| Bond Investing : Myth versus Reality |
In the world of financial geniuses there is absolutely no dearth of advise coming on equities and mutual funds. Any financial website or investment consultant worth his/her salt will provide you a long list of investment tips and checklist for buying stocks and mutual funds. But probe a bit further about bonds and you are up against a wall. So what exactly are bonds and debt instruments.
Ever borrowed money from someone? Sure you have. It happens all the time. Forget your lunch money? Wanna buy a soda? Need cab fare? People borrow money every day for all kinds of reasons.
Much like people, large organizations such as companies, the central government, and state and local bodies all need to borrow money occasionally. A bond therefore, is nothing but a fixed income security which will provide a stable return over a fixed period of time but not the fabulous returns that equities or promise.
Due to a lack of clarity on bonds there are a variety of myths floating around pertaining to bonds. A myth versus reality checklist for bond investors
Some popular myths about bonds :
1. Bonds are safe since the returns are assured : Forget it. This statement needs to be qualified. Bonds in the market range from gilt bonds issued by governments to Junk Bonds, which are high return / High risk bonds. Unrated bonds can be as risky as equities if not more.
2. Government bonds are entirely risk free : Another popular myth. While it is true that bonds issued by the Central government are free from default risk, they are definitely prone to inflation risk and the reinvestment risk. Inflation risk means that falling purchasing power will reduce the real returns on a bond. Reinvestment risk means that if market interest rates change then intermediate cash flows get reinvested at lower rates of interest
3. By investing in a Deep Discount Bond I am immune to interest rate changes : Yeah theoretically right but practically never so. Most companies are very smart to include a call option in any long term deep discount bond so that when interest rates actually fall, they will call back the bonds and raise fresh funds at lower rates. That is exactly what IDBI did with its 25 year bonds and investors were left in the lurch.
4. You can protect yourself from inflation changes by buying inflation indexed bonds : Most investors forget that inflation indexed bonds are based on the benchmark WPI whereas what actually affects consumers in India is the Consumer Price Index (CPI).
5. A good credit rating is assurance of the health of the bond issuer : Classic myth. A credit rating rates instruments and not the company per se. Also upgrades and downgrades are more therapeutic rather than prophylactic in nature. Most ratings fail to capture the dynamics in the financial environment.
T S Harihar
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