What are Bonds?

A bond is a kind of debt security. Lenders issue bonds to raise capital from investors who are willing to provide a loan to them for a certain period. When one buys a bond, they provide financing to issuers as a form of loan, which can be a corporation or government. In exchange, the issuer agrees to pay them a specified interest rate while the bond exists. Additionally, the issuer pays the principal amount when the bond “matures,” or falls due, after the predetermined time. Let’s understand in detail what bonds are, their types, who issues them, their characteristics, and more.

Key Highlights

• Bonds are debt securities where investors lend money to companies or governments for a specified period.

• When purchasing a bond, investors receive interest payments and the return of the principal amount at maturity.

• Bonds serve as a way for organizations to raise capital while providing investors with fixed-income investments.

• There are various types of bonds, including callable bonds, fixed-rate bonds, zero-coupon bonds, and floating-rate bonds.

• The creditworthiness of the bond issuer impacts the interest rate offered and the level of risk for the investor.

Understanding Bonds

Bonds are securities in which investors lend money to a company or government for a specified period and the bond issuer pays interest in return. The bond between the lender and the borrower is considered as I.O.U. (I owe you) as it includes aspects like the loan terms and repayment schedule. Additionally, bonds earn a fixed rate of return over their lifespan, they are often referred to as fixed-income investments.

How do Bonds Work?

Organizations such as governments, and corporations issue bonds to investors. Companies usually sell bonds to finance their ongoing business operations, new projects, or acquisitions. Governments sell bonds to raise money. An investor buys bonds at principal value, which issuers pay at the end of a specified period. Along with this, issuers pay a fixed rate of interest rate the principal amount.

The institution’s loan portfolio is legally and financially accessible to investors who purchase bonds. If the company faces bankruptcy, the creditors will pay the amount to the bondholders before the stakeholders do. 

In addition, each bond carries a risk of default by the issuer. Although, many credit rating agencies evaluate the credit risk of lenders. Investors can access information on the credit ratings of the particular organizations in which they are planning to invest. This may help them assess risk and understand interest rates.

Lenders with lower credit ratings usually pay higher interest rates on their loans. On the other hand, an organization with a low credit rating may offer better interest rates, but there might also be certain risks. Hence, an investor is suggested to consider all the important factors before investing and choose accordingly.

Types of Bonds

There are various types of bonds available to investors. These can be categorised by amount, type of interest rate, or coupon payment i.e. interest rate. The following is the list of the some common types of bonds:

• Callable Bonds: When an issuer calls the right to redeem a bond before maturity, it is called a callable bond. This offers flexibility to manage debt obligations to investors.

• Fixed-Rate Bonds: Bonds whose coupon rate or interest rate remains constant during the term or period of issue are called fixed-rate bonds. This type of bond ensures that the investor or a bondholder may receive a better rate of interest constantly throughout the lifespan of the investment. The lock-in period of such bonds is usually for 1-5 years.

• Zero-Coupon Bond: A zero-coupon bond occurs when the coupon rate is zero and the bond issuer pays only the principal to the investor at maturity.

• Putable Bond: In this kind of bond, the investor sells their bond and gets their invested amount back before the maturity date.

• Floating-Rate Bond: The interest rate that varies over the investment tenure is called a floating-rate bond. This means this type of bond usually does not pay a fixed rate of interest. The interest rate is adjustable and impacted by factors such as the reference rate. This additionally protects investors from interest rate risks.

What are Different Bond Categories?

The different categories of bonds include:

• Government Bonds: These are bonds issued by the Government of India and State Governments. RBI i.e. The Reserve Bank of India controls and regulates government bonds. This type of bond generally consists of low interest rates.

• Asset-Backed Securities: Asset-backed securities are bonds issued by banks or various financial institutions. This type of bond is severed against various pools of loans that have similar characteristics. This pool usually consists of various assets, and repayments and interest rates on these assets can be experienced by bondholders.

• Corporate Bonds: These are bonds issued by private companies. This bond consists of both types i.e. secured bonds and unsecured bonds. Companies offer it to raise capital at low interest rates. Corporate bonds may offer varying interest rates and maturity periods, which depend on market conditions and the creditworthiness of the company.

