Bonds should be a vital component of a diversified securities portfolio

Jan 25 2013, 08:57 IST
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SummaryMany of us are active investors in the stockmarkets. But how many of us actively trade in bonds? Many investors believe that bonds are predictable and boring.

be endorsed by one party in favour of another and, consequently, represent non-negotiable investments. Similarly, if we were to acquire a National Savings Certificate from a post office, we cannot sell it to another party prior to maturity.

The psychology of bond traders is usually different from that of stocktraders. While most investors in stockmarkets periodically trade, many investors in bonds are content to hold the securities until maturity and collect periodic coupon payments. In practice, when a bond is newly issued, there is active trading. After a while, however, most holders choose not to play an active role in the market.

Consequently, newly issued bond issues are said to be ‘on-the-run’, while relatively seasoned issued are referred to as ‘off-the-run’. While the two categories of securities are, in principle, indistinguishable, on-the-run securities tend to be more liquid and, thus, carry lower yield than off-the-run securities. For instance, while we would term a three-month debt security issued yesterday as on-the-run, a six month debt security with the same characteristics issued three months ago would be termed as off-the-run. Although the two would obviously be similar in all respects, on-the-run issues carry lower yields.

Most companies issue only one type of equity securities although, at times, there could be variants such as non-voting or restricted-voting shares. However, there are an enormous variety of bonds in the market. Let us consider the case of a company like Reliance. It can issue bonds maturing in 2015, 2020, or 2025. Each is obviously a different security. In 2015, we can have bonds maturing in January or November, which would obviously be classified as two different assets. Finally, in January 2015, we can have bonds with a 6% coupon or 8% coupon, which, too, would be construed as two different entities. In the case of multinational issuers, we can go a step further. In January 2015, we can have 6% coupon bonds denominated in US dollars or in euros. The point we are trying to make is that there are an enormous number of debt securities in the market compared to the variety of equities.

For instance, in the case of municipal bonds in the US, which are very popular with investors seeking tax-free returns, an investor has a choice of close to 2 million securities. Considering this and the fact that the psychology of bond investors is different, it is obvious why most fixed income securities

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