Bonds : Meaning, Types, Categories & Advantages

What is Bond?

A bond is defined as a debt asset that reflects an investor’s loan to a borrower, usually an authority or a firm. When a company issues a bond, it is borrowing money from investors and promising to pay periodic interest payments (coupon payments) and repay the entire principal amount (face value or par value) at the end of the bond’s term. Bonds are important for several financial reasons,

• First, frequent coupon payments give investors a constant income stream, making them essential for income-focused strategies.
• Second, because bonds are less volatile than equities, they help investors preserve capital.
• Third, bonds help investors diversify risk across asset types.
• Fourth, bond credit ratings let investors evaluate issuers’ creditworthiness, enabling smart investments.
• Lastly, the bond market helps governments and enterprises raise funds for initiatives, promoting prosperity and stability.

Who Issues Bonds?

Governments and organisations issue bonds to raise funds. By purchasing a bond, you are making a loan to the issuer, who agrees to repay the face value of the loan on a particular date and to pay you periodic interest payments along the way, usually twice a year. In India, the Central Government issues both Treasury bills and bonds or dated securities, whereas the State Governments exclusively issue bonds or dated securities, known as State Development Loans (SDLs). G-Secs have almost no default risk and are thus referred to as risk-free gilt-edged products.

How Do Bonds Work?

Bonds function as debt instruments, allowing institutions such as organisations or governments to raise funds by borrowing from investors. Understanding how bonds work involves understanding the major mechanisms at work about their issue, payment of interest, prices, and maturity. Here’s a detailed description of how bonds work,

1. Issuance: The issuer, which might be a government or a firm, decides to raise funds through bond issuance. The issuer determines the bond’s face value, coupon rate, maturity date, and other terms.

2. Investors’ Purchase: The debt instruments are then promoted for sale to primary market investors. Bonds are purchased by investors at the initial public offering price, which is usually the face value.

3. Payments with Coupons: Bonds give bondholders periodic interest in the form of coupon payments. The coupon rate is determined at the time the bond is issued, and the rate of interest is computed as a proportion of the face value.

4. Price Fluctuations in the Market: The market price of a bond can fluctuate due to a variety of reasons, including fluctuations in rates of interest, economic conditions, and the creditworthiness of the issuer. Existing bonds with cheaper coupon rates can be sold at a discount to their face value if prevailing interest rates rise after the bond is issued.

5. Yield: A bond’s yield is the effective return an investor receives after accounting for the present market price, coupon payments, and the period to maturity. Yield is calculated as a percentage and may differ from the coupon rate. The yield is different from the coupon rate when a bond moves at a premium or discount.

6. Maturity: Bonds have a predetermined completion date, which is the date on which the issuer repays the bondholders’ principal (face value). The bond ceases to exist upon maturity, and the issuer fulfills its duty by paying the principal value to the bondholder.

7. Trading on the Secondary Market: Bonds may be purchased and traded on the secondary market after they have been sold in the primary market. Bondholders who intend to sell their bonds before maturity can do so on the secondary market. The secondary market pricing can be affected by factors such as interest rate movements and the issuer’s credit position.

Categories/Varieties of Bonds

Bonds come in a variety of forms, each customised to certain investor demands or preferences. Here are some examples of bonds,

1. Government Bonds: These are debt securities that are issued by governments to pay public spending. US Treasuries, UK Gilts, and Japanese Government Bonds (JGBs) are a few examples.

2. Municipal Bonds: These are bonds issued by municipal governments or municipalities to support public works projects like schools, roads, and utilities. Municipal bond interest is frequently tax-free.

3. Corporate Bonds: These are bonds that are issued by companies to raise funds for a variety of reasons, such as growth or debt refinancing. Corporate bonds are classed according to their creditworthiness (investment grade or lucrative) and industry.

4. Zero-Coupon Bonds: These kinds of bonds do not pay interest regularly (coupon payments). They are instead issued at a discount to face value and eventually mature at face value. The gap between the buying price and the face value profits investors.

5. Convertible Bonds: Give bondholders the option of converting their bonds into a set number of common stocks of the issuing firm. This enables investors to profit from prospective stock price increases.

6. Floating Rate Bonds: The interest rate on these bonds changes in response to changes in benchmark interest rates. Because the coupon payments adjust regularly, this helps shield investors from interest rate risk.

7. High-Yield Bonds (Junk Bonds): Issued by lower-rated corporations that are more likely to default. High-yield bonds pay higher interest rates to compensate for the heightened credit risk.

