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.

Many 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. However, such securities can form a vital component of a well-diversified securities portfolio.

What exactly are bonds? A bond, also termed as a fixed income security, is an IOU issued by the borrowing entity, where the acronym stands for I OWE YOU. As can be surmised, it represents a loan from the acquirer to the issuer.

Unlike a shareholder, a bondholder does not become a part owner of the business by acquiring such securities and, consequently, is not entitled to a share of the profits. Unlike shares, which yield income in the form of dividends, bondholders receive what are termed as coupon payments, which represent interest on the face value of the security.

The term arose because in earlier days, the acquirer was issued a booklet of post-dated coupons. At periodic intervals, he was expected to detach a coupon and claim his interest for the preceding period. These days, of course, in most cases, the issuer will credit the bank account of the bondholders as and when payments become due. Bonds are also referred to as debentures in certain cases. In India, we often use the terms interchangeably, but, in the US, the term debenture represents an unsecured debt security, whereas bond is used to describe a secured debt security. In the case of secured debt, the issuer will pledge specific assets as collateral.

In the event of a default, the holders can have these assets attached and sold to recover their investment. However, in the case of unsecured debt, the investor can only hope that the issuer will have adequate solvency and liquidity when the time comes for repayment.

Interest from a bond is independent of the profits made by the issuer and is usually set right at the outset. Even in the case of floating-rate bonds, where the coupon is linked to a benchmark, such as Libor, once the interest is fixed at the start of the period to which it applies, it is not a function of future profitability. This is why bonds are referred to as fixed income securities.

Bonds may be negotiable or non-negotiable. Shares are negotiable for we can always buy and sell from fellow investors. However, certain investments are non-negotiable. Bank FDs held by retail investors cannot 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 are not actively traded. A second consequence of the fact that there are an enormous number of bond issues available is that security identification becomes critical for a potential investor. That is in addition to the issuing firm or government, the coupon, the maturity date, and, if required, the currency as well, should be clearly specified.

Interest on bonds is paid out of pre-tax profits, that is, coupon payments represent a tax-deductible expense for issuers. Thus, coupon receipts are invariably taxed at the hands of the investor. The tax-deductible feature of such securities also provides equity shareholders with leverage. That is, equity returns get magnified since payments to bondholders are fixed in nature.

The writer is the author of Fundamentals of Financial Instruments, published by Wiley, India

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