Basics of Bond
A bond is debt security for investors and a debt obligation for the entities in which they invest. They are contractual obligations between the investor and borrower wherein the borrower promises to pay the entire principal, the invested amount, and a particular return when the bond matures.
To a bond issuer, bonds are liabilities or obligations employed for acquiring short-term financing. Bonds are generally issued in primary markets by governments & corporations to raise money. Institutional investors such as mutual funds, hedge funds, commercial banks, insurance companies, etc., are buyers in the primary market. The bond issued is then traded in the secondary market or stock exchanges at a certain coupon rate, where individual investors in public get to trade in them through brokers, intermediaries between investors and businesses.
Bonds are considered secure investments as they are less risky than their equity counterparts. However, risks arise if the borrowing entity fails to repay the bond value and/or profit. Also, bond prices & interest rates can fluctuate, causing bond yields to fluctuate. Bondholders then trade those bonds in the secondary market or stock exchanges for bonds with better coupon rates.
Let’s have a look at the different bond categories existent in India.
What are Different Bond Categories?
There are primarily four categories of bonds issued in Indian primary markets.
1. Corporate Bonds
Companies issue corporate bonds. Bonds are an excellent way for companies to raise money and get short-term funding from the public at low-interest rates and with significant benefits. Corporate bonds provide higher yields than government bonds, but their prices and yields are susceptible to interest rate risk, credit risk, and inflation risks.
2. Municipal Bonds
Municipal bonds are a form of government bonds issued by city or town municipalities. Though they pose higher risks than government bonds but lower than corporate bonds, government and municipal bodies generally pose zero risk of default or bankruptcy. But, they do suffer from inflation risk.
3. Government Bonds
Issued by central and state governments, government bonds in India are regulated directly by the Reserve Bank of India. As the country’s administrative bodies issue them, risks are nearly non-existent. Three subcategories of government bonds include bills ( less than one year maturity period), notes ( 1 to 10 years maturity period) and bonds ( maturity period more than 10 years).
4. Agency Bonds
Government-sponsored enterprises issue agency bonds. They are a subcategory of government bonds and come with greater credit risks. However, the risks associated are generally lower than a corporate bond of an equivalent amount, interest rate, and other key features.
5. Asset-Backed Securities
Asset-backed securities are debt securities linked to pools of asset-backed loans. Mortgage-backed securities are one of the most common types of asset-backed securities. Investors buy mortgage bonds linked to pools of secured bank loans offered by financial institutions. Mortgage-backed securities have house or land mortgages as primary securities or collateral.
Now, look at the various types of bonds issued and traded in India.
What are the Different Types of Bonds?
1. Traditional Bonds:
The most generic type of bond, a traditional bond, allows bondholders to withdraw the entire principal amount at maturity.
2. Callable Bonds:
A callable bond can be called out by the bond issuer at their discretion and redeemed before its maturity date. The bond issuer may also transform a high-debt bond into a low-debt bond.
Callable bonds are high-yield or junk bonds, which assure high returns but have a higher risk of default due to the poor credit rating of the bond issuer.
3. Fixed-Rate bonds:
These investment-grade bonds possess a fixed coupon rate throughout their tenure.
4. Floating Rate Bonds:
Unlike fixed-rate bonds, a floating-rate bond has its coupon rate varying throughout its maturity period.
5. Putable bonds:
Putable bonds are bonds where bondholders have the option to sell bonds and get their money back before the maturity date.
6. Mortgage Bonds:
These are asset-backed and mortgage-backed securities linked to mortgage-backed loan pools. House and real-estate backed act as primary collateral for a mortgage bond.
7. Zero Coupon Bonds:
A zero-coupon bond offers no coupon payments or interest return at maturity. Instead, buyers buy these bonds at a substantial discount on the bond’s par value. On maturity, bondholders get the full principal amount higher than the bond’s face value.
