What are Bonds?

Bonds are a type of investment where you loan money to a company or government for a set amount of time and they pay you back with interest. Bonds are usually issued by governments, corporations and municipalities. Bonds are usually issued as NCDs (Non Convertible Debentures) that will not convert to equity shares on maturity. Bonds are considered less risky relative to equities and can provide a steady stream of time-based income.

Bonds have different maturity dates and a fixed interest rate. The interest rate on the bond, also known as the coupon rate, is determined at the time of issuance and remains fixed over the life of the bond. Bondholders receive periodic interest payments, usually monthly, semi-annually or annually until the bond matures and the principal amount is paid back.

Bonds are a good way to diversify your investment portfolio and reduce risk.

What are the different types of Bonds?

The common types of bonds are

Government bonds (or GSec); These bonds issued by the central bank like RBI on behalf of the central government. These bonds are considered to be very safe investments, as the government is least likely to default on its debt.

Corporate bonds: These are bonds issued by corporations - like banks, NBFC, microfinance companies, manufacturing and trading companies. These bonds are considered to be riskier than government bonds, as there is a greater risk that the corporation could default on its debt.

Municipal bonds:These are bonds issued by state and local governments like Indore Municipal Corporation. These bonds are typically less risky than corporate bonds and are now gaining favour among large municipal corporations in India.

High-yield bonds: These bonds are issued by companies with low credit ratings. These bonds are considered to be very risky, as there is a high risk of default. Investors with high risk appetite can look at these bonds as they offer higher returns.

MLDs: Market linked debentures (MLDs) used to be a type of tax-saving debt instrument. With MLDs, the interest payments were linked to an external market variable, in order to provide tax benefits to the investor. However, in the Finance Bill of 2023, this tax benefit has been removed.

Perpetual bonds: These bonds are typically issued to meet specific capital requirements viz. AT1 bonds by banks to meet their Tier1 capital requirements. Such bonds will also have a call/put date specified on which date the bond will be called by the Issuer or the investor will have an option to return the bond to the Issuer.

How do bonds work?

Bonds work by allowing a borrower, such as a corporation or government, to raise money by issuing bonds to investors. When a bond is issued, it has a face value, which is the amount of money that the borrower will repay to the investor at the maturity date. For example, let's say you buy a bond with a face value of Rs 10,000 at a coupon of 8% and a maturity date of 10 years. This means that the issuer of the bond will pay you Rs 800 per year in interest (8% of Rs10,000) for 10 years. At the end of the 10 years, the issuer will also repay you the principal amount of Rs10,000.The coupon could be paid monthly, semi-annually or annually.

The coupon rate is set at the time of issuance and is typically based on prevailing market interest rates, the creditworthiness of the issuer, and the length of the bond term. When interest rates rise, newly issued bonds will typically have higher coupon rates to attract investors. Conversely, when interest rates fall, new bonds may have lower coupon rates. Bonds offer the flexibility of being bought and sold on secondary markets, just like stocks. This provides an opportunity for the investor to sell when liquidity is needed.. The market value of a bond will fluctuate based on changes in market interest rates and the creditworthiness of the issuer. If interest rates rise, the market value of existing bonds will fall because their fixed interest payments are less attractive than the higher interest rates offered by new bonds. If interest rates fall, the market value of existing bonds will rise because their fixed interest payments become more attractive than the lower interest rates offered by new bonds.

When a bond matures, the borrower repays the face value of the bond to the investor, and the investor stops receiving interest payments. Bonds can also be called, or redeemed, before their maturity date if the issuer chooses to do so. In this case, the investor is paid the face value of the bond plus any accrued interest up to the call date.

The risk of default is typically higher for corporate bonds of the Issuer with weak financials or those having challenges in business environments. This is because such Issuers are more likely to go bankrupt.

Bonds can be a valuable addition to a diversified investment portfolio. They can provide investors with a steady stream of income and a way to reduce their overall risk.

What are the risks of investing in bonds?

Bonds are considered to be relatively safe investments compared to equity, but they are not without risk. Some of the most common risks of investing in bonds include:

It is important to understand these risks before investing in bonds. By understanding the risks, you can make informed investment decisions and manage your overall risk.

What kind of returns can I expect from investing in bonds?

It's important to note that the returns from investing in bonds are typically lower than the potential returns from investing in stocks, but bonds are generally considered to be less risky. Investors who prioritise capital preservation or a reliable stream of income over capital appreciation may find bonds to be an attractive investment option.

How do I get started on investing in bonds?