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With interest rates on bank fixed deposits plummeting, investors in search of predictable returns may look at investing in the bond market that offers higher returns than FDs and also come with a lower risk than equity markets.

However, the present low interest rates cycles could put investors in a duration-risk in bond markets that could throw in mark to market losses.

What are bonds?

Bonds are debt instruments. When an investor buys a bond or any other debt instrument, the investor is actually lending money to an institution, for which the an interest is earned.

Bonds come with fixed coupon rates, or interest rates, and usually a defined maturity date. For investors looking for such predictability in returns, bond market investments may be better than fixed deposits.

Vidya Bala, Founding Partner, Prime Investor said, “With interest rates in FDs at 5-6 year lows, most investors are looking at options where they can improve their returns. The problem today is that most investors are not initiated in capital markets or equities. Markets are volatile, your investments can go down as fast as they go up. It is important to look at alternate ways to build wealth without getting too hurt. That’s where fixed income market, or debt market, comes into play.”

Bonds VS Fixed Deposits

Bonds can be of two types – the ones issued by the government are called government securities and those issued by corporate organisations are called corporate bonds.

In case of fixed deposits, another debt instrument, the bank acts as a middle man and lends to a company seeking a loan. With bonds, an investor lends directly to the company, so extra returns are earned. For the same reason, bonds come with a comparatively higher credit risk than FDs that have banks acting as both middlemen and hedge.

What’s the other risk?

The other risk is duration risk. Bala states, “If you don’t enter at the right time, you may buy at lower yields. Interest rates may subsequently go up so the next issuance by the same entity may give you higher returns than the current one (you entered in).”

Bonds are traded in the open market and rising interest rates will lead to higher yields. As market rates go up, prices come down. Bala said, “Investors should not enter at the bottom of the interest rate cycle.”

Bonds vs debt mutual funds

The difference between bonds and debt mutual funds is that in the case of the latter, a fund manager will tweak one’s portfolio based on interest rate movements. The fund manager could put the money in a corporate bond fund and may might want to shift from long duration to short duration bonds based on interest rates – something an investor may not be able to do without expert intervention.

“Retail investor should simply put money in a debt mutual fund for a short duration goal,” Bala said.

Goal setting with bonds

Bala said investors with short term goals may consider debt mutual funds as investment tools. She said some investors also use debt funds to build emergency funds for a medical emergency or a potential job loss to keep liquidity intact.

Other goals may be those of paying education fees or an insurance premium in a year or so.

Some investors choose to allocate investments in debt markets also to balance equity volatility, she said.

Are bonds liquid?

“Some bonds like government securities are highly liquid, so you can buy and sell them anytime you want. But if you take a AA or a AA- rated bond where your interest rate may be higher, you may not be able to sell fully or sell at a lower rate than the previous day rate,” Bala said.

She also said that ‘mark to market’ losses may be booked as ‘real losses’ if an investor liquidates at a time when real interest rates have gone higher. Something that will never happen with FDs. “In debt mutual funds, you can overcome this. In the bond market, in a climbing interest rate cycle, you will book actual losses. For very short term goals, it would be better to stick to FDs,” she said.

Comparing returns

Bonds and debt mutual funds have offer anywhere between 6 to 8 percent return over a 3 year period, which according to Bala, is a good return. Anything more than that should be considered as bonus. FDs have gradually come down to 5 to 6 percent for established banks.