Why investing in bonds makes sense in a falling market

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SummaryBonds are among the safest investment options, but going beyond that characteristic, how good are they?

Bonds are among the safest investment options, but going beyond that characteristic, how good are they? Similar to any other asset class, there are several pros and cons to investing in bonds.

Among their most attractive features is safety of capital, with oneís principal being secured (especially in the case of government bonds). Bonds also are more liquid than most fixed-income assets such as fixed deposits as they are now available in demat form and can be traded on the secondary market.

One can purchase bonds for long-term investment but, at the same time, during an emergency, one can sell them in the secondary market at the current rate without huge losses. This gives bond investors much-needed liquidity with fixed-income security.

Another advantage of bonds is that the interest rate is known beforehand and locked-in for the period of the bond. For example, a 10-year bond with an interest rate of 7.5% will bear this rate for the next 10 years, irrespective of how the economy is doing, what other asset classes offer, and so on. However, there are a few negatives to bond investing as well. One of the main negatives is that one loses the power of compounding, since the bond interest is paid out each year and not accumulated.

It is advisable to compare bond rates with that of fixed deposits as, many times, banks may offer better returns (especially to senior citizens).

Another aspect is the reinvestment risk, since bonds offer the interest to the bondholder, one needs to decide where to reinvest this money.

Since bond returns are typically modest, you might be able to make more returns on other asset classes such as equities.

This being said, it is advisable to have a portion of your investment corpus in debt assets such as bonds. Ideally, one should have 20% of portfolio in fixed-income assets.

An important factor to keep in mind is that bond prices are negatively correlated with interest rates. This means that falling interest rates will lead to higher bond prices and vice versa.

Bonds are also typically inversely related to the stock markets, with bonds doing well when the markets are under-performing and vice versa.

Bond investments are advisable for people who have longer investment horizons, as, typically, the tenure ranges from 10 years to 20 years.

It is beneficial to hold bonds for a longer duration since the possibility of capital appreciation is higher. In the longer run, it would also be possible to sell your bonds in the secondary market for a substantial profit (as bonds are now in demat form). The Rural Electrification Corporation (REC) tax-free bonds have just hit the market and offer investors time horizons varying from 10 years to 20 years, with interest ranging from 8.26% to 8.62% per annum.

The interest on these bonds will be paid annually and does not attract any tax. However, the principal repayment will be liable to capital gains tax ó either long-term or short-term tax, depending on the duration one holds the bonds.

The writer is CEO and founder of Right Horizons

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