You’ve probably read our article on bonds.
Suppose you are a company with all your assets in equities (stocks) and no debt. So you have a certain number of people as the owners (shareholders) of the company who you split the profits between. Now you want to raise money to build a new factory for your business as you don’t have enough liquid cash yourself. There are a few ways to do this, you could issue new stocks to people meaning more friends to split the cake with or you could turn to debt and take a bank loan, whereby your credibility will be evaluated to decide on the loan. Chances are, you will have to pay high-interest rates on this loan which makes it difficult to operate the business. So you decide instead of borrowing from one lender (in this case, a bank), you borrow small amounts from 2000 lenders in the form of bonds. These are everyday people. They give you money in exchange for repayment of the loan with interest after a fixed period of time. So, how is it any different from a loan? The primary difference between a bond and a loan is that a bond is a secured debt in the sense that the investor is sure to receive a fixed interest at regular intervals until the bond matures.
The bond market broadly describes a marketplace where investors buy debt securities that are brought to the market by either governmental entities or publicly-traded corporations.
How do we price a bond? It depends on three things majorly. The credit rating of the organization, the interest rates in the market, and the bond maturity date.
- Credit Ratings: Credit rating agencies like S&P, Moody’s and Fitch generate credit ratings for a company. A good rating gives the company legitimacy to charge lower interest rates because interest is directly proportional to risk. The highest quality bonds are called ‘investment grade’ and are issued by very stable organizations and governments. If a particular company bond has low ratings, hence higher risk, the investor might demand a higher interest rate considering the risk involved.
- Market Interest: The price of a bond is almost always inversely proportional to the interest rates. This is so because any investor receiving a larger interest elsewhere wouldn’t buy the bond for its face value from a bondholder. Think about it, if you’re getting a 15% interest in the market compared to a 10% interest on a ₹100,000 bond, why would you buy this bond then? What investors do when they buy a bond on the secondary market like this is simple. The amount you pay for a ₹100,000 bond in this scenario, after you do all the fancy math on your spreadsheet should equalize what you would earn with a 15% interest rate. So you’d pay ₹90,737 and receive the ₹100,000 bond. Similarly, if the interest rate falls down to 5%, then the 10% interest bond is more valuable as it is shielded from any market movements and its fixed interest stays the same, so now it trades at what’s called a premium, in which, investors pay more than the face value of the bond coming out to be ₹108,843, in our case.
- Maturity Date: Finally, the tenure of the bond plays a part. An average investor has a better understanding of the markets a month from now than 3 years from now. Hence, the level of certainty of the businesses of the company issuing the bonds is gauged by investors. The longer the tenure, the higher the risk and the interest sought on a bond by investors go further up.
Classes of Bonds
Not everybody on the debt market gets the same class of bonds. There are different tranches of debt available and from top to bottom they are called senior secured debt, senior unsecured, subordinate and unsecured debt. In this hierarchy, the senior debt holders get paid first in the event of insolvency and so forth. So what happens in the event of bankruptcy when there isn’t enough to pay off all the debtors even after selling assets of a company? There are many solutions to this and every bank probably has its own. We’ll take a look at different varieties of bonds to learn more.
Varieties of Bonds
Bond varieties are differentiated by their interest rates, coupon payments, embedded options and more:
- Zero-Coupon Bond: Zero-coupon bonds do not make coupon payments. That is not to say they do not pay interest. They are actually issued at a discount of the face value (say ₹95,000), and the investor gets paid the full face value (₹100,000) upon maturity. The difference between the face value and the discount price is the earning for the investors.
- Perpetual Bond: Perpetual bonds make coupon payments throughout the lifetime of a company. Bonds with maturity above a hundred years are also called perpetual bonds.
- Convertible Bond: Simply put, convertible bonds have options embedded in them to be converted into stock depending on certain conditions at a pre-set conversion price. In bankruptcy, some investors have their stock converted to equity when the asset sell-off isn’t enough to pay them.
- Callable Bond: A callable bond is one where the issuer can ‘call’ the buyback of debt before the maturity date. If a particular bond is issued with a 10% coupon maturing in 4 years, issuers can call back the bond if the interest rates have fallen before maturity, for instance, 7%. What a company does then offers new bonds to investors at a lower interest rate. As the callback bond certainly comes with such a risk, they are usually issued at a higher interest rate.
- Puttable Bond: It is the opposite of a callable bond wherein, the bondholder can ‘put back’ or sell the bond to the issuer at a specified price before the maturity date. So the ball is in the investor’s court and hence, these are issued at a low-interest rate. These bonds trade at a higher value owing to their flexibility in the hands of their holders.
- Fixed-Rate Bond: This refers to a bond that helps one to receive a fixed interest rate throughout the tenure of the bond. On maturity, the investors will receive the initially invested amount along with the fixed interest. Longer the tenure of the bond, the higher the interest received as compared to the short-term bond. In this type of bond, an investor can almost accurately estimate the returns on maturity along with the interest rates. But if the bond issuer defaults, then this calculation can go wrong. It also possesses ‘interest rate risk’, that is due to its fixed period of investment, the interest rate remains the same and there might be a time when the market interest rate will be more than the interest rate that your bond offers. This can be a drawback.
- Floating Rate Bonds: The opposite of fixed-rate bonds, with these bonds, the interest rate of the bonds keeps on changing after a certain period of time, as per the changes in the underlying securities or index in the market. This interest rate is revised after a certain period of time. In these types of bonds, ‘interest rate risk’ can be eliminated to a greater extent. Here, accurately calculating the estimated return is not possible.
- Sovereign Gold Bonds: These bonds are issued by the RBI (Reserve Bank of India) on behalf of the Government of India. Basically, these bonds refer to government securities that are denominated in grams of gold. If someone is looking for a substitute to buying physical gold, these bonds are for them. Here the investment has to be done in cash and also bonds are to be redeemed in cash, on maturity.
The benefits of possessing these types of bonds are:
- No need to bear the risk of storing the physical gold
- The cost of storing physical gold is ruled out
- No need to worry about purity or making charges of gold in jewellery.
- The interest is paid semi-annually by crediting in the investors’ account.
- They can be used as collateral while applying for loans from financial institutions, banks and NBFCs.
- Inflation-Indexed Bonds: Here, the principal amount and interest rate is inflation-indexed. The principal is adjusted to the wholesale price index (WPI). The periodically adjusted principal determines the fixed interest rate that needs to be paid to the investors. These bonds try to protect the investment against inflation and at the same time, give security of capital. As the principal amount is linked with the inflation rate, any changes in the inflation rate impacts the principal.
- 7.75% GOI Savings Bonds: These bonds have a 7.75% interest rate per annum. The tenure of the bonds is 7 years. These bonds can be good substitutes for fixed deposits, as they offer fixed interest rates that are slightly higher than FD. It is more suitable for people looking for safe returns and regular income. But they are not tradeable, not transferable and also they cannot act as collateral for the loan.