Bond investing is not as straightforward a game as it might appear to investors creating a debt portfolio. Investing in high yield bonds could be a tricky job. The investor would be aiming for superior returns amid the offerings in the debt universe. At the same time it would require managing the risks associated with investing in bonds that give higher returns. Yes, though it is considered safer compared to many other asset classes, bond investing has its own risks such as credit risk and liquidity risk that one needs to be aware of. Here are some basic hygiene checks one should undertake while deciding on the best way to invest money while building a high yield bonds portfolio.
Is the risk worth taking?
For all those who are still searching for the questions such as – How to invest money or where to invest money for best rewards, high yield bonds in India can be explored, provided they balance the risk with return. To start with, decide on how much of the portfolio you want to allocate to high yield bonds. Also ask the question whether you have the risk appetite for the high-yield bond offerings and would you be comfortable taking that risk?
High yield bonds generally come with credit ratings below AA and may carry higher credit risk compared to government bonds or AAA rated bonds. As a smart investor looking for higher yields you should check the yields available on AAA bonds and government securities. This is one of the parameters that an investor needs to consider.
It also makes sense to draw a line on the maximum risk one is willing to take to build a high yield bond portfolio.
Getting the duration right
Often investors may want to adopt an investment strategy that includes a fair sprinkling of high return investments. In the process they end up buying long term high yield bonds. In the normal course of action, longer the tenure higher the rate of interest on offer. However, not all long term bond investments may ultimately prove to be rewarding.
Investors must be aware of the fact that high yield bonds are generally not liquid in secondary markets. Hence having a portfolio of high yield bonds brings in the element of liquidity risk. Investors in such bonds should be mentally prepared to hold on till maturity, instead of selling them below fair value in the secondary market. Mature bond investors match their investment horizon with the residual maturity of the bonds. In easier terms, if an investor requires liquidity only after three years, he or she should prefer to buy bonds that mature in three years or less.
However, there might be a situation that an investor is unsure of the future financial goals and liquidity requirements and consequently may not have any preferred investment duration. In such a situation it is ideal to split the bond investment over various durations, which is also referred to as laddering. While doing this, investors opt to buy bonds maturing at different points in time which may be split in three, five, seven and even ten years. The invested bonds keep maturing at regular intervals and proceeds can be redeployed at that time. This also helps protect the investor from the vagaries of interest rate cycles. Investors do not invest all the money at the peak of the interest rate cycle nor at the bottom. Spreading out across maturity helps.
Choose multiple issuers
Concentration risk is another hurdle one should avoid while building a portfolio of high yield bonds. Smart investors would not like to bet their entire high yield bond investment corpus with one or two issuers since if the issuer faces financial problems or goes belly up, the entire investment may not be lost. One needs to be extra careful when the economy slows down and some companies come under pressure. Ideally, investors should spread the investment around a number of issuers and not take excessive exposure to a single issuer.
Spread across sectors
Investors must also ensure that the list of issuers in which they have invested is spread across diverse sectors. Even when there is a slowdown, not all their investments are at risk, because different sectors react differently to macro-economic events. Paying attention to underlying business helps a lot in containing risks in a high yield bonds portfolio. There could be diversity within a particular sector classification. Thus, naïve investors may say that since many bond issuers are non-bank finance companies (NBFC) investing in them is not going to materially change the risk quotient of their portfolio. Seasoned investors have learnt to spread their risks even when they are subscribing to NBFC bonds. They choose to invest in issuers that operate in diverse businesses such as commercial vehicles financing, two-wheeler financing, gold loan companies, housing finance companies and stock broking.
Opt for listed over unlisted
Listed bonds can be sold in the secondary market relatively easily compared to unlisted bonds. Though high yield bonds portfolios are constructed with a view to hold on till maturity, one should keep some leeway for selling them midway if the need arises. Listed bonds are better placed in this respect.
Taxation
(Please note that this is only a generic representation of taxation of bonds. These can be different on a case to case basis. We recommend you consult your tax or financial advisor before making an investment)
Capital gains booked on listed bonds held for more than one year are treated as long term capital gains and taxed at 10 percent rate of tax without indexation. If sold in less than one year, the gains are considered as short-term capital gains and taxed as per slab rate.
But capital gains booked on unlisted bonds held for more than three years are treated as long term capital gain and taxed at 20 percent rate of tax without indexation. Such bonds, if sold in less than three years, are considered as short term capital gains and taxed as per slab rate of the investor. Thus, on the taxation front the listed universe looks better.
Investors need to take careful and calibrated steps and understand the risks associated with high yield bonds investments while building a portfolio.
Team AltiFi.