8. Sovereign Bonds: These are bonds that are issued by foreign governments and are priced in a currency other than the investor’s home currency. Eurobonds and Samurai Bonds are two examples.

9. Green Bonds: These are bonds that have been issued to fund environmentally beneficial projects. The funds will be used for projects that have a favourable environmental impact, such as renewable energy or sustainable infrastructure.

10. Sukuk (Islamic Bonds): Sukuk are Islamic bonds that indicate investment in a commodity, service, undertaking, or business. The performance of the underlying asset is used to calculate returns.

11. Perpetual Bonds: They have no maturity date and hence pay interest eternally. The principle is not obligated to be redeemed by the issuer. Perpetual bonds are also referred to as “consols.”

12. Inflation-Linked Bonds: These bonds are intended to safeguard investors from inflation. The principal amount varies in response to fluctuations in the Consumer Price Index (CPI), to guarantee the investment keeps up with inflation.

13. Callable Bonds: Enables an issuer to redeem the bonds at an agreed-upon call price before maturity. Callable bonds give issuers flexibility, but they expose buyers to the risk of reinvestment if interest rates fall.

14. Foreign Bonds: Bonds issued by foreign governments or companies in the issuing country’s currency. Currency risk exists for investors because volatility in currency exchange rates may impact returns.

15. Asset-Backed Securities (ABS): Securities that are secured by a group of assets, such as mortgages or vehicle loans. Payments are made to investors according to the revenue produced by the assets that are being invested.

16. Secured Bonds: Bonds that are collateralised by the issuer’s specified assets. Investors have an entitlement to the actual securities if the issuer defaults. Secured bonds include mortgage-backed securities (MBS).

17. Unsecured bonds (Debentures): Unsecured bonds are those that are not secured by specific collateral. Rather, they depend on the overall creditworthiness of the issuer. Debentures are a sort of unsecured bond that is commonly used.

How are Bonds Priced?

Investors should be aware of bond pricing conventions. Bonds are not traded in the same manner that stocks are. When compared to observing the value of a stock or mutual fund fluctuate, the pricing dynamics that drive bond market fluctuations do not appear as clear. This is because stocks and shares are traded based on their expected future worth (based on prospective earnings growth). Every debt instrument has a par value and can trade at, above, or below par depending on the market. The interest payment on a bond is fixed. If the bond’s price varies, so does the bond’s yield, which refers to the annual interest rate concerning the present market price.

Bond Prices and Interest Rates

Bond prices have a negative correlation with interest rate fluctuations; that is, if market rates rise following a bond issue, bond prices fall, and vice versa. Let me illustrate this with an example. Assume ABC Ltd issued bonds with a face value of ₹100 and an interest rate (also known as a coupon in bond terminology) of 10% per annum a year ago. The rates of interest have generally been falling over the last year, thus ABC Ltd is issuing new bonds at 9% today. The price of the previous bonds, which were issued with a 10% coupon, would now rise above their face value, to say ₹105. This is because the old bonds are being priced concerning the current interest rate. Even in today’s low-interest rate environment, investors receive the same ₹10 coupon from the old bond and are willing to pay a premium over its face value. The amount of impact on bond prices is determined by the coupon rate and the bond’s residual maturity. For the same interest rate movement, lower coupon rate bonds are more influenced than higher coupon rate bonds. Similarly, bonds with a longer residual maturity (years until maturity) are harmed more than those with a shorter duration.

Types of Bonds

Among the various various types of bonds are:

1. Bonds with Fixed Interest Rates: Fixed-rate bonds pay continuous payments until they mature. Bondholders receive consistent and guaranteed returns regardless of market conditions. For example, on April 20, 2003, an investor purchased a ₹1000 ten-year fixed-rate government bond with a coupon rate of 7.5%. The investor would receive a fixed interest of ₹75 each year until April 20th, 2013.

2. Bonds with Floating Interest Rates: Floating-rate bonds do not provide consistent returns. Instead, interest rates fluctuate throughout time depending on the benchmark. For example, in 2015, a customer purchased an 8-year variable rate bond. The bond pays 40 basis points more than the current National Savings Certificate interest rate. This means that the NSC interest rate is the benchmark, and any changes in it have a direct impact on the coupon payment of this bond.

