We are not talking of James Bond, we are talking of investment bonds.
We are in a situation where the fixed deposit rates are at a general low and there is a lot of discontent among depositors of fixed deposits.
Whenever we see a situation like this, one way or the other, the bond markets come to the rescue. It comes to the rescue of smart depositors, who are agile to move their money from fixed deposits to bond funds.
Let’s understand what is happening and why.
What Exactly is Happening in the Bond Markets?
It is likely that in this year, investors of bond funds will make handsome gains. Bond prices may rise and there may be capital gains. Investors of bond funds not only earn the rate of interest, but also earn capital gains. So that way, they make more than the return they would make on fixed deposits. The returns could be a high single digit or sometimes as high as double digits.
Over three years, this will become practically tax free or the tax would be a very small amount. So, basically, I am thinking that a rally will happen in the bond market. There are three main reasons for this — reduction in government borrowing (which is favourable), recovery of trading losses (which is favourable) and no change in monetary policy (which is neutral).
A word of caution, however, that such bond market investments are also subject to bond-market volatility and should be considered ideally with the help of a financial expert.
Before proceeding further, let us, therefore, quickly explain a bond, bond fund and bond market. We need to do this because few people understand the bond markets and even fewer invest in the bond markets.
Bond is nothing, but a commercial transaction where the borrower is issuing a bond to the lender and the lender will earn a certain rate of interest. When interest rates fall, everyone becomes interested in owning that bond.
As a result, the demand for the bond increases, the price of the bond increases and the bondholder makes capital gains.
A bond fund is a fund where ordinary investors pool in their money and a fund manager buys them a portfolio of bonds.
Moving onto the Reasons For a Rally in Bond Funds…
Now, the fundamental reason for a rally is reduction in interest rates as it stimulates economy and growth.
Firstly, the government is a massive borrower of funds. So a reduction in government borrowing reduces the demand for money in the economy. As a result, prices of bonds rise and this contributes to capital gains for bond holders.
Secondly, the Reserve Bank of India (RBI) recently announced that the commercial banks and RBI, which are the largest lenders to the government, will have another year to offset losses they have incurred on account of buying government bonds in the past. This action will lead to a rise in the price of bonds and this contributes to capital gains for bond holders.
Lastly, on one side due to the rise in oil prices, there is more inflation and thus more money is needed for circulation in the economy. On the other side, many government bonds are maturing, which will provide money supply. So, it is likely that we see a neutralising effect and thus RBI will take no action. This inaction here will support capital gains as explained above. Hence, this year might be a year of good gains for the bond investors.
Kartik Jhaveri is an expert at planning money, life and aspirations. He is a Certified Financial Planner, Wealth Manager & Financial Freedom Coach.