What is a bond?

Bonds are debt instruments issued by a company for raising funds that are highly tradable in the market. So what does that mean? In simple terms, bonds are certificates of loans used by borrowers and lenders. They’re investment securities where an investor lends money to a company or the government for a fixed period of time, in exchange for regular interest payments called “coupons”. When the bond matures, the bond issuer returns the investor’s money. 

They often have a fixed rate and can be traded. They are usually issued to borrow money for building roads, schools, railway tracks, buildings and other projects. They have important details, including the date when the principal of the loan is due to be paid along with the interest, the terms of whether the interest is fixed or variable and the interest rate.

Bonds are also commonly described as “fixed income” since the investment earns certain fixed payments over the tenure of the bond. 

How do bonds work?

Let’s say someone decides to lend money using bonds and they buy a bond of ₹10,000 at a rate of 10% per annum with a maturity rate of 3 years. So, they will get 10% of 10,000 which is ₹1000 rupees at the end of every year and at the end of year 3, they will get their final ₹1000 along with the principal amount of ₹10,000.  So, in this case, the person is getting a profit of ₹3000.

Basics of Bonds:

The above example explains how a basic corporate bond works but there are some things one should know before investing in them. 

  1. Bond prices are inversely proportional to investment rates: they fall when rates go up and vice-versa.
  2. Corporate bonds have higher rates than government bonds as they are riskier.
  3. The bond markets are very liquid and active but they are misconstrued as taking a back seat to stocks and not seeming to be the best place for part-time investors. However, that is not true as bonds provide a great way of investment for everyone as it provides diversification.
  4. A coupon or coupon payment is expressed as a percentage of the face value and paid from the issue date until maturity. 

Different Types of Bonds:

  1. Government Bonds: Government Security (G-Sec) is a tradable instrument issued by the Central or State Governments for periods ranging from 5 to 30 years. G-Secs, in most cases, have no risk of default and are called risk-free gilt-edged instruments. The government usually resorts to issuing such bonds when it faces a liquidity crisis and requires funds for the purpose of infrastructure development. Initially, G-Secs were issued for the purpose of large investors, such as companies and commercial banks. Eventually, the Government of India made G-Secs available to smaller investors such as individual investors and cooperative banks. The reasons why people prefer government bonds are that they are risk-free, give good returns over the long term, offer good liquidity and diversify their portfolio. Buyers are enticed by paying out the face value listed on the bond certificate on the agreed maturity date, while also issuing periodic interest payments along the way. This characteristic makes government bonds attractive to conservative investors. There are two types of G-Secs:

(a) Central Government Bonds: They are issued by the RBI on behalf of the governments for raising funds, which are used to meet the deficits of the government budget. It offers types of bonds including treasury bills, cash management bills and dated securities, which differ from each other on the basis of maturity periods and interest offered. 

(b) State Government Bonds: Government bonds issued by State Governments are called SDLs (State Development Loans).  These bonds are issued in facilitation with the Reserve Bank of India using the negotiated dealing system. SDLs are dated securities issued through a normal auction similar to the auctions conducted for dated securities issued by the Central Government. They offer higher interest rates than Central Government Bonds, in most cases. These bonds are very similar to Central Government Bonds and are equally safe. This makes them low-risk investments.

