9 things to consider before investing in bonds in high interest rate scenario

To tackle inflation the central banks world over increase interest rates to control money supply in the economy. The US 10-year Treasury yield hit 4.80% which is the highest in 16 years. In fact, our Indian 10-year G-sec bond yield hit 7.2%.

The Nifty 50, which serves as the benchmark for the Indian stock market, has delivered a 14% return in the past year, indicating that investing in stocks for the long term can be a wise choice. Nevertheless, it’s also prudent to allocate a portion of your capital to bonds or other fixed-income securities for a balanced investment approach especially when interest rates are high.

However it’s essential to start with thorough research and understanding of the bond market.

So, what exactly are bonds? They are basically financial instruments which represent a form of debt or fixed-income security. It means when you as an investor are buying or investing in fixed income securities you are actually lending money to the government or corporates and in return you are receiving a fixed interest rate at regular intervals. Therefore, bonds are considered a relatively conservative investment compared to investing in stocks.

So, when in a high interest rates scenario, investing in fixed income securities seems lucrative for many investors, but one should understand the risk and reward before making investment decisions. You also need to understand that bond prices and interest rates move in opposite directions. So when interest rates went up, the bond prices went down. Now in future when you are expecting interest rates to go down, bond prices should move up again.

Understanding your risk tolerance is a crucial aspect of investing in bonds as they come with varying levels of risk. As discussed earlier, these fixed income securities can be issued by both government and corporate for several reasons. Government bonds, commonly known as G-secs, are generally considered among the lowest-risk investments because they are backed by the country’s sovereign. The risk of default is extremely low for government bonds. However, corporate bonds can vary significantly in terms of risk, depending on the creditworthiness. For example, high-rated corporate bonds (e.g., AAA, AA) are less risky, while low-rated ones (e.g., BB, B) carry higher default risk. So choose ones that align with your financial goals and risk appetite.

Check Credit Ratings: Look for bonds or any other fixed income securities with high credit ratings (AAA, AA, or A) from rating agencies like CRISIL, ICRA, or CARE. Higher ratings indicate lower default risk.

Assess the Issuer’s Financial Health: It is essential to analyse the financial health of the company issuing the bond before investing in corporate bonds. Think a company with good financial health is like a friend who has a good job, doesn’t owe too much money, and always has money coming in. This makes it less likely that they’ll have trouble paying back the money they borrowed from you, right? So, when investing in corporate bonds it’s a good idea to check how well the company is doing financially to reduce the default risk. Look at its profitability, debt levels, and ability to generate cash flow. A strong financial position reduces default risk.

Evaluate Yield vs. Risk: Don’t chase yield blindly. Bond yield represents the return an investor can expect to earn from a bond. The simple formula to calculate yield:

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Now, when investing in bonds, it’s essential to balance yield and risk. Higher-yield bonds often come from riskier issuers and might carry a higher chance of default. Investors need to assess if the extra yield compensates for the additional risk. Lower-risk bonds, like government bonds, offer lower yields but provide more security. As a bond investor you must strike a balance based on their risk tolerance and financial goals.

Diversify Your Portfolio: Warren Buffett rightly pointed out, “Don’t put all your eggs in one basket”, meaning diversify your portfolio of stocks to lower your risk. The same concept applies to bonds as well. You must spread your investment across different bonds issued by various companies or sectors (like technology, healthcare, or finance) as well as government bonds. This way, if one bond or sector doesn’t do well, it won’t hurt your entire investment.

Understanding the tenure of a bond is essential before investing: Every bond or any fixed income securities comes with a maturity which is commonly known as tenure of a bond. A shorter tenure bond offers more liquidity but may have lower yields, while longer tenures may provide higher yields but tie up your money for a more extended period. Long-term bonds are most sensitive to interest rate changes.

Liquidity matters for any investment: It ensures how quickly you can convert your investment into cash. Similar to buying and selling stocks from the exchanges, there is also a secondary market for the bonds. Many bonds are listed on exchanges which can be traded through your broker. It’s crucial to have an option to sell if the need arises. Click here for a list of listed bonds on NSE.

Tax Implications: Be aware of the tax implications of your investment. The interest income from bonds may be taxable, so factor this into your decision-making.

Consult a Financial Advisor: If you’re not sure about your choices, seek advice from a financial advisor. They can help you navigate the complex world of investing in bonds.

Monitor Your Investment: Your job doesn’t end after investing. Keep an eye on your bond’s performance and the issuer’s financial health. Be ready to adjust your portfolio if needed.

Remember, investing in corporate bonds or fixed income securities can be a valuable addition to your portfolio during high-interest rates, but it requires careful consideration and due diligence. Make informed choices to secure your financial future.

Vineet Patawari is Co-founder and CEO at StockEdge

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Updated: 14 Oct 2023, 11:55 AM IST