What are bonds and how do they work? 

Blog | Trading 101

In a nutshell, a bond is a loan made to a company or government that pays a fixed interest. Read on to find out if it’s an instrument that works for you and your risk appetite. 

A bond is a relatively straightforward financial instrument. When a company or government is in need of funds to finance projects and operations, it can issue a bond to investors and offer them a fixed rate of return for a specified period of time. It is a loan typically issued by a company, municipality, state, or a sovereign government that comes with a maturity date when the principal amount must be paid back in full or risk default. 

The return on bonds is usually in the form of a ‘coupon’ which is paid by the bond issuer at regular intervals. For example, an ₹1 lakh bond with a 5-year maturity date and a coupon rate of 8% would result in returns of ₹8,000 every year for 5 years, after which the face value of the bond will be paid back to the investor. 

Being a fixed income instrument, bonds can be an important component of your portfolio and help you manage your overall risk exposure. 

Terms to remember

  • Face value is the amount the bond will be worth at maturity; it is also the base amount the issuer uses when calculating interest payments. The actual market value of a bond can be different from the face value and depends on a number of factors, such as the creditworthiness of the issuer, time left to maturity, and the interest it carries as compared to the current rate of interest in the market. 
  • Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond. Bonds come with certain coupon dates, at which the bond issuer will make interest payments. Payments can be made in any interval, but usually made annually or semi-annually. 
  • Maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
  • Issue price is the price at which the bond issuer originally sells the bonds. This can be higher or lower than the face value.

What are the advantages of buying bonds? 

    • Low volatility: The volatility of bonds is lower than that of equities. Thus, bonds are generally viewed as safer investments than stocks. In addition, bonds also have less day-to-day volatility than stocks and can help to be a balancing force in your portfolio. 
  • Fixed income: Bonds pay interest at regular, predictable rates and intervals. For pensioners or other individuals who have a lower risk appetite, bonds can be a solid asset to own.
  • Variety: There are also a variety of bonds to fit different needs of investors, including fixed-rate bonds, floating-rate bonds, zero-coupon bonds, convertible bonds, and inflation-linked bonds. 

Do bonds carry any risk?
While bonds carry some of the lowest risk as an asset, they are not entirely risk-free. There is a degree of interest-rate risk, liquidity risk, default risk, and inflation risk. One important factor to consider while evaluating a bond is its credit rating. You can invest in high-quality AAA-rated bonds or lower-rated bonds depending on your risk tolerance. Generally, the highest-quality AAA-rated companies carry interest rates slightly higher than those provided by bank FDs. Lower-rated bonds carry higher risk and hence provide higher yields to compensate the investor for the higher risks.

Types of bonds you can buy in India
There are a number of bonds available to purchase in India that come with different characteristics. You can buy a bond directly from the issuer in the primary market or in the secondary market also called the Over-The-Counter market. The different types of bonds you can buy in India are: 

  1. Central government bonds: These bonds are issued by the central government to raise funds. These bonds are issued by the RBI on behalf of the government. These bonds are the safest bonds to invest in and typically have the highest credit rating, since they are backed by the government and will be repaid on maturity.
  2. State government bonds: These bonds are issued by the state government to meet their fiscal deficits. These bonds are listed on the stock exchange. These bonds are also backed by the government, making them low-risk investments.
  3. Municipal and local authority bonds: A municipal corporation or a local authority may raise finance to meet funding for specific goals such as constructing infrastructure, public water works, etc. These bonds are also rated by credit rating agencies and it is important to consider the rating and past records before investing in them.
  4. Corporate bonds: Corporate bonds are issued by companies to finance new projects or expansion. Checking the credit rating and track record of the company is crucial before investing as they carry higher risk than government-backed bonds.
  5. Public sector bonds: These bonds are issued by highly rated public sector companies for meeting their growth and expansion needs. These bonds are relatively less risky since PSUs are under the government. Generally, these bonds are issued by companies in which the Central Government is the majority shareholder.
  6. Tax-free bonds: Companies such as the National Highways Association of India (NHAI), Indian Railways Finance Corporation, HUDCO, Rural Electrification Corporation (REC) issue these bonds. The interest earned on these bonds is completely tax-free in the hands of the investor.

So are bonds a good investment?
When strategically used along with other asset classes, bonds can be a great addition to your portfolio.

Stocks can earn better returns, but they carry more risk. Depending on your time horizon and risk appetite, you could consider the right mix of fixed-income assets like bonds to help you weather rough patches in the equity environment and maintain a healthy portfolio.

Another important feature that makes bonds an attractive investment opportunity are tax deductions. If planned strategically, you can choose the right type of bond that fits your risk profile and gain a potential tax break. 


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