Different Types of Bonds: Features, Advantages & Disadvantages

Last Updated: 30 Dec 2024

When the government or corporate requires funds, they may consider issuing bonds. They are financial instruments which raise funds from the general public for a specific period. However, the bond issuer compensates the investors during the tenure and promises to pay the principal back at the end of the tenure. Bonds can be categorized based on coupon rates, maturity, convertibility, and so on.

This article guides on different types of bonds, features of bonds, and the things Investors should consider before investing in the bonds.

Types of Bonds

The various types of bonds include:

• Fixed-rate bonds

  Fixed-rate bonds pay consistent interest amounts until maturity. The bondholders earn predictable and guaranteed returns regardless of the prevailing market conditions.

  For example, An investor purchased a ten-year fixed-rate government bond of Rs. 1000, issued on 20th April 2013 which offers a coupon rate of 7.5%. The investor will get a fixed interest of Rs. 75, annually every April, till 20th April 2023.

• Floating-rate bonds

  Floating-rate bonds do not pay fixed returns each period. Instead, the interest rates vary, depending on the set benchmark, during the tenure.

  For example, an investor purchased an 8-year floating rate bond issued in 2015. The bond pays interest of 40 points higher than the prevailing National Savings Certificate interest rate. This means the NSC interest rate is the benchmark and any fluctuation in it directly affects the coupon payment of this bond.

• Zero-coupon bonds

  As the name implies, these bonds do not pay periodic coupons during their tenure. Though, these bonds are issued at a discount and repayable at the par value. The difference is the yield for investors.

  For example, an investor buys a 20-year zero-coupon bond, with a face value of Rs. 1000, at Rs. 700. At the end of 20 years, the issuer will pay Rs. 1000 to the bondholder.

• Perpetual bonds

  Perpetual bonds are those debt securities which do not have a maturity. In this type of bond, the issuer does not repay the principal amount to the bondholders. Though, they keep paying steady coupon payments to the bondholders till perpetuity.

• Inflation-linked bonds

  These types of bonds aim at minimizing the impact of inflation on the face value and coupon payments. The principal is adjusted according to the inflation and coupon payments are made based on the adjusted principal.

  For example, an investor purchases an Inflation-linked bond with a face value of Rs. 100. After a year, the inflation-adjusted principal amounts to Rs. 107. Therefore, the coupon will be paid considering Rs. 107 for that period.

• Convertible Bonds

  The investors holding convertible bonds get the right to convert the bond to a predefined number of equity shares in the issuing company at a particular time from the tenure. Though, the investor can also opt to receive the principal repayment at the maturity, if they don’t want to exchange it with shares.

• Callable Bonds

  Callable bonds are high coupon paying securities that give the issuer the right to call back the bonds at a pre-agreed price and date.

• Puttable Bonds

  Puttable bonds give the bondholder the right to return the bond and ask for repayment of principal at a pre-agreed date before maturity. Since the benefit offered is for investors, these bonds pay lower returns.

•  Municipal Bonds

Either state or local governments issue municipal bonds to finance public projects like infrastructure development, schools, or transportation systems. They are often tax-free and very attractive for investors seeking tax-free returns.

For example, a state government issues a municipal bond with a 5% coupon rate to finance a new highway construction.

• Corporate Bonds

Corporate bonds are debt obligations the company issues to raise capital for expansion, operations, or debt refinancing. Corporate bonds normally carry higher yields than Treasury bonds but are riskier.

For instance, a technology company raises funds for building new data centres by issuing a 7-year corporate bond carrying an 8% coupon rate.

•  Treasury Bonds

Treasury bonds are long-term debt securities issued by the government with a maturity period of more than 10 years. They are risk-free because they are supported by the government’s full faith and credit.

Example: The Indian government issues a 20-year treasury bond with a fixed interest rate of 6.5% to fund public welfare schemes.

• High-yield Bonds

High-yield bonds, also called junk bonds, are issued by companies with lower credit ratings to investors as a reward for accepting a higher risk.

For instance, a start-up company issues a 5-year high-yield bond with a 12% coupon rate because of its low credit rating to attract investors.

• Mortgage-Backed Securities

MBS are bonds secured by a pool of mortgage loans. Investors receive periodic payments derived from homeowners’ mortgage repayments.

For example, a financial institution packages home loans into MBS and offers them to investors with a projected yield of 4.5%, dependent on loan repayments.

Features of Bonds

The key features of bonds are as follows.

• Issuer: Bond issuers borrow money from investors against bonds. Commonly found bond issuers are the government, government institutions, municipalities, and corporations.
• Face Value: The face or par value of the bond is the price of a bond repayable at maturity. This price may differ from the bond price prevailing in the secondary market.
• Coupon rate: The issuer of the bonds compensates the bondholders by paying them interest. The rate of interest or coupon payment varies depending upon the economic circumstances, the creditworthiness of the issuer, type of bond, maturity, etc.
• Maturity: Except for perpetuity bonds, all the bondholders get repaid at a specific date when the bonds get matured. The bonds are categorized as short-term or long-term bonds based on their maturity date.
• Credit rating: Each bond holds the rating, provided by credit rating agencies. A higher rating suggests a lower amount of risk and lower yields. If the rating is lower, the risk involved in the bond is higher along with higher returns.
• Yield: Yield means the return investor gets from the bond for a specific time. If the bond is held till maturity, the return is termed as yield to maturity. The yield can be calculated considering the face value, annual interest, maturity, and the market price of the bond.

Things to consider before investing in Bonds

To sum up, there are many types of bonds available to investors. Generally, bonds are considered safer assets as compared to equity and other riskier investment options. Though no investment avenue is completely risk-proof, and bonds are no exception. Investors can invest in those bonds which best suit their risk-return expectations.

