Prior to investing in bonds, it is necessary to understand its features, pros and cons, risks, and its ability to offer returns you expect as an investor.
Let us learn about the essential features to consider when considering an investment in bonds.
Here are 7 things to consider before investing in bonds:
Bonds are classified in two key categories – secured/unsecured. A secured bond promises bondholders particular assets owned by the issuer to secure the raised loans.
This asset is also known as a collateral on the raised loan. The assets are transferred to the investors in case the bond issuer defaults or is unable to repay the obligation.
Unsecured bonds do not pledge an asset. The principal along with the coupon (interest) is promised only by the issuer and is not backed by any collateral. These bonds are riskier in comparison to secured bonds.
It is the date on which the bond issuer is liable to pay back the bondholders the principal or par amount of the bond. It is to be considered based on your different financial goals. The maturity can be short-term (1 to 5 years), intermediate-term (5 to 12 years), and long-term (more than 12 years).
3. Liquidity Preference
A firm in the condition of default repays its investors in a predefined order. After the firm sells its assets, the investors are paid based on the liquidation preference. Bondholders get priority over stockholders and get paid the outstanding money first.
4. Coupon Rate
The coupon rate here refers to the fixed interest paid at a predetermined interval (generally annually or semi-annually). The coupon rate although varies, you need to consider as it works as a secondary income for many investors.
Bonds are known to offer an annual interest in the range of 8-12% (if held until maturity) which can be comparatively higher than fixed deposits.
5. Tax Factor
The income from bonds is generally taxable. However, there are a few bonds that are known to provide the benefit of tax exemption. For example, green bonds, income and capital gains in a few government bonds and municipal bonds are tax-exempt. The bonds with tax-exempt features relatively offer lower interest. You can compare tax-exempt bond returns with that of taxable bonds.
Some bonds come with callable features under which an issuer can pay off bonds before maturity. Interest rates if allowing an issuer to borrow at a better interest can choose to call its bonds. Bonds with callable features attract investors as it offers relatively better coupon rates.
7. Creditworthiness & exit options
Bond issuers declaring default is a major risk associated with the investment in bonds. You can assess the chances of an issuer declaring default by considering the ratings assigned by the different credit rating agencies to the issuer. Consider investing in bonds with higher ratings preferably bonds with Triple-A (AAA) rating.
Also, consider your liquidity requirements and match your investment horizon with the maturity of bonds. You may be required to experience volatility in the interest rate in case of premature selling of bonds.
(This is an educational series about Bonds, types of Bonds, benefits, and various other details will be covered in the upcoming articles) Track complete series here