14 pc bond returns: Higher income or higher risk? What investors should know

Mr Krishnan is a retired senior citizen. He is a risk-averse person and hence has invested all his retirement corpus funds in bank fixed deposits. He earns between 7 and 8 per cent interest on these deposits.

Recently, he comes across two full-page advertisements in leading newspapers wherein it has been mentioned that one can invest in bonds and earn fixed returns up to 14 per cent per annum. It has also been mentioned that these are secured and credit-rated bonds.

Should he divert his bank fixed deposit to this bond investment? Let us analyse.

What is a bond?

A bond is a fixed-income financial investment where an investor lends money to a borrower, such as a corporation or government, in exchange for regular interest payments and the return of the principal amount when it matures.

What is coupon?

Interest rate on the bond is called a coupon.

Understanding yield and yield to maturity

Bonds are issued for a face value. Interest or coupon will be calculated on the face value. Bonds are also traded in the bond market. When you buy a bond in the market it may be more than the face value or less than the face value.

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For example, if a bond has a face value of Rs 100, you may buy it for Rs 99 in the market. If the coupon rate is 8 per cent, you will get Rs 8 on your bond every year. This means that your return on Rs 99 is Rs 8 per annum every year. This return works out to 8.08 per cent and this is called current yield (Rs 8/99 * 100)

On the other hand, if you buy the same bond for Rs 101, then your current yield will be 7.92 per cent (Rs 8/101*100).

While current yield measures the cash flow return you get today based on the bond’s current market price, yield to maturity (YTM) estimates your total annualised return if you hold the bond until it completely expires, factoring in all interest payments and any capital gain or loss

How safe is your investment?

Safe options

Government Securities (G-Secs) & T-Bills: Issued by the central government, these carry sovereign backing and have virtually zero risk of domestic default.

State Development Loans (SDLs): Issued by state governments through the Reserve Bank of India (RBI), offering high safety similar to central government bonds.

Public Sector Undertaking (PSU) Bonds: Issued by government-backed enterprises, offering a strong balance of high safety and slightly better yields.

Higher risk options

• Corporate Bonds: Issued by private companies. Safety relies on the company’s financial health and credit rating (AAA is safest; single-A or lower carry higher default risk).

• Unlisted/High-Yield Bonds: These promise high returns but lack exchange listings, transparency, and easy liquidity, making them much riskier for regular investors.

Key risks to consider

• Credit Risk: The chance that a corporate issuer fails to pay interest or return your principal.

• Interest Rate Risk: If market interest rates go up, the market price of your existing fixed-rate bond goes down if you try to sell it before maturity.

• Inflation Risk: If inflation rises faster than your bond’s fixed interest rate, your real purchasing power drops.

• Liquidity Risk: Unlike bank fixed deposits, which generally offer a relatively straightforward mechanism for premature withdrawal subject to applicable conditions and penalties, some bonds may have limited secondary-market liquidity. An investor who needs money before maturity may therefore have to sell the bond at a discount or may find it difficult to find a buyer.

Bank deposits vs corporate bonds

Banks deposits are covered by deposit insurance up to Rs 5 lakh deposits under DICGC coverage. Moreover, banks are well regulated by the RBI. During the last seven decades of Indian banking, no commercial bank depositor has lost any money due to bank failures. The RBI and the Government of India have ensured timely intervention of any bank failure and arranged for takeover of problematic bank by a sound bank.

Can you rely on bond ratings?

AAA-rated bonds in India are considered the safest corporate debt, but historic collapses of top-rated entities prove they are not immune to sudden default.

Major failures of high-rated issuers

• IL&FS (2018): Held high investment-grade ratings before defaulting suddenly on its debt obligations, triggering a massive liquidity crunch in India’s non-banking financial sector.

• DHFL (Dewan Housing Finance Corporation): Enjoyed strong ratings shortly before severe governance and liquidity issues led to a catastrophic collapse and default on bonds.

• Reliance Capital & Reliance Communications: Both groups saw their paper rated safe by agencies before rapid financial deterioration dragged their ratings down to default (D) status.

Even bank-issued bonds aren't risk-free

The Yes Bank episode is a particularly important warning about AT1 bonds. In March 2020, ₹8,415 crore of the bank's Additional Tier 1 instruments were written down to zero as part of its reconstruction. AT1 instruments carry special loss-absorption features and therefore should not be compared with ordinary senior bonds or bank fixed deposits.

Who are bonds suitable for?

Bonds can be a useful investment for investors who understand the risks involved and are prepared to hold the investment until maturity. They may suit investors who have a moderate risk appetite, a stable source of income, a reasonably long investment horizon and sufficient diversification across issuers and instruments. Investors who can evaluate the credit quality of the issuer and understand the implications of credit risk, interest-rate risk and liquidity risk may also consider corporate bonds as part of their fixed-income portfolio.

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However, bonds offering unusually high returns should not be treated as a substitute for bank fixed deposits, particularly by risk-averse investors. A promise of a 12–14 per cent return should immediately prompt the investor to ask: Why is the issuer offering such a high return when safer instruments offer considerably less? The higher return is generally compensation for taking higher risks.

For a retired person like Mr Krishnan, whose primary objective is capital preservation and a regular, predictable income, moving the entire retirement corpus from bank deposits to high-yield corporate bonds may not be appropriate. Even a “secured” and “credit-rated” bond is not risk-free. A credit rating represents an assessment of credit risk at a point in time; it is not a guarantee of repayment. Similarly, “secured” does not necessarily mean that an investor will immediately recover the entire amount in the event of default.

This does not mean that bonds should be avoided altogether. Government securities and other high-quality fixed-income instruments can have a place in a conservative investor’s portfolio, while carefully selected corporate bonds may be considered by investors who understand and are willing to accept the additional risks.

The golden rule is therefore simple: Do not choose a bond merely because its coupon or advertised return is higher. Look at the issuer, security, credit rating, maturity, liquidity, taxation and, most importantly, the risk involved.

For a retiree, the question should not be “How much more can I earn?”, but rather “How much of my retirement corpus can I afford to put at risk?”