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Experienced investors allocate their capital to equities as they are volatile and can offer better returns but keep aside a portion to invest in debt instruments. The motive behind the move is to have certain investments that can offer regular income by mitigating investment risk. Within debt instruments, investors prefer Bonds as they offer regular interest payments and repayment of the principal investment amount to the bondholder.
This blog will help you understand the meaning of bonds and bonds definition and how you can use the asset class to make informed investment decisions.
The meaning of Bonds can be attributed to a financial instrument that governments and private organisations use to raise money in the form of loans from the general public. Since bonds are used to seek loans from the public, they are included in the category of debt instruments. The bonds definition states that it is a loan agreement between the issuer and holder, which details the terms of payment (debt servicing) and maturity. These come with a face value (principal) to be repaid on maturity and can be issued either at a discount or a premium.
Bonds are fixed tenure debt instruments issued to finance specific projects by the issuer. The interest (based on coupon rate) is paid in pre-defined instalments to the bondholder until maturity. Bond prices are inversely proportional to market interest rates and dependent on various factors such as the credibility of the issuer, maturity, and interest rates in the market.
Here are some terms to understand bonds in a better way:
Banks and other financial institutions usually cater to the financing needs in the market. However, the value of loans they can offer is limited, and they have to abide by certain regulatory norms. This is where the bonds come into the picture.
The government or large corporations typically issue bonds for their huge capital needs. These are either publicly traded or over-the-counter. Bonds originally came with fixed coupon rates, which is why these were called fixed income instruments. Nowadays, variable or floating interest rates are also quite common. The benefits entail:
The most important feature of bonds is that these are tradable instruments in the secondary market and often attract investors looking for safer and secure investment options.
The government or a private company needs capital to fund its business operations. Although the government may raise funds through disinvestment in public companies, or a private company may raise capital by selling shares in an IPO, the need for capital is constant. Thus, governments and private companies issue bonds to raise funds as loans from the general public. Any investor can invest in bonds issued by such entities with the promise that the issuer will provide regular interest on the principal amount and repay the principal amount at the time of maturity. Investors receive regular interest payments based on the coupon rate of the bonds, which is specified at the time of bond issuance.
Once the bonds are issued, investors can hold them until maturity to realise interest payments or can trade them anytime to make profits. However, if the bonds are traded and sold, the new buyer would start receiving the interest payments until maturity or the further sale of the bond.
How do bond yields fall and rise? A bond yield is an actual return received by the investor from the bond’s coupon (interest payments). Similar to everything else in the secondary market, bond yields also depend on the supply and demand equilibrium. Bonds yield has an inverse relationship with bond prices. For example, if you have a bond with a 5-year maturity, a 5% coupon rate and a face value of Rs 10,000. Each year the bond will pay you interest of Rs 500. Now, if the interest rates in the market rise above 5%, investors will not buy your bonds but buy the new ones that come with an interest rate higher than 5%.
As a result, you will have to lower the price of your bond to increase its yield. When you lower the price, the coupon rate increases because of the lower face value, thus increasing the bond’s yield.
There are numerous types of bonds that allow investors to achieve their financial goals while decreasing risk exposