Why bonds that offer interest payments once a month might not be the best investment

Non-convertible debentures (NCDs) with monthly interest payments have been issued to the public recently. In June of 2023, for instance, IIFL Finance advertised five-year NCDs paying 8.65% interest and disbursing principal and interest monthly. Interest on NCDs issued by Indiabulls Housing Finance was initially offered on a monthly basis, beginning in early March. The interest rates on the NCDs with 24-month and 36-month terms were 9.64% and 9.88%, respectively.

Bonds that pay interest on a monthly basis, along with other fixed-income instruments, are common investments for retirees and others who need a reliable source of income to cover their living expenses. This aids them in keeping up with their consistent cash flow. Even people whose salaries, business profits, or pension payments are more than enough to cover their monthly bills will sometimes choose to invest in bonds that pay interest on a periodic basis, such as monthly. The main reasons for doing this are: 

1) Liquidity needs: Cash in hand ensures better liquidity, which is a comforting factor.

2) Low credit risk: Some investors believe such regular payouts lower the loss in the event of a default. As interest is paid each month, it does not accumulate, and to that extent, the money at stake is reduced compared to the interest being payable at maturity.

Bonds with a monthly interest payment option may seem appealing to investors for a number of reasons, but there are some drawbacks to consider. This includes:

Leakages

Investors who receive such payments on a periodic basis may choose to spend the money. This is especially true if the amount received is modest, it is saved in a bank account, and it is used for frivolous purchases. It's possible the investor lacks the foresight to choose the finest monthly investment options, resulting in the funds being spent haphazardly.

Sub-optimal returns

The total portfolio returns suffer as a result of these leakages. Even if the funds are not used and instead remain in the investor's savings bank account, they will earn a meagre interest return of around 3%. Bonds may provide much greater returns, so the investor should consider them if he thinks he will not need the money soon. There is a current return of 6.7 percent on one-year corporate fixed deposits of good quality. The portfolio returns would suffer significantly if the money was held in a bank account earning roughly 3 percent interest instead of investing in the initial bond, which earned 8 percent interest per year at monthly intervals.

Compounding

Typically, portfolios consist of long-term investments. They are tasked with growing their capital at a rate faster than inflation. Equities, albeit they outperform inflation, are highly volatile in the short run. Bonds are reliable, but they can't keep up with inflation. When this occurs, the interest earnings must be invested wisely. The money needs to be invested on a regular basis so that it can earn interest and compound.

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Reinvestment risk

The risk associated with reinvesting is also often underappreciated by investors. Upon receipt of the funds, they will need to investigate potential investment vehicles. They can be as thorough as they like in investigating all of the market's potential investment vehicles, but they can do little to influence the interest rates that are available at any one time. As interest rates fluctuate over time, investors may be forced to reinvest their earnings at a lesser rate than was originally agreed upon. Interest payments received from a bond paying 8% may need to be invested at 6% if, by the time the interest is paid, interest rates in the economy as a whole have dropped significantly.

Taxes

A taxpayer's tax rate "slab" is applied to interest income. An annual distribution may make the most sense because most investors would rather pay tax on interest on an accrual basis.

However, debt mutual funds (MFs) are the way to go if the investor wants to put off paying taxes on bond interest. These MFs use the coupon payments from the bonds they own to further invest in the market. Moreover, they provide the control of risks. Debt mutual fund capital gains are subject to taxation at the same rate as interest income, although this tax is not due until the moment the fund's units are sold. Investors who are astute would wait to cash out their debt fund holdings until retirement, when their income is expected to decrease.

Therefore, if there are no consistent cash-flow needs, a methodical strategy to investing in interest-bearing bonds can aid in the money's compounding.

The systematic withdrawal plans (SWPs) offered by MF institutions are yet another effective means of generating a reliable stream of income. Here, the investor directs the MF firm to sell a specified number of units from his existing MF investments in order to pay him a specified amount of money. By taking this action, your remaining MF units will keep growing your investment. The tax implications of starting an SWP with equity-focused MF units are significantly more favourable. Capital gains, such as those from the sale of shares, are taxed at more lenient rates than ordinary income.