Look Beyond the Yield: Choose Bonds That Fit Your Needs
Introduction
Yield is usually the first figure an investor checks when choosing a bond, and often the one that decides it. Faced with two bonds, one offering 12% and the other 8%, most would pick the higher number without a second thought.
That is where many bond portfolios start to go wrong. A bond’s yield is not a reward for choosing well. It is the market’s price for the risks the bond carries, and a higher yield usually signals more of those risks, not a better deal. As more Indians buy bonds directly, it helps to understand why the yield quoted at purchase and the return actually earned can differ. Four factors explain most of that gap.
A higher yield is the price of higher risk
In India, government securities are the reference point for all fixed income. The 10-year government bond has traded above 7% in recent weeks, and corporate bonds are priced against this level. The extra yield a company pays over the government shows how the market rates its ability to repay. That judgement rests on the company’s earnings, how much it has already borrowed and how financially sound its business is.
A well-rated company with stable cash flows can raise money at only a small premium over the government. A company with weaker finances must offer much more to persuade investors to lend to it. Hence, when a bond pays 12% or 14%, the gap over the government yield is not a bonus. It is compensation for a meaningfully higher chance that interest or principal will be paid late or only in part.
A bond’s yield to maturity is an estimate and not a promise
Most bond listings show the yield to maturity, which is a helpful way to compare bonds, but is built on three conditions. First, the investor holds the bond until it matures. Second, the issuer makes every payment in full and on time. Third, each interest payment is reinvested at the same rate.
Real investments rarely follow such a clean path. If interest rates fall, payments may have to be reinvested at lower returns. If the investor needs money before maturity, the bond must be sold at the market price, which may be below what was initially paid. Therefore, the yield to maturity should be read as a possible result and not a fixed outcome.
The coupon and the yield also differ. The coupon is the interest rate on the bond’s face value. A bond with an 11% coupon, bought above face value, will return less than 11% over its life, because the extra amount paid is not refunded at maturity.
Two bonds with the same yield can carry different risks
Bonds with the same yield do not always offer the same safety. A secured bond is backed by specific assets of the issuer, while an unsecured bond is not. Some bonds are repaid ahead of other lenders if the issuer runs into difficulty, and others are repaid only after them. These features are seldom highlighted, yet they decide how much an investor can recover if the payments stop.
Some bonds come with a call option, which lets the issuer repay investors before maturity. Issuers usually do this when interest rates have fallen and they can borrow more cheaply elsewhere. The investor then earns the high yield only until the call date and gets the money back when new investments pay less. For such bonds, the yield to call is a more realistic guide than the yield to maturity. The offer document sets out all of these terms, and it often explains why a bond is priced the way it is.
Tax and liquidity decide the returns an investor keeps
Bond interest is added to an investor’s income and taxed at their slab rate. For someone in the highest tax bracket, a 12% coupon may be worth around 8% or less once tax is paid, which brings it much closer to safer alternatives. Comparing bonds on their after-tax return gives a truer picture.
However, how easily a bond can be sold also matters. Many corporate bonds, especially smaller or lower-rated ones, are not traded often. An investor who wants to exit early may struggle to find a buyer, or may have to sell at a lower price. Part of a higher yield can be payment for this difficulty, not only for the risk of non-payment.
The best bond is the one that fits the investor’s goals
This does not mean higher-yielding bonds should be avoided. They can add to a portfolio’s returns when investors understand the risks, keep each holding small and spread their money across different issuers and sectors. The problem lies not with high yields, but with choosing a bond on yield alone. A better decision begins with three things an investor should be clear about. The first is their financial goals. The second is how much of the original investment could be lost without causing real difficulty. The third is how much income is needed after tax. A bond that meets these needs will often serve an investor better than one that simply pays more.
India’s bond market has become far more accessible to individual investors, and that is a welcome change. Wider access, though, places more of the decision in the investor’s hands. The investors who do well in bonds tend to look past the highest yield and understand the risk it carries.
