Is Monthly Interest Paying Bond is Good?

Investing in bonds that offer monthly interest pay-outs can be appealing, especially for retirees and individuals seeking regular cash flow. These bonds provide liquidity and are perceived to lower credit risk. However, there are potential drawbacks to consider. This article explores the advantages and disadvantages of bonds with monthly interest pay-outs and highlights alternative strategies for optimizing returns and managing taxes.

Advantages of Bonds with Monthly Interest Pay-outs

1-Liquidity Needs: Bonds with monthly interest pay-outs offer the benefit of regular cash in hand, ensuring better liquidity. This feature provides comfort and flexibility, allowing investors to meet their ongoing expenses.

2-Lower Credit Risk: Investors may believe that regular interest pay-outs mitigate potential losses in the event of default. As interest is paid each month, the amount at stake is reduced compared to interest payable at maturity, providing a sense of security.

Disadvantages of Bonds with Monthly Interest Pay-outs

1-Leakages: Regular inflows of money may tempt some investors to spend the funds on trivial things or make impulsive purchases. This can lead to suboptimal returns and erode the overall portfolio value.

2-Sub-Optimal Returns: If the received funds are not spent but kept in a savings bank account, they typically earn a low rate of interest, around 3 percent. This leads to suboptimal returns, especially when higher-yielding investment opportunities are available. For instance, good-quality corporate fixed deposits currently offer returns of 6.5 to 7 percent for a one-year tenure.

3-Compounding: Long-term investment portfolios are often designed to compound money at a rate higher than inflation. While bonds provide stability, they tend to lag behind inflation. To optimize portfolio returns, accrued interest needs to be reinvested wisely at regular intervals.

4-Reinvestment Risk: Investors must consider reinvestment risk when the interest pay-out is received. The prevailing interest rates at that time may be lower than the original contracted rate, potentially impacting future returns. Changing interest rates can limit the options available for reinvestment.

5-Taxes: Interest earned from bonds is taxed at the investor's slab rate. Opting for a yearly pay-out allows investors to delay their tax liability. However, investing through debt mutual funds (MFs) can offer tax advantages. Debt MFs reinvest coupon payments, delaying tax liability until the units are sold, and potentially benefiting from lower tax rates during retirement.

Alternative Approaches for Regular Income

1-Systematic Withdrawal Plans (SWPs) of Mutual Funds: SWPs allow investors to receive fixed sums of money by selling a specified number of units from their existing mutual fund investments. This approach ensures regular income while allowing the remaining units to continue compounding. SWPs from equity-oriented mutual funds can provide tax benefits as capital gains are taxed at concessional rates.

2-Structured Investment Approach: A structured approach to investing in interest-bearing bonds can help maximize compounding potential, provided there are no immediate income needs. This approach involves reinvesting interest payments into higher-yielding opportunities to optimize overall portfolio returns.

Conclusion

Bonds with monthly interest pay-outs offer certain advantages, such as liquidity and perceived credit risk reduction. However, investors must be mindful of potential leakages, sub-optimal returns, reinvestment risk, and tax implications. Exploring alternative strategies, such as SWPs and structured investment approaches, can provide more efficient ways to earn regular income and optimize portfolio growth. It's important to assess individual financial goals, risk tolerance, and taxation considerations when deciding on the most suitable investment approach.