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There are two quotes that should be cited: One, ‘Some people dream of success, while other people get up every morning and make it happen.’ by Wayne Huizenga. Two, ‘Someone’s sitting in the shade today because someone else planted a tree a long time ago.’ by Warren Buffett. The former quote alludes to the significance of business activities, and the latter upon investment. These two factors are incontestably the prime determiner of the economy of a country. The presence of correlation and causation relationship between business and investment further strengthens the previous statement.
There is an incessant flow of ideas emerging from every corner of the world, but only a few happen to become a successful business. Why so? Because only the ideas which show a potential for commercial viability is invested upon. And if it is an already established business, then investment enables expansion of the products and services offered by the business both in terms of its merit (i.e., through investment in the R&D), and its marketability.
So, what are the factors that prompt an investor to invest? These are the interest rates, economic growth, expectations, technological developments, availability of finance, and other matters like government policies, etc. Among these the economic growth and expectations (or the investor’s psychology) plays a dominant role in investments. So when there is a recession or an anticipation of a recession, the investors tend to shift to other modes of safe investments.
This is what is happening presently in the global scenario: the escalating trade war between USA and China; an economic slowdown in the biggest economies like, India, US, etc.; a long recession in Germany and Japan which is moving towards recession; the Chinese debt-crisis; the Brexit, etc. provides an insight into the state policies, financial and economic position of the country. As a consequence, many investors have sought the option of government bonds as a safe portal for investment. But before proceeding further some preliminary questions have to be answered:
What are bonds?
Bonds are debt instruments issued to raise additional capital. This is in form of a promissory note promising to pay a sum of interests (called, bond yields) for a specific period and to repay the principal amount on a specified date. There are broadly two types of bonds: corporate bond and government bond. The corporate bonds are generally issued for expansion of business and the government bonds are issued to bring in and develop infrastructural projects. The former has a high risk and high return associated with it when compared to the latter which features low risk and low return, hence a safer investment.
Why bonds are considered a safer investment?
- Bonds are secured by collateral.
- The risk factor is less.
- Interest is paid on accrual basis and the financial performance of the issuing party is not relevant, and
- On liquidation, the bond-holders are given priority over the debenture-holders and only then the equity-holders.
What is the working of bond yields?
Many of the investors usually go for equity instruments or debentures (a debt instrument), but when the stock market goes tumbling, they will pull out their investments from the above sources and shift towards the bond market, a safer instrument. And as widely seen in practicality, the poor economic growth of a country discourages the investors to opt for the corporate sector, hence many feel safe to invest in government bonds. As a consequence, the demand for the government bonds increases. When demand increases, the price of the bond also increases but the bond yield substantially decreases, it being a fixed amount.
Why do corporates prefer bonds when compared to the equity instruments and debentures?
Since, bonds feature a long–term investment it does not entail an immediate cash outflow. The interests paid can be claimed for tax purposes. Further, there is a boost in the return on equity as there is less dilution of equity. This is crucial because equity entitles ownership and with that comes control. Thereby, the corporates are in an advantageous position.
What is the current scenario regarding the bond market?
The current scenario here is about the trends in the western markets. Many have started investing in the government bonds around the world because of the slow economic growth that is being witnessed all over. As a result, the bond yields continue to decrease. For example, the US Treasury Bonds shows an inversion yield, i.e., the return on a longer tenure bond is lower than the yield on a shorter tenure bond; the bond yields in the Eurozone is also less – for instance, in Germany, the yields are in negative, etc.
Now, when we look into the position of India with regards to investment it has a lower domestic investor base while the numbers of Foreign Portfolio Investors (FPIs) are steadily increasing. Many foreign investors tend to invest in Asian countries because it is the emerging market and here India and China are the most desired countries to invest in. This can be attributed to the highly potential human resources and the presence of a huge market. But the issue with the FPIs is that they do not trade their investment instruments and rather keep it till its maturity. This impacts the liquidity.
So, what should be done? The first thing to be done is to increase the investor base in the country. This can be done by imparting financial awareness to the society. A majority of Indians invest in gold and silver with a mind-set that it will assist them in case of emergencies. They are much inclined to savings rather than asset building (which generates income constantly). If their perception changes then it will prove to be beneficial to both the investors and the businesses, which will further show an overall shift in our economy.
There are a few initiatives taken on behalf of the government to enhance domestic investments in the corporate sector like the proposal to set up a Credit Guarantee Enhancement Corporation (CGEC) which will aid in boosting the credit rating and potentially attract a large number of investors to invest. But, more people would invest in the corporate sector only when they understand the working of it and that can be accomplished only when they are financially educated. Hence, financial education should begin from a very young age. this will also assist us in escaping from the conservative approach of money that has entangled a majority of the population, i.e., strive hard and work for money which should be converted to make money work for you.
For starters, bonds are a good choice of investment because it is considered to be a safer instrument. And through experience, we will get to know the workings of the market and get wiser: there is always a boom and fall in the economy, and the choice is ours whether to play it safe or play it smart because in both cases we get returns, but how much is what matters. Thus, an early investment in imparting financial education can change our perspective and yield to be beneficial to the businesses and the investors.
-This article is brought to you in collaboration with Harshini from School of Excellence in Law, Chennai.