• Investment goals: Each investor has preferences when it comes to investment. Therefore, investors shall match their risk, return, liquidity, and tax savings expectations with the actual risk, return liquidity, and taxability of bonds.
• Risk and return: Though bonds are considered safe assets, they are not risk-free. There exists inflation risk, interest risk, liquidity risk, default risk, etc. If the investors are ready to take more risk, they shall see whether they get compensated with a higher return. They can compare the bonds in the same category to get a more clear picture.
• The creditworthiness of the issuer: Default risk is the biggest risk for investors. This means the risk of the inability of the issuer to repay the principal to the bondholders. The default can be also for interest payments. Therefore, investors shall look into the ratings of bonds before investing in the bond. A higher rating suggests lower risk and vice versa.
• Liquidity: Another important factor to consider is the liquidity of bonds. Usually, bonds have large tenure. Investors get the full principal at the end of this large tenure. Though they are traded in the secondary market, exiting the bonds before maturity may expose the investors to the volatility of the market.

Advantages of Investing in Bonds

Bonds are a popular investment due to their various benefits. They can be used in conservative and diversified portfolios.

• Guaranteed Income: Bond income is regular and certain because of periodic coupon payments. This stability attracts income-seeking investors, such as retired individuals.
• Capital Protection: Bonds are safer investments than equities, and government bonds, backed by the sovereign, can be considered risk-free.
• Diversification: Bonds are great for diversification because they lower risks. Bonds usually remain intact and even appreciate when equities decline.
• Tax Advantages: Certain bonds, like municipal bonds in some regions, offer tax-free interest, which can enhance overall returns, especially for high-income investors.
• Flexibility: Bonds are issued at different maturity periods and vary in their level of risk, so investors can choose one that suits their needs, investment goals, and risk capacity.
• Liquidity: Many bonds are easily tradable in secondary markets, offering liquidity to investors who might need quick access to funds.

Limitations of Bonds

Like all other financial instruments, bonds come with certain disadvantages:

• Interest Rate Risk: When interest rates rise, bond prices fall, leading to potential capital losses if sold before maturity.
• Credit Risk: Corporate and high-yield bonds bear the risk of issuer default, affecting returns.
• Inflation Risk: The fixed interest may get eroded by inflation, thus diluting the real return.
• Lower Returns: While equities make higher returns, bonds offer low returns, thus limiting growth.
• Liquidity Risk: Some bonds, especially long-term or lesser-known ones, may be harder to sell before maturity.

How to Invest in Bonds in India

Investing in bonds in India is a simple yet effective way to diversify your portfolio and earn a steady income. Here’s how you can get started:

Step 1: Understand Different Types of Bonds

Start by exploring the types of bonds available in India. Some popular options are government, corporate, municipal, and tax-free bonds. Each type varies in risk, interest rates, and maturity periods, so choose based on your financial goals and risk tolerance.

Step 2: Choose the Right Platform

In India, bonds can be bought through various platforms. You can approach banks or financial institutions, as they typically offer government and corporate bonds. Alternatively, you can buy bonds directly from the stock exchanges like the NSE or BSE, provided you have a Demat account. For direct government bond investments, the RBI Retail Direct Scheme offers a way for individuals to purchase government bonds.

Step 3: Open a Demat Account

To trade bonds through stock exchanges, you will need a Demat account. This electronic account stores your bond securities and facilitates easy transfer and sale. Many banks and online brokers provide this service.

Step 4: Select Bonds Based on Your Investment Goals

Choose bonds according to your risk profile and investment horizon. If you seek safety, government bonds are ideal, while corporate bonds can offer higher yields but come with greater risk. Tax-free bonds might suit those seeking tax advantages.

Step 5: Monitor Your Investment

After purchasing bonds, monitoring interest payments, bond ratings, and overall market conditions is essential. Periodically review your investment to ensure it aligns with your financial objectives.

Conclusion

Bonds offer opportunities for diversified portfolios, a steady flow of income, and risk management. There is a wide variety of bond types for every investment goal, risk appetite, and time horizon. Bonds can be a great investment option for conservative investors with an equity-heavy portfolio. 

However, like any other investment, credit risk, interest rate fluctuations, and inflation are always factors to consider when making bond investments. Knowing bonds’ features, advantages, and potential limitations helps investors make informed decisions that match their long-term financial goals. In this way, investors can take advantage of the benefits of bonds and build a balanced, stable investment plan.

Frequently Asked Questions

1. What are the most popular types of bonds?

There exist various bond categories. Some commonly found bond types are fixed-rate bonds, floating-rate bonds, zero-coupon bonds, perpetual bonds, inflation-linked bonds, convertible bonds, government securities bonds, and so on.

2. What is the safest type of bond?

Though no investment comes risk-free, the bonds issued by the government or government institutions have the lowest amount of risk and are therefore considered the safest type of bond.

3. What are the 3 basic components of bonds?

The three basic components of a bond are face value, coupon rate, and maturity. The face value is the principal amount the issuer will repay at maturity. The coupon rate is the interest paid to bondholders, and maturity is when the bond issuer repays the principal.

4. Who issues bonds?

Bonds are issued by various entities, including governments (national, state, municipal), corporations (private companies seeking capital), and government agencies or financial institutions. These entities issue bonds to raise funds for infrastructure development or business expansion.

5. Which are the three different types of debt market bonds?

The three main types of debt market bonds are government, corporate, and municipal. Government bonds are issued by national or local governments and are considered low-risk. Companies issue corporate bonds and offer higher yields but with greater risk. Local governments or agencies issue municipal bonds for public projects.

6. What is the maturity period for medium-term bonds?

Medium-term bonds typically have a maturity period ranging from 3 to 10 years. They offer a balance between yield and risk, with returns generally higher than short-term bonds but lower than long-term bonds.