Things to know before investing directly in bonds

When you buy a bond based on the coupon (interest) rate and the purchase price, you can calculate the yield to maturity (YTM), which is the annual effective return you would get provided you hold the bond to maturity . The yield levels currently available are high. Among bond categories, G-Sec will have relatively lower yield levels as it is of the highest credit quality. In corporate bonds, it depends on the credit rating of the bond and other factors. Higher rated bonds typically have lower yields. Sometimes lower-rated bonds from well-known business houses change hands at lower yield levels than relatively higher-rated bonds from business houses with tarnished names. Perpetual bonds tend to have higher yields than regular bonds because you’re looking at the issuer for that long. Bank AT1 Perpetual Bonds have a call option after five years of issue when the bank can call back the bonds. These are traded in the market as five-year bonds, although technically they are perpetual bonds and the call option is only an option with the issuer.

There are different types of risk associated with bonds. In terms of credit or default risk, it is measured by credit rating. AAA is the highest credit rating, followed by AA and so on. Bank AT1 Perpetual Bonds have a credit rating of one or two notches lower than normal bonds of the same bank. The compensation, in terms of yields, is proportionately higher. Volatility risk or interest rate risk is a function of the remaining maturity of the bond; The higher the residual maturity, the higher the volatility. For investment purposes, you can go for AAA and AA rated bonds or A only when you are sure of the creditworthiness of the issuer. Volatility risk can be managed by matching your investment horizon with the residual maturity of the bond. When you hold a bond till maturity, there is volatility in the interim, but at maturity you get the initial contracted return.

Coupon (interest) is taxable at your marginal slab rate. If you sell the bonds before maturity, and sell at a profit, the capital gains are taxable at a relatively low rate. For a listed bond, on a holding period of more than one year, long-term capital gain is applicable at 10%, plus surcharge and cess. If the holding period is less than one year, then the short term capital gain is taxable at your marginal slab rate. If you hold till maturity, there is no capital gain, taxation is at your slab rate. In zero-coupon bonds, the difference between the issue price and the maturity price is taxable as interest.

For G-Sec, you need to open an account with Retail Direct of Reserve Bank of India (rbiretaildirect.org.in). Through this you can invest in G-Sec in retail lot. In corporate bonds, there are bonds listed on the exchanges (NSE/BSE). The face value, which is the minimum trading lot size, is retail in nature. However, the trading volume is limited. You may not get the bond of your choice when you want to buy and you may not get liquidity when you want to sell. The secondary market is wholesale in nature, where the participants are the big boys of the market such as banks, insurance companies, mutual funds, etc. There are bond intermediaries and wealth management organizations that provide their services to their clients. You can buy a bond of your choice from the inventory sheet. For bonds with higher ratings, you can get liquidity through bond houses i.e. sell at minimum impact cost.

Joydeep Sen is a Corporate Trainer and Author