Different Types of Bonds
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 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 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.
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 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.
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.
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 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 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.
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.
Frequently Asked Questions Expand All
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.
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.