Things to know before investing directly in bonds

There are many categories of bonds that people can invest in. The first and safest of these is government bonds or securities (G-Secs). Corporate bonds include tax-free bonds issued by certain public sector units earlier, the usual plain vanilla bonds, perpetual bonds issued by banks called additional tier I (AT1) as well as non-bank plain vanilla perpetual bonds. Another variety—market-linked debentures (MLDs)—has become less popular now, post the tax changes in the Union budget.

When you purchase a bond, based on the coupon (interest) rate and purchase price, you can calculate the yield to maturity (YTM), which is the annualized effective return you will get, provided you hold the bond till maturity. The yield levels available currently are higher. Among bond categories, the yield level will be relatively lower in G-Secs as it is of the highest credit quality. In corporate bonds, it depends on the credit rating of the bond and othe factors. Higher rated bonds would usually have a lower yield. Sometimes lower rated bonds of well-known business houses change hands at yield levels lower than relatively-higher-rated bonds of business houses with tarnished names. Perpetual bonds have a higher yield than the usual ones, as you are taking a view on the issuer for that long a period. In bank AT1 perpetual bonds, there is a call option after five years from issuance, when the bank can call back the bond. These are traded in the market as five-year bonds, though technically these are perpetual bonds and the call option is only an option with the issuer.

The risks associated with bonds are of various types. In the context of credit or default risk, it is measured by the credit rating. AAA is the highest credit rating, followed by AA and so on. The credit rating of bank AT1 perpetual bonds are one or two notches lower than the usual bonds of the same bank. The compensation, in terms of yields, is commensurately higher. Volatility risk or interest rate risk is a function of the remaining maturity of the bond; higher the residual maturity, higher is the volatility. For investment purposes, you may go for AAA and AA rated bonds, or A only if you are sure of the credentials of the issuer. Volatility risk can be managed by matching your investment horizon with the residual maturity of the bond. When you are holding a bond till maturity, there will be volatility in the interim, but on maturity you get the initially contracted return.

The coupon (interest) is taxable at your marginal slab rate. If you sell the bond before maturity, and sell at a profit, then the capital gain is taxable at a relatively lower rate. For a listed bond, on a holding period of more than one year, the long-term capital gain is taxable at 10%, plus surcharge and cess as applicable. If the holding period is less than one year, the short-term capital gain is taxable at your marginal slab rate. If you are holding till maturity, then there is no capital gain, taxation is at your slab rate. In zero-coupon bonds, the differential between issue price and maturity price is taxable as interest.

For G-Secs, you have to open an account with retail direct of the Reserve Bank of India (rbiretaildirect.org.in). Through this, you can invest in G-Secs in retail lots. In corporate bonds, there are bonds listed on the exchanges (NSE/BSE). The face value, which is the minimum trading lot size, is retail in nature. However, the traded volumes are limited. When you want to buy, you may not get the bond of your choice and when you have to sell, you may not get liquidity. The secondary market is wholesale in nature, where the participants are the big boys of the market e.g. banks, insurance companies, mutual funds, etc. There are bond intermediaries and wealth management outfits who offer their services to their clients. You can purchase the bond of your choice from the inventory sheet. For highly rated bonds, you can get liquidity through the bond house i.e. sell at minimal impact cost.

Joydeep Sen is a corporate trainer and author