It is advisable to make bonds a part of your investment portfolio if you need a steady income stream. So lets understand what are bonds and how it can help to generate returns.
Bonds were almost a forgotten word in the last few years. The stock markets were exciting and were giving anywhere between 25 to 50 percent returns per annum. Stories of investors gaining great wealth in the stock market were dime a dozen. Generating returns on an equity portfolio seemed a cakewalk.
Bonds, on the other hand, did not have the same appeal. Bonds were boring during bull markets when they seemed to offer an insignificant return compared to stocks. However, with the crash in equity markets, investors saw their capital erode by almost 50-75 percent in less than six months. Scorched by the experience, investors are now looking at other options to park their surplus funds. All it took was a bear market phase to remind investors of the virtues of a bond's safety and stability.
What are bonds?
Bonds are just like IOUs. Buying a bond means you are lending out your money to companies or the government. Just like people, companies and governments need money for their activities. A company needs funds to produce more goods, while governments need money for everything from infrastructure to social programmes to subsidies. Hence, large organisations, apart from borrowing from banks, also raise money from the public through bonds. Thousands of investors lend a portion of the capital needed.
The organisation that sells a bond is known as the issuer. Most bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or annually too. The interest/coupon is expressed as a percentage of the face value of the bond. If a bond pays an interest of 10 percent and its face value is Rs 1,000, then it will pay Rs 100 of interest a year.
A rate that stays as a fixed percentage of the face value like this is a fixed rate bond. You can also have an adjustable interest payment, known as a floating rate bond. In this case the interest rate is tied to market rates through an index.
The maturity date is the date in the future on which the investor's principal will be repaid. Maturities can range to as long as 30 years. Bonds that mature in one year are much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, longer-term bonds have higher interest rates.
Bonds for safety
It's an investing saying that stocks return more than bonds. In the past, this has generally been true for the last five to seven years. Does this mean you shouldn't invest in bonds? The answer is no. Bonds are appropriate any time an investor cannot tolerate the short-term volatility of the stock market. The easiest example to think of is an individual living off a fixed income. A retired person simply cannot afford to lose his principal, as income from it is required to run the house.
On the other hand, if money is needed for a specific purpose in the near future, fixed income securities are likely to be the best investments. In fact, for many investors it makes sense to have at least part of their portfolio invested in bonds. Most personal financial advisors advise a diversified portfolio and changing the weightings of asset classes throughout the lifetime. For example, equities get higher allocation if you are in your 20s and 30s. In your 40s and 50s bonds start getting a higher allocation. In retirement, a majority of your investments would be in the form of fixed income instruments.
Therefore, making bonds a permanent part of your portfolio will ensure higher safety of your investment surplus.
