Balance yield with rating when choosing a bond, be aware of liquidity risk

Invest in individual bonds only if you can analyse and monitor the credit profile of companies

With debt mutual funds (MFs) losing the indexation benefit, investors in the higher tax brackets are looking for alternatives. Many are considering investing directly in bonds.

Control over security selection

Investing directly gives you control over what you buy. “You can decide the quality of the company whose bonds you will invest in and exit those you don’t wish to hold any longer,” says Ankit Gupta, co-founder, BondsIndia.com. In a debt MF, the fund manager decides the portfolio composition.

According to Vishal Goenka, co-founder, IndiaBonds, “Bonds can offer higher returns as there is no expense ratio cost, as is there in a debt MF.” He adds that they also generally offer higher interest rates than fixed

deposits.

People who want regular payouts can get them from bonds. Debt MFs can’t offer regular payouts in an assured manner.

Investors can choose from a variety of bonds. “They can invest in government securities (G-Secs) and corporate bonds, and in bonds with varied credit profiles, returns, and tenures,” says Arnav Pandya, founder, Moneyeduschool.

Gupta adds that investors can today earn yields ranging between 7.5 and 13.5 per cent.

“Investors can also enjoy mark-to-market (MTM) gains from bonds if interest rates decline, as is expected over the next 18-24 months,” says Munish Randev, founder and chief executive officer (CEO), Cervin Family Office and Advisors.

Beware credit, liquidity risk  

The key risk bonds carry is credit risk — the risk that the borrower may not pay the interest or repay the principal. “Retail investors may find it difficult to track a bond’s credit quality since they don’t have access to company-related information and data to the extent fund managers have,” says Randev.

Remember that credit ratings only indicate a company’s quality in the past, not what could happen in the future.

Investors should be cognizant of liquidity risk. “Higher-rated bonds are generally more liquid and hence easier to sell. The opposite is true of lower-rated papers,” says Gupta. An investor who wants to exit during a bond’s tenure may find it hard to find a buyer for an illiquid bond, and could be forced to sell at a discount.

Bonds also carry interest-rate risk (more pronounced in longer-duration bonds). “In a rising interest rate scenario, investors could suffer mark-to-market (MTM) losses,” says Gupta. With interest rates at or near the peak, this risk is less pronounced currently.

Investors also expose themselves to concentration risk if they hold only a few bonds and are overexposed to one sector. A deterioration in the fundamentals of that sector could spell disaster for their portfolio.

Match risk profile with rating

First, consider your own risk profile and select bonds having an appropriate rating. A conservative investor, for instance, should invest only in AAA- or AA-plus rated bonds.

“Examine the creditworthiness of the issuer by analysing its financial statements and credit rating,” says Goenka.

Besides the current rating, check the trend. “If the rating has been on a downward trajectory, be careful,” says Randev.

Second, do a governance check at the group level. The group the company belongs to shouldn’t be involved in negative developments. “If the bonds you plan to invest in are AAA-rated, but other companies within the group are in trouble or have defaulted in the past, be cautious,” says Randev.

Three, you will be adequately rewarded for buying a bond with a longer maturity only if the yield curve is slanting upwards. If it is flat, you won’t be compensated adequately, and will be better off with a bond having a lower tenure.

Consider your investment horizon. If you don’t need the money for, say, five or seven years and are getting a good rate over that tenure, lock into it. But if you could need money in the interim, then pay heed to the bond’s liquidity profile, so that you are able to exit when you need to.

Says Goenka: “Bear in mind that longer-term bonds offer higher yields but are also more sensitive to interest rate changes.”

Consider whether you would prefer to invest in a secured or an unsecured bond. “Secured bonds are generally backed by collateral, while unsecured ones are not. However, unsecured bonds provide a higher return on investment as compared to secured bonds,” says Goenka.

By investing in G-Secs, you can eliminate credit risk, and by matching your investment horizon with a bond’s maturity date, you can circumvent interest-rate and liquidity risk.

According to Pandya, “If you are a savvy investor who can analyse and monitor the credit profile of companies, and have a large portfolio, go for individual bonds. Novice investors with a small corpus should stick to debt MFs.”

Finally, do a few basic checks on the bond platform through which you invest. “Ensure that it is Sebi-registered and licensed. Check its payment and settlement process,” says Goenka.