8. Serial Bonds:
A serial bond matures in a step-by-step manner. Issuers pay back the principal amount plus interest rate at regular time intervals. This helps in reducing the financial obligations of the issuer during the time of maturity.
9. Extendable Bonds:
The maturity period of these bonds can be extended at the investor’s discretion.
10. Convertible bonds:
A special type of bond, a convertible bond, can be converted from a debt instrument to an equity instrument.
11. Dynamic Bonds:
Another special type of bond, dynamic bonds, are open-ended in nature. These kinds of bonds have a dynamic approach towards bond maturity and do not impose any restrictions concerning maturity periods. Unlike serial bonds, dynamic bonds have only a singular maturity date.
12. Inflation-Linked Bonds:
Government bonds are called inflation-linked bonds when they are specifically designed to counter the effect of inflation on interest rates & principal payments. Inflation-linked bonds are unlike traditional bonds in that their principal & interest payments are linked to any nationally-recognized inflation measure index. The face value gets adjusted as inflation risk changes. However, the interest rate of these bonds is generally lower than other bond types.
13. Climate Bonds:
Climate bonds are a form of government bonds that raise funds from the public during any adverse or destructive climate event.
14. War Bonds:
Another type of government bond, war bonds, is issued to raise funds during times of conflict.
Important Features of a Bond
Every different type and category of bond shares certain characteristics. Here they are in no particular order.
The bond issuer is the organization that makes the initial public offering in the primary market. Governments, municipality bodies, and businesses are common bond issuers.
- Face Value
For all types of bonds, the face value or par value is the principal amount to be paid to the bondholder by the issuer at the time of maturity. Unlike bond prices, face values do not fluctuate and are not subject to market risks.
- Coupon Rate
The coupon rate is the return or interest rate the bond issuer promises to pay the bondholder when the bond matures. The coupon rate, and thereby the coupon payment, can vary based on market conditions, types of bonds, maturity period, etc.
A bond’s maturity occurs when the bondholder has to relinquish their ownership in place of coupon and principal payments from the bond’s issuer.
- Credit Rating
Credit rating agencies rate businesses based on their credit repayment history, incidences of any default, and overall financial standing.
This is the return or interest that the bondholder gets when the bond matures. The total yield depends on the current market prices, the annual interest rate or coupon rate, the face value of the bond, and the maturity period.
How are Bonds Priced?
A bond is called a fixed income instrument as it assures bondholders of a fixed payment on maturity. Bonds have two key values, the face value or par value and the market or issue price. The face value remains the same throughout and is what the investor receives on bond maturity. However, the issue price or the price at which it is offered to the public in the primary market depends upon the borrower & their credit ratings, business requirements, interest rate, and the holding period.
The selling prices are subject to market risks and changes in the coupon rate. Bond prices fall when market interest rates rise as new bonds come up in the market to compete against older bonds.
Yield-To-Maturity is a measure to determine the market price of a bond. A bond’s yield-to-maturity is the amount one may receive if one holds the bond till maturity. It is the long-term yield of the bond expressed annually and is equal to the internal rate of return of the bond. Higher the internal rate of interest or YTM, the more profitable an investment.
The formula for calculating YTM is:
YTM= (Face Value/ Current Value)^(1/n) – 1
Where n is the maturity period. Note that the current value of a bond is not its current market price but the present value of the bond’s future interest payments.
YTM is compared with the coupon rate of a bond to decide whether to hold on to that bond or not.
Bonds are fixed-income instruments that are much more secure than stocks or equities. They assure a fixed return on maturity and are ideal instruments for investors with low-risk tolerance who are looking to diversify their investment portfolio. Some assets or security generally backs bonds, and their prices increase when interest or coupon rates fall.
There are quite a few different ways to buy bonds in India. You can:
- Open a Demat and trading account with a brokerage house and invest in bonds through them.
- Buy mutual funds or exchange-traded funds.
- Invest in government bonds through an RBI Retail Direct Gilt Account.