  1. Municipal and Local Authority Bonds: A municipal corporation or a local authority may raise funding in the form of these bonds for specific goals such as constructing infrastructure or public waterworks. Municipal bonds have existed in India since 1997. In 2015, the Securities and Exchange Board of India (SEBI) circulated detailed guidelines for urban local bodies to raise funds by issuing municipal bonds. It has been mandated that municipal bonds must have a rating above the investment-grade for public issues, must come with a maturity period of three years and financial institutions like banks must be delegates as a fiscal bureau. These bonds are usually low-risk, but one must invest in them after researching carefully.
  1. Corporate Bonds: These are debt funds issued by public or private companies that lend their money to companies with the highest possible credit rating. This rating is given to companies that are financially strong and have a high probability of paying lenders on time. Companies issue corporate bonds to raise money for a sundry of reasons, such as financing current operations, expanding product lines or opening up new manufacturing facilities. Corporate bonds usually describe longer-term debt instruments that provide a maturity of at least one year. These are high-risk bonds since their maturity depends on the track record of the company. Before investing in such bonds, one must do a complete study into the company and its performance.
  1. Public Sector Bonds: These bonds are issued by highly rated public sector companies for meeting their growth and expansion needs. They are essentially medium or long-term debt instruments issued by PSUs such as railways, electricity boards, housing boards and water boards, that are owned and managed by the Central or the State government. PSU bonds started in the 1980s when the Central Government reduced funding to PSUs through the general budget. The market for PSU bonds has grown substantially over the past two decades. Most of these are issued by infrastructure-related companies such as railways and power companies with their sizes varying widely from ₹10-₹1000 crores. They have maturities ranging between 5-10 years. The majority of PSU bonds are privately placed with banks or large investors. Usually, bonds issued by state-owned PSUs carry interest payment and principal payment guarantees by the respective State government. These bonds are relatively less risky since there is government affiliation.
  1. Tax-Free Bonds: As the name suggests, tax-free bonds exempt the investor of taxes, as per Section 10 of the Income Tax Act of India 1961. They offer a fixed interest rate and hence is a low-risk investment avenue. The chances of defaulting on interest payments are very low, as these schemes are from the government itself. They also offer capital protection, fixed monthly or annual income and are, thus, considered safe. Tax-free bonds generally have a long-term maturity of ten years or more. The rate of interest offered on tax-free bonds generally ranges between 5.50% to 6.50% annually. In India, they are offered by government public sector companies like the NHAI (National Highway Authority of India), the NTPC (National Thermal Power Corporation), the HOUDC (Housing and Urban Development Corporation), the REC (Rural Electrification Corporation) and the IREDA (Indian Renewable Energy Development Agency). The interest earned on these bonds is completely tax-free in the hands of the investor. 

6. Mortgage-Backed Bonds: These issues, which consist of pooled mortgages on real estate properties, are locked in by the pledge of particular collateralized assets. They pay monthly, quarterly, or semi-annual interest. 

7. Emerging Market Bonds: Issued by governments and companies located in emerging market economies, these bonds provide much greater growth opportunities, but also a greater risk than domestic or developed bond markets.

Trading of Bonds:

  1. Primary Market:

This is the market where the borrower approaches investors to raise capital. The issue price of the bonds and the coupon rate is fixed at the time of raising capital.

  1. Secondary Market:

Most of the bonds are traded in the stock market. They can be sold depending on when the investor wishes to exit from the bond. However, it is to be noted that the price of the bonds depends on how close the bond is to interest payment. As the bond nears the interest payment date, the price goes up. The price and coupon rate of the bond move inversely i.e if the price goes up, the interest rate goes down and vice versa. This is because the net return to the investor stays the same as when the bond was issued in the primary market.

If bonds get insurance in the primary market, then they are traded between investors in the secondary market. Most bonds are not traded in the secondary market via exchanges. Rather, bonds are traded over the counter. There are several reasons why most bonds are traded OTC, but the chief one is diversity.

Why should one invest in bonds?

This must be a question on anyone’s mind while reading about bonds, some great advantages of investing in bonds are:

  1. Steady and safe source of income: When a person invests in bonds, they are provided with a reliable and steady source of income. The rates of bonds may not be high but they provide a reasonable profit. It is a safer option when compared to stocks and they have higher interest rates than money market funds.
  1. Diversification: In today’s day and age, one always focuses on risk vs reward and bonds are easily classified as low-risk investments. It is often said that it is a good option to invest money in various areas, rather than putting it all together; that way, you always have security. Bonds are a safe place to invest.
  1. Preserving principal: Bonds guarantee a return of the principal, so even if you don’t have a profit, at least you won’t make a loss. This property of bonds makes it more appropriate for people who might need cash for a particular reason, such as parents who have kids going to college soon or in unprecedented circumstances like the COVID-19 pandemic. Those who don’t wish to invest in stocks for fear of losing money can do so in bonds, as it is comparatively safer.
  1. Tax advantages: Certain types of bonds are useful for relieving tax burdens, most money market funds and equities are taxable however municipal bonds are tax-free, making it a preferable option.

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