Bonds offer income, but risks remain under the surface

Debt in personal finance is loan and is an instrument generating interest income. That’s why these are also called as fixed income instruments. The most common form of debt instrument is a bond. This is nothing but a promissory note that the borrower provides to the lender. The indentureof the bond consists of the terms and conditions of the loan i.e., the amount, the tenure, and the interest (coupon) rate.

These bonds are issued at their face value i.e., the amount on which the coupon is calculated. For instance, a Rs.100 bond with a coupon of 10% gives the buyer or the lender Rs. 10 (assuming an annual rate). However, when large corporations, institutions and even governments raise capital through debt, these instruments i.e., bonds are allowed to trade. This provides liquidity to the system, serves as collateral and risk mitigation to the buyers.

Trading of bonds allows to discover its price i.e., deviation from the face value – could be at a discount or a premium – depending on the macroeconomic situation and underlying factors that affect the issuer. And these bonds are rated by rating agencies based on their current financials, fundamentals and future estimation of these credentials. So, the rating is subject to the changes or reviews with AAA being the highest denoting stable while D as default or bankrupt. There’re numerous layers of stability in between with bonds with B and below are treated as high yield bonds.

As the name suggests the yield on these bonds are relatively higher than the traditional fixed income instruments. While the coupon is fixed, the yield varies on the bond price. This is the market price which could be different from their issue price. As the bonds are traded i.e., bought and sold the return on their purchase price is the yield of that bond. These bonds could be collateralized i.e., backed with some assets are called secured bonds.

Continuing the earlier instance, the bond pays Rs.10 as interest irrespective of the purchase or bond price. So, if the bond is trading at a premium to the face value, then the return or yield on the bond is less than 10% and if the bond price is lower than the face value then the yield for the investor is higher than 10%. The return generated on the bond price is the yield and it varies with the bond prices.

Now, let’s visit some economics 101. All prices are a product of demand and supply and so are the bond prices. While I mentioned about the utility earlier, the demand comes primarily from the yields these generate. But why would the prices of a ‘fixed income’ instrument fluctuate? This is where the underlying principles of bond ratings come to fore. The rating is done based on the risk associated with each of these instruments and investors willing to underwrite a risk would demand an equivalent return. So, higher the risk of the bond, the higher the return i.e. yield.

This could be perfectly aligned in a new bond issuance where the prevailing market conditions are built-in but for those already existing, this is reflected in the discounting of the bond price. If the risk-free interest rate (say bank deposits or govt bond) is hiked, the risk premium for the bonds should proportionately rise and so is adjusted in the bond prices. So, as the bond prices fall, the yield potential increases. Going with the earlier example, the Rs.10 coupon earned on the bond will generate a yield of over 11% if the bond price moves to 90. Usually when inflation edges up, interest rates are hiked which results in reduction of bond prices and vice versa.

I was surprised, recently when one of my clients, expressed that she wanted to invest in bonds to generate more returns. She sees that the returns on bonds are in double digits and so wanted to move part of the capital. The capital allocation calls should be taken not based on the return potential alone but importantly based on risk profile, timelines and goals. There’s a basic assumption amongst many investors is that a bond or a NCD (Non-Convertible Debenture) is safe or a secured bond is guaranteed.

While technically, a secured or a collateralized bond is better placed than the unsecured one, it all depends on the value of the collateral at the time of stress. Currently in the US, with the ongoing AI infrastructure built-up boom, the traditionally asset lite businesses of tech industry are increasingly funding newer capex beyond their cashflows. Earlier, these companies were funding any of their expansion from their own accruals or business cashflows.

Debt is being raised with higher rating and so at a relatively lower coupon as the current fundamentals of these companies are good but as the original capital is returned into a later date in future, we don’t know the prospects yet. That’s the risk and as the quantum of expenditure is steep and quick, market is increasingly questioning the risk premium attached to these instruments. With the overall interest rates going up, pushes the cost of capital further, probing the serviceability of this debt.

If the returns on the capex outlay pans out as envisaged, then the capital is returned safe but that will create a multi-fold profitability to these companies so if you have a high conviction in these companies, you would be better off being an equity holder than a debt holder. No, I’m not against debt investing but to equate all debt to behave consistent across the timelines is incorrect. During events of economic turmoil, even a real estate collateral attached to the bond sees value erosion, potentially increasing the risk of the bond.

Investors should acknowledge that there’s no free lunch in investing and everything is priced. So, investors exploring bonds or other debt instruments should make themselves aware of the risks associated with these instruments other than just looking at returns and treating them as safe. Also, it’s beneficial for the risk averse investors to explore the MF (mutual fund) route to gain exposure into these instruments. It’s not as if debt MF are foolproof, but the regulatory mechanism and other liquidity mandates provide decent cushion to the investors in times of stress.

(The author is a partner with “Wealocity Analytics”, a SEBI registered Research Analyst firm and could be reached at [email protected])

ABOUT THE AUTHOR

K Naresh Kumar

K Naresh Kumar[email protected]