Let us talk about some conservative money instruments. Debt needs to form one pie of the overall diversified portfolio. The exact pie of equity versus debt would vary depending on your risk appetite and time-based financial goals. So there is no magic number that I follow or recommend. With the ever-changing taxation, and most recent (year 2023) rule changes, they are getting less and less lucrative. However, these instruments are not meant to give you substantial capital appreciation. Instead, they should serve more as a means to keep pace with the inflation, while keeping your capital intact. This post covers two such investment avenues, Bonds and Debt Mutual Funds.
Bonds
Bonds are debt securities issued by borrowers. In simplified terms, when you buy a bond, you are lending money to the issuer who promises to return the capital at the time of maturity (i.e. a period for which you are lending) and an additional interest (else why else you would lend!). The interest can be repaid at regular intervals or at the time of maturity. The issuers can be private organizations or the government (both central and state). The borrower raises the money for some specific purpose. For example, a private organization would raise money for capital expansion, or the government would need money for infrastructure development.
In recent years Bond purchase has become easy. One of the platforms I would recommend is goldenpi.com where you can purchase various types of bonds (Government Securities, Corporate Bonds, etc.). It is a Zerodha-backed platform, hence credible. You can browse all information about the maturity timeframe and the lending rates.
The most important information you should consider is the Credit Rating. In the current financial world order, anything below AA is best avoided. Of course lower the rating, the higher will be the returns, a classic case of high-risk high reward. But unlike stocks, you need to be even more careful about the risk-reward dynamics here. A low-rated bond is much more prone to default (which is popularly known as Credit Risk) if the market conditions deteriorate. My general thumb rule is, do not see bonds as high capital appreciation instruments, and therefore go with highly secure bonds with AAA ratings.
You can also check out the cash flow on your investment. It will show up something like this:
Investing is straightforward. One just needs to complete a KYC and make a payment through standard modes such as RTGS to a specified account. If you have a Demat account (such as Zerodha), this bond purchase will be linked to that account. This essentially means the bond in the dematerialized form can be traded in the secondary market just like any other demat instrument. As per documentation, what you also receive is an authorized Deal Sheet that proves your ownership.
So what are the Pros and Cons of bonds?
Pros
- Less volatile and lesser risky compared to equities (as long as you are going with high-rated bonds)
- Bonds fall under the fixed-income asset class and provide a regular income channel.
Cons
- The minimum investment chunk is high. Unlike equities (such as Mutual funds where you can start investing with as low as INR 500), bonds have a high entry barrier to the principal investment, and they are traded in lots.
- They are less risky but are tied to economic conditions (Interest Rate Risk) and borrower Default Risk.
- Gains are taxed at your income tax slab (unlike equities where you have relatively lesser tax implication for Long Term Capital Gains)
- They are some liquidity risks associated here. You may not always get an immediate buyer if trying to do a distressed sale.
Debt Mutual Funds
So now that you have some idea about bonds, let us talk about Debt Mutual Funds. Similar to bonds, Debt Mutual Funds are conservative money instruments that are managed by Mutual Fund AMCs. These mutual funds invest in underlying debt securities. If you are already investing in mutual funds, this is no different. They are highly liquid (provided you are investing in Open-ended funds) and you can start off investing with a very small amount. There are various types of debt mutual funds to invest in, each depending on the underlying security, duration of maturity, etc.
The returns on Debt mutual funds would vary around the same mark as bonds, but it also depends on the market conditions around how the global interest rates are moving. In a very simplified sense, if the underlying securities you are owning from the past are bought at interest rate X. And due to changing economic conditions, the interest rate of similar new securities dips. So what you are holding is essentially of a higher value that can be traded. And the vice-versa, i.e. with rising interest rates, your existing underlying instruments would lose value. A detailed explanation would be a lot more complicated than this of course, but the point to note is, there is an aspect of timing here on when is a more suitable time for investment in debt, which is based on current and trending interest rates.
Pros
- One can start investing with a very small amount.
- You can trade easily just like any other mutual fund (either from AMC directly, or through a distributor).
- Less volatile compared to equities.
Cons
- The capital gains are subject to high taxation. With the recent changes in the budget, they no longer hold indexation and capital gain benefits and are taxed at your income slab. Hence, in the current state of interest rates, they have become lesser lucrative compared to other fixed instruments such as Fixed Deposits.
- Unlike direct investments in bonds where you self-manage everything, the AMC charges a fee for managing your fund.
- They too hold the same risk as the underlying debt securities in terms of Credit Risk. Investors would get lured on low rated funds (which promise higher returns but have risky underlying debts).
Evaluating all the pluses and minuses would lead you to make your judgment. If you believe in diversification and preserving capital with constant returns, these instruments would be something to consider in your financial portfolio.
