attract the investors.

PSU and other Government bonds have nearly zero risk of default and are hence are rated very high, in general. They therefore have very low yields associated with them.

Example:

Issuer: South Indian Bank Ltd.

Face Value: Rs. 1 lac

Coupon: 13.75% p.a.

Payment Term: Yearly

Date of issue: 24 Jan 2020

Date of maturity: 24 Jan 2025

Minimum investment: Rs. 2 lacs

ISIN: INE683A08051

This is an annual coupon paying bond. If you want to invest in this bond on 24 Jan 2020, you will have to invest a minimum of Rs. 2 lacs. In return, you will get Rs. 27,500 at the end of every year for 5 years. On 24 Jan 2025, you will get Rs. 27,500 along with your original investment of Rs. 2 lacs