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Bonds are commonly perceived as safe investments, particularly compared to equities. However, the concept of “safety” in bond investing requires careful examination. While bonds offer certain protective features, they carry specific risks that investors must understand to make informed portfolio decisions.
Bond Fundamentals and Key Features
Bonds represent debt instruments where investors lend money to companies and government institutions in exchange for regular interest payments and principal repayment at maturity. Key characteristics include:
Income Generation: Regular coupon payments provide predictable income streams
Maturity Structure: Fixed term with defined repayment date, unlike open-ended equity investments
Repayment Priority: Senior claim over equity holders in bankruptcy proceedings
Lower Volatility: Generally exhibit less price fluctuation than listed equities
These features make bonds attractive to conservative investors and those seeking steady income, particularly retirees and pension funds.
Risk Factors in Bond Investing
Credit Risk
Credit risk varies significantly across bond types. Government of India securities carry minimal default risk due to sovereign backing. Corporate bonds present varying degrees of credit risk, as demonstrated by defaults in IL&FS and DHFL despite previously acceptable credit ratings.
Credit rating agencies (CRISIL, ICRA, CARE) assess issuer creditworthiness:
- AAA Rating: Highest safety, lowest default risk
- Lower Ratings: Higher yields but increased default probability
- Rating Limitations: Ratings represent current assessment, not future guarantees
Interest Rate Risk
Bond prices move inversely to interest rate changes. When RBI increases policy rates, newly issued bonds offer higher yields, reducing demand for existing lower-yielding bonds.
Impact Example: During 2022-23, RBI raised repo rates by 250 basis points, causing significant price declines in long-term government securities.
Mitigation Strategy: Holding bonds to maturity eliminates interest rate risk as investors receive full principal repayment.
Liquidity Risk
If you purchase a high-rated bonds, in majority cases, there shouldn’t be any need to worry about liquidity. But if you go for lower-rated bonds which are not traded often in the secondary market, you might find it difficult to sell the bond. Make sure you choose the right OBPP and the right bond to invest after very careful evaluation.
Inflation Risk
Real returns erode when inflation exceeds bond yields. A 7% annual coupon provides minimal real return if inflation reaches 6.5%. This effect compounds over longer investment periods.
Solution: India has introduced inflation-indexed bonds, though liquidity remains limited in this segment.
Strategic Role of Bonds in Portfolios
Portfolio Diversification
Bonds provide negative correlation with equities during market stress. When stock markets decline, investors typically shift to government securities, creating a “flight to safety” that can support bond prices during equity market downturns.
Regular Income
Bonds offer predictable cash flows through regular coupon payments. PSU and bank bonds maintain strong demand from income-focused investors, particularly retirees requiring steady payouts.
Capital Preservation
High-grade bonds rarely experience the 40-50% losses possible in equity markets during severe downturns, making them effective capital preservation tools.
Bond Categories and Investment Options
Government Securities (G-Secs)
- Treasury Bills: Short-term instruments for liquidity management
- Government Bonds: Long-term securities backed by sovereign guarantee
- Yield Range: Currently 6% – 6.7% for various maturities
- Risk Level: Minimal credit risk, subject to interest rate fluctuations
Corporate Bonds
- Investment Grade: Blue-chip company bonds yielding 7-8%
- High Yield: Higher-risk corporate debt offering double-digit returns
- Credit Analysis: Requires thorough evaluation of issuer financial health
Tax-Saving Bonds
Section 54EC Bonds: Issued by REC, PFC, and NHAI for capital gains tax exemption
- Lower yields compensated by tax benefits
- Popular among property sale proceeds investors
- Fixed tenure and investment limits apply
Ideal Bond Portfolio Allocation
Ideal portfolio allocation varies significantly by age group to balance growth potential with risk management. Young investors aged 25-35 years should maintain an aggressive allocation with 70% in equity for long-term wealth creation, 20% in fixed income for stability, and 10% in alternative assets for diversification. Investors above 35 years require a more conservative approach with 40% in equity to continue growth while reducing volatility, 25% in fixed income for steady returns and capital preservation, 20% in real estate for inflation protection and diversification, and 15% in alternative assets for enhanced portfolio balance. This age-based allocation strategy recognizes that younger investors can withstand higher equity exposure due to longer investment horizons, while older investors need greater stability and income generation as they approach or enter retirement.
Indian Bond Market Context
Market Size:
- Government securities: ₹188+ trillion outstanding
- Corporate debt securities: ₹54+ trillion outstanding
- Retail participation: Under 3% currently
Access Improvements:
- RBI Retail Direct platform for direct G-Sec investment
- Online Bond Platform Providers reducing entry barriers. Currently 40+ OBPPs are registered with NSE/BSE.
- Recent PSU bond issuances at 7.5-7.8% yields attracting retail interest
Investment Considerations
Risk Assessment: Bonds offer lower risk than equities but are not risk-free. Safety depends on issuer creditworthiness, interest rate environment, and holding period.
Income Generation: Bonds provide superior income compared to traditional fixed deposits while offering lower volatility than equity investments.
Portfolio Balance: Bonds serve as great instruments for portfolio diversification, providing regular income when riskier assets underperform.
Conclusion
Bond safety is relative rather than absolute. While government bonds and high-rated corporate bonds offer high security, low-rated bonds carry credit risk, and all bonds face interest rate and inflation risks. The primary value of bonds lies in portfolio diversification, regular income generation, and capital preservation during market volatility.
Effective bond allocation depends on investor age, risk tolerance, and market conditions. Rather than seeking spectacular growth, bonds provide the consistency and stability essential for balanced portfolio construction. In volatile markets, this reliability often proves more valuable than high-risk, high-return alternatives.
For Indian investors, the expanding bond market offers growing opportunities to achieve portfolio balance and steady income generation through professional platform access and improved market infrastructure.