3. Bonds with No Coupon: These bonds, as the name implies, do not pay regular coupons throughout their tenure. These bonds, however, have been issued at a discount and are repaid at the par value. The return for investors is the difference. For example, suppose an investor pays ₹700 for a 20-year zero-coupon bond with an initial value of ₹1000. The issuer will pay the bondholder Rs. 1000 at the end of 20 years.

4. Permanent Bonds: Perpetual bonds are debt securities that have no maturity date. The issuer does not refund the principal amount to the bondholders under this form of bond. Nonetheless, they continue to provide consistent coupon payments to bondholders in perpetuity.

5. Bonds Linked to Inflation: These bonds are designed to reduce the impact of inflation on the face value and coupon payments. The principle is updated for inflation, and coupon payments are calculated using the adjusted principal. For instance, suppose an investor buys an inflation-linked bond with a face value of ₹100. The inflation-adjusted principle after a year is ₹107. As a result, the coupon will be calculated using ₹107 for that period.

6. Convertible Bond: Convertible bondholders have the right to convert the bond into an agreed-upon amount of equity shares in the issuing firm at a specified period during the lifespan. If the investor is not willing to swap the principal for shares, they can choose to receive it at maturity.

7. Callable Bonds: Callable bonds are high-yielding securities that provide the issuer the right to call the bonds back at a predetermined price and date.

8. Puttable Bonds: Puttable bonds allow the bondholder to forfeit the bond and request a return of principal at a predetermined date before maturity. Because the advantage provided is for buyers, the returns on these bonds are smaller.

Why Should You Buy Bonds?

Bonds are issued by governments and enterprises to raise funds. By purchasing a bond, you are making a loan to the issuer, who agrees to repay the face value of the loan on a particular date and to pay you interest at regular intervals, usually twice a year. Unlike stocks, corporate bonds provide you with no ownership rights. So you don’t necessarily gain from the firm’s development, but you also don’t see as big of an effect when the business isn’t doing so well as long as it still has the wherewithal to keep its loans current. Bonds, as part of your portfolio, can provide you with two potential benefits, they provide a steady stream of income while mitigating some of the risk associated with stock ownership.

Advantages of Investing in Bonds

Bond investing has various advantages, making it an appealing alternative for a wide range of investors. Here are some important benefits of bond investing,

1. Consistent Income Stream: Bonds pay bondholders recurring interest, known as coupon payments. This consistent income stream is especially enticing to revenue-focused investors, such as retirees, who rely on consistent cash flow.

2. Capital Preservation: Bonds are often thought to be less hazardous than stocks and are often regarded as a more conservative investment. The restoration of principal at maturity protects capital, particularly for bonds issued by reliable organisations.

3. Diversification: Bonds can be quite useful in diversifying an investing portfolio. They frequently have little to no association with stocks, which means they may react significantly to market conditions. Bonds in a well-diversified portfolio can help to minimise overall portfolio risk.

4. Security and Safety: Government bonds, particularly those that are issued by financially sound governments, are regarded as among the safest investments. Even corporate bonds issued by respectable corporations with excellent credit ratings might give some protection when compared to riskier assets.

5. Predictable Returns: Fixed-income products, such as bonds, have a known interest rate, allowing investors to calculate and forecast their future returns. This regularity might be advantageous in terms of financial preparation and investment strategy.

6. Variety of Options: Bonds are available in a variety of formats, such as bonds issued by governments, bonds for municipalities, corporate bonds, and convertible bonds. This variety allows investors to select bonds that match their risk tolerance, income requirements, and investment objectives.

7. Potential for Capital Appreciation: While bonds’ primary job is to pay income, they can also bring capital appreciation. If market interest rates fall after a bond has been issued, the present bond may become more appealing, potentially leading to a price increase.

8. Liquidity: Bonds are frequently traded in the secondary market, which provides investors with liquidity. This means that investors can readily acquire and sell bonds, particularly government and high-quality business bonds.

9. Tax Benefits: Certain forms of bonds, like municipal bonds, may provide tax benefits. Municipal bond interest income is frequently excluded from the government’s income tax, and in some situations, it may also be exempt from state and local taxes.

Factors Affecting Bond Prices

For initial investors who want to retain bonds until maturity, the market value is unimportant because they will get regular interest and subsequently the principal amount at maturity. The market value is critical for investors who want to acquire and sell securities on the secondary market. The following are some of the elements that impact bond prices,

1. Rates of Interest: There is an inverse correlation between bond valuation and market interest rates. The net present value of a bond is computed using the current interest rate on the market as the discount rate. When the discount rate on a bond rises, the market interest rate rises, and the discount rate on cash flow rises the bond’s value declines. When the bond interest rate falls, the value of the bonds rises as the related future cash flows are discounted. This leads to a greater bond value.

