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Highlights
- Bonds are fixed-income financial instruments in which investors lend money to governments or companies for a given period of time in lieu of interest payments at periodic intervals. Once the bonds mature, the money is returned to investors.
- Bonds are issued by either the government or private entities to raise funds for business purposes.
- While the bonds backed by the government are free of default risk, corporate bonds might carry default risk.
Bonds are debt market financial instruments which offer fixed interest rate at periodic intervals and are redeemable at a specific time-period. These are issued by either the government or some private entity to raise funds for business purposes.
While the bonds backed by the government are free of default risk, corporate bonds might carry default risk. Thus, investors should be aware about all kinds of risks before investing in private sector bonds.
Here are a few factors to consider before buying private sector bonds:
Who is backing the debt?
It is most important to find out if the debt is backed by a reputed and a fundamentally strong business group or not. As already discussed, private sector bonds are subject to default risk compared to government-backed bonds. Investors are generally impacted in two ways:
- A company with weak financials may default on its interest payments and principal repayment.
- A downgrade by credit rating agencies may result in fall of bond prices, negatively impacting investors.
Thus, investors should always conduct an in-depth study about the financial wellbeing of the bond issuer.
Source: © Kiosea39 | Megapixl.com
Don’t run after high returns blindly
With higher risk comes higher returns. It is common to see investors and fund managers running after a bond by going down the rating curve. However, it is not advised to do so. For instance, an AAA rated corporate bond will pay the lowest interest rate compared to AA or A rated bonds whose yield will be higher. Even though not all firms with AA rating and A rating are prone to default, it is a risk that investors need to be careful of.
Debt funds can be good options
In case you are not comfortable investing in individual bonds, debt funds may be a better option for you. They may offer you the much-needed stability. These funds may give you the advantage of interest earned on the bond, along with the capital appreciation when rates fall.
Debt funds create a diversified portfolio of debt instruments and bring down the overall risk. Since these funds are liquid, they can be redeemed at a short notice.
Source: © Littlemacproductions | Megapixl.com
Bottom Line
Even corporate bonds offer higher returns compared to most other financial instruments, risks are also relatively higher. Thus, it is important for investors to carefully consider all pros and cons before going ahead and parking their hard-earned money into them.
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