Before investing in bonds, you need to understand their characteristics, pros and cons, risks, and their ability to deliver the returns you expect as an investor.
Let’s learn the essential features to consider when considering a bond investment.
Here are 7 things to consider before investing in bonds:
1. With guarantee/without guarantee
Bonds fall into two main categories: secured/unsecured. A covered bond promises bondholders particular assets owned by the issuer to secure the loans raised.
This asset is also known as collateral for the loan obtained. Assets are transferred to investors in the event that the issuer of the bond defaults or is unable to pay the obligation.
Unsecured bonds do not commit an asset. The principal together with the coupon (interest) is promised solely by the issuer and is not backed by any collateral. These bonds are riskier compared to covered bonds.
It is the date on which the issuer of the bond is obligated to repay the bondholders the principal or face value of the bond. It should be considered based on your different financial goals. The maturity can be short-term (from 1 to 5 years), medium-term (from 5 to 12 years) and long-term (more than 12 years).
3. Liquidity Preference
A company in default pays its investors in a predefined order. After the company sells its assets, investors are paid based on liquidation preference. Bondholders have priority over shareholders and are paid outstanding money first.
4. Coupon rate
The coupon rate here refers to the fixed interest paid at a predetermined interval (usually annually or semi-annually). The coupon rate, although it varies, should be taken into account as it works as a secondary income for many investors.
Bonds are known to offer annual interest in the range of 8-12% (if held to maturity) which can be comparatively higher than time deposits.
5. Tax factor
Bond income is generally taxable. However, there are some bonds that are known to provide the benefit of tax exemption. For example, green bonds, income and capital gains on some government bonds and municipal bonds are exempt from tax. Bonds with tax-exempt features offer relatively lower interest. You can compare the yields of tax-exempt bonds with those of taxable bonds.
Some bonds come with callable features under which an issuer can pay off the bonds before maturity. Interest Rates If you allow an issuer to borrow at a better rate you can choose to call your bonds. Bonds with callable features attract investors as they offer relatively better coupon rates.
7. Creditworthiness and exit options
Bond issuers defaulting is a significant risk associated with investing in bonds. You can assess the chances of an issuer defaulting by considering the ratings assigned by different credit rating agencies to the issuer. Consider investing in higher rated bonds, preferably Triple-A (AAA) rated bonds.
Also, consider your liquidity requirements and match your investment horizon to the maturity of the bonds. You may have to experience interest rate volatility in the event of premature bond sales.
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