Last Updated on September 18, 2023 by BFSLTeam BFSLTeam
If you are a beginner to investments, you may be eager to invest in the stock market. You may even have done a lot of research on how to select stocks for your portfolio. However, it’s crucial to diversify your investments across different asset classes, including debt instruments. Bonds are among the most lucrative debt securities available in India.
As a new investor, you may not be aware of how to choose bonds that are suitable for your financial goals. Many beginners make the costly mistake of choosing the wrong bonds. This could result in a lot of time and resource wastage. To avoid this pitfall, you need to get better at the art of bond selection — and this article can help you with it.
5+ Tips to Help You Choose Suitable Bonds
When it comes to choosing bonds to invest in, you need to look into various aspects of these debt instruments. The factors to account for include the bond’s maturity date, coupon rate, issuing entity, nature of coupon payouts, credit rating and much more.
Let’s take a closer look at how to select bonds that can help you achieve your financial goals effectively.
- Look at the Bond’s Credit Rating
Government bonds are considered to be the safest bonds since they are backed by a sovereign guarantee. Corporate bonds, however, carry varying levels of risk. Bonds issued by fundamentally strong companies are safer investment options than those issued by weaker companies.
Credit rating agencies CRISIL and ICRA evaluate the risks associated with corporate bonds and assign different credit ratings to the securities. To identify which corporate bonds carry lower risks, you must look at the credit rating they carry. Bonds with lower credit ratings may offer higher coupon rates, but they may not be paid out if the company defaults.
- Consider its Coupon Rate
The coupon rate is another important factor to look into when you are choosing bonds to invest in. This is the rate at which interest payments are made by the issuer to the investor. The coupon payments are calculated on the face value of the bond. Depending on the type of coupon rates they carry, bonds can belong to any of the following categories:
- Fixed rate bonds, which carry a specific and fixed rate of interest
- Floating rate bonds, which carry a variable rate of interest linked to benchmarks like the repo rate
- Zero coupon bonds, which do not have any coupon rate because they offer no coupon payments
You need to proceed with your bond selection only after considering which type of coupon rate best suits your requirements. It is also important to compare bonds and choose the ones that offer the most competitive coupon rates.
Additional Read: Sovereign Gold Bond
- Check the Post-Tax Yield
Unless they are tax-free bonds, the financial payouts from bonds in India are taxable as per the Income Tax Act, 1961. The interest payouts, for instance, are taxed as per the income tax slab rate applicable to you. The capital gains from the sale of bonds are also taxable. To truly understand how profitable a bond is, you must consider its post-tax yield before deciding to buy it. This is because the gross returns from a bond may be high, but its post-tax yield could be much lower.
- Assess the Risk-Reward Ratio
An important part of learning how to choose bonds is to factor in the risk-reward ratio. Some types of bonds may carry higher risks, but they may be offset by higher returns. Others, like government bonds, may offer lower coupon rates but have negligible risk. The overall risk-reward ratio must be favourable, so you get the advantage of earning good returns without taking on disproportionate risks.
- Look Into the Maturity Period
The maturity period of a bond is the duration during which your capital will be locked in. You will continue to receive coupon payments during this tenure, but you will only receive the face value of the bond on the maturity date. So, when you are choosing bonds to invest in, you must ensure that you are comfortable with having your capital locked up over the maturity period.
- Factor in Your Investment Goals
This is perhaps the most important — and often most overlooked — aspect of the process of bond selection. Ultimately, the kind of bond you choose must align with your investment goals. For instance, if you want to protect your returns from inflation, you may find inflation-indexed bonds suitable. Similarly, if you want to earn stable income payouts without any risks, government bonds fit the bill nicely. And if you are looking for tax savings, you can consider investing in tax-saving government-approved bonds.
As your investment goals change, the type of bonds that you need to choose will also vary accordingly. For this reason, you must revisit your portfolio every year or so and ensure that the bonds therein are suitable for your overall financial requirements.
Also Read: The Different Types of Bonds
Conclusion
Bonds can be an invaluable part of your investment portfolio — irrespective of your risk profile. Unlike high-risk investments, which are best suited for aggressive investors, bonds are for everybody. The trick to making the most of these debt securities lies in choosing bonds that align with your financial goals and investment capacity.
Given the wide range of choices available, you need to keep the pointers outlined in this article and make a smart decision about how to choose bonds for your portfolio. If you are having trouble with bond selection, you can always approach a financial planner for expert guidance on this subject.