• Municipal Bonds: Municipal bonds are issued by municipalities or government entities. These bonds came into the picture when the government wanted to raise funds for public development projects. Municipal bonds are available for short-term as well as long-term maturity periods.

Characteristics of Bonds

Bonds have several features that investors should be aware of. This includes: 

Face Value

Face value refers to the value of one unit of a bond issued by the company. Principal, nominal, or par are alternatively used to address the value of the bonds. Issuers have a legal obligation to return this value to the investor after a specified period.

Bond Tenure

A bond tenure indicates when the bonds will mature or the lifespan of the bonds. These are financial debt agreements between issuers and investors. The financial and legal obligations of the issuer to the bondholder are valid till the tenure’s end only.

Interest Rate/Coupon Rate

Bonds usually have fixed or floating interest rates over their tenure and pay these rates periodically to lenders. Traditionally, bond interest rates are also called coupon rates to find interest rates on paper bonds that are in coupon form. The yield rate of interest on a bond depends on various factors such as tenure, the reputation of the issuer in the public debt market, and creditworthiness.

Credit Quality

The credit quality of a bond reflects the creditors’ view or analysis of the issuer’s asset performance over a long period. The credit quality is determined by the factors like level of confidence that investors have in the company’s bond. Credit rating agencies classify bonds based on a company’s default risk on debt repayment.

Tradable Bonds

Bonds are traded in the secondary market. Ownership can therefore change between different investors within the tenure. These bondholders often sell their bonds to other entities when the market price exceeds the nominal value because they have the choice to opt for secure bonds that have the potential to provide better yields and favourable credit ratings.

Who Issues Bonds?

The bonds are usually issued by the following entities:

• Government: When government entities need money to support development projects such as making new roads, dams, schools, and other infrastructure projects they issue bonds. Generally, the credit rating of government bonds is quite good and is considered to be the secure and safest way to invest in bonds. However, this factor may also vary depending on the issuing government. Hence, choose wisely or consider consulting a financial expert before investing. 

• Corporations:  Companies also issue bonds to borrow finances to accelerate business operations. This operation includes expansion of business, buying property and equipment, investing in research and development, or hiring employees.

Advantages of Bonds

Bonds provide stability and income for investors but also come with certain risks. The following are the benefits of bonds –

1. Stability: Bonds provide a steady income stream and are less volatile than stocks, making them suitable for risk-averse investors.

2. Legal Protection: Bondholders have a legal claim to repayment and usually receive priority over shareholders in case of company bankruptcy.

3. Portfolio Diversification: Including bonds in an investment portfolio can help spread risk and potentially improve overall returns.

4. Predictable Income: Bonds pay regular interest, allowing investors to plan their cash flow more effectively.

Disadvantages of Bonds

1. Inflation Risk: Bond returns may not keep pace with inflation, potentially leading to a decrease in purchasing power over time.

2. Lower Returns: Bonds typically offer lower returns compared to stocks, which may limit long-term growth potential.

3. Limited Liquidity: Bonds are often less liquid than stocks, making it harder to sell them quickly without incurring penalties or fees.

4. Interest Rate Sensitivity: Bond prices can fluctuate based on changes in interest rates, potentially affecting their value.

Things to Consider Before Investing in Bonds

The following are several factors that one should know and consider before investing in bonds:

• Bond Quality: The quality of the bond is the most important factor when choosing to invest. It shows the probability that bondholders will receive fixed cash flows on specific dates. Hence, choose wisely.

• Calculating Yield: There are two methods of calculating yield. One is the current yield (annual interest payments divided by market value). The other is the yield to maturity (YTM) which is more realistic for bond calculations. The formula for YTM is [(face value/present value)1/duration]-1. The YTM is compared to the coupon rate/interest rate which allows bondholders to decide whether to continue the investment or not.

Conclusion 

Bonds can help you have a steady and secure income. This means bonds are suitable for people looking for potentially better returns with reduced risk factors. Furthermore, bonds provide stability, legal protection, and portfolio diversification. Although bonds offer many benefits it has some risks associated as well that investors should equally consider while making investment decisions. Investors need to be aware of factors such as inflation risk, lack of earnings, and potential returns with the investment. This helps investors make the right choice according to their risk tolerance and investment objectives. It is recommended that you do research or consult with a financial advisor before making an investment decision.

FAQs on Bonds