Debt Market and Options
In a case where the investors are looking for safer options to invest, they might choose debt instruments. They are derivatives contracts that use bonds or other fixed income securities as their underlying asset. The class that believes in saving as well as the retirees are not very happy in the current scenario, where the repo rate is at 4 percent. The fixed deposit rates are hence low. At the same time inflation rate too is affecting the investing options.
The fixed deposit investors are opting for bonds in order to earn more interest than those offered by the banks.
Depending on the security and maturities there is an upwards trend of 25 to 45 basis after the budget 2021. Debt markets expect higher market borrowings by the government. Fixed deposits interest rate will not improve all of a sudden in the near future. Before choosing bonds as an option investors need to understand the risks that they are taking.
- Interest rate risk: when the interest rates go up prices of bonds come down. This also covers bank fixed deposits.
- Credit default risk: A defaulting company fails to meet its obligations and thereby bondholders are affected.
- Liquidity risk: When investors decide to sell the bonds before maturity, they might not find buyers or they end up getting lower price.
- Bonds/Debentures are issued by both the public and private sector units. These bonds could be either secured against the assets of the issuer or an additional security or they could be totally unsecured. Interest payment is monthly,quarterly,semi quarterly and annually which will be as per the terms of the instrument.
- Zero coupon bonds are issued at deep discount to the face value of the bonds. Investors get the face value at the end of maturity.
- Perpetual bonds have no maturity and they carry higher interest rates. Some of them carry a call option where the issuer can call back the bond from the investors. Some of them are treated as quasi equity.
- Tax free bonds are issued by Government owned entities. The interest derived therefrom are tax free in the hands of the investors.
- Pass through Certificates are different loan asset pools. Each pool gets rated and sold to investors.
Other pros and cons:
- Interest income on bonds is taxed at the marginal rate of tax applicable to the investor. When the interest is received on maturity along with the principal, it will be taxed as interest income and not as capital gains.
- Usually the coupon or interest rate is known at the time of purchase of a bond making it easier to choose.
- Any capital gain arising by way of selling the bonds in the stock markets is treated as long term capital gain when held for more than a year. Benefit of indexation can be sought in such cases.
- One can subscribe to bonds in the IPO as well as in the secondary markets.
- When a default arises in the case of secured bonds, it might take a long time in selling the assets.
- An investor needs to diversify the portfolio both in the primary and secondary markets. Also diversifying them into different sectors will lower the risk.
- The rating agencies evaluate the risk only when at the time of investing but they fail to find the inability on the part of the issuer to service debt.
- Bonds from banks and other public sector units can be combined as investments. While choosing from the private sector however the ones with the highest credit rating should be opted for.
- When goal oriented investment is made, say to meet any financial obligation after a certain time, make sure that the targeted amount is received from the issuer at the desired time.