2. Maturity of Bonds: Long-term bond prices, which have a longer maturity date, are prone to move based on interest rates. Bond valuations decrease faster for bonds with longer maturity periods as interest rates rise than for bonds with shorter maturities. This is often referred to as the bond term factor.

3. Bond Credit Score: The credit risk profile of an issuer is determined by the bond credit rating. This is offered by organisations such as CRISIL, CARE, and ICRA and is denoted as AAA, AA, and A in decreasing order in terms of financial strength. A high-credit-rating issuer will usually be able to service the bond’s coupon payments and principal payments on time. The greater the yields, the poorer the credit ratings. As a result, investors are more ready to invest in low-rated bonds. When a bond’s credit rating changes, so does its price. A poor credit rating reduces the value of a bond, whereas higher yields enhance its profit. A high credit rating, on the other hand, will increase the bond’s value while decreasing its yield. As a result, before investing in bonds, investors must conduct adequate research on the issuer and comprehend its financial strength.

4. Structure of Bonds: The price of a bond might vary depending on the bond’s structure. A floating rate coupon bond, for example, does not move as much with interest rates as a fixed coupon rate bond. Furthermore, Call and Put Options can affect bond pricing as maturity approaches. A Call Option is one in which the issuer has the right to redeem a bond before its final maturity, whereas a Put Option is one in which the bondholder has the right to demand repayment before maturity.

5. Market Situation: Bond prices can be influenced by broad market conditions. When the shares are rising and the country’s economy is performing well, it is usual for investors to shift their money away from bonds and into equities. When equities markets experience a correction or collapse, investors become risk cautious and migrate to the greater security of bonds, causing bond prices to climb.

6. Inflation: Bond prices generally fall during times of inflation. This is due to investors’ need for higher yields to make up for inflation. Bond prices, on the other hand, tend to climb during periods of declining inflation.

Taxation on Bonds

Bonds provide income to investors in two ways: interest and capital appreciation. In India, the following are the tax structures for various bonds,

1. Regular Taxable Bonds: These bonds are taxable, as the name implies. These bonds can make you money in two ways, capital gains and interest. Income generated by the investor at the point of maturity is referred to as capital gains. Capital gains are the difference in price between the sale and acquisition prices of bonds. Individuals earn interest on bonds, which is added to their gross total income and taxed at the applicable slab rate.

2. Tax-Exempt Bonds: Ministries and PSUs issue such bonds to raise funding for a variety of national-importance initiatives. Tax-free bonds are issued by the government to fund infrastructural and welfare-related projects like as roadways, transportation systems, harbors, development of towns and villages, and so on. The interest generated from these is tax-free for investors. However, based on the holding duration, the returns obtained from these bonds upon maturation or sale are classified as LTCG or STCG.

3. Tax-Saving Bonds: Individuals who own any long-term capital asset, such as land or a building, can save money on taxes by investing in these bonds. They can reinvest the revenues from the sale of these assets in 54EC bonds. These bonds provide complete LTCG tax exemption. This tax benefit, however, will only be available if the interval between sale and investment is less than 6 months. These can result in capital gains for investors. Capital gains are taxed as either LTCG or STCG. The government also permits investment deductions of up to ₹20,000 per year. It is more than the ₹1.5 lakhs deduction under Section 80C. 54EC bonds can be issued by NHAI, REC, and PFC.

4. Zero Coupon Bonds: A coupon is the interest that investors receive when they invest in a bond. Zero coupon bonds do not pay interest but can be purchased at a significant discount. On maturity, the investor gets the full face value. Because there is no recurring interest payment, there is no interest tax. Capital gains can be earned by investors; capital gains are taxed as LTCG or STCG. These bonds can only be issued by NABARD, REC, and certain government agencies.

Conclusion

In conclusion, bonds are essential to finance, allowing investors, institutions, and governments a wide range of investment possibilities. Their face value, coupon rates, credit ratings, and maturity dates make them useful securities for investors. Bonds diversify investment portfolios and provide a constant income stream through coupon payments. Any investment requires knowledge and understanding to make smart choices. Bonds’ characteristics, variations, and risk profiles provide investors with a variety of ways to attain financial goals, maintain wealth, and participate in global financial markets. Bonds provide income and strengthen diversified investment portfolios in the ever-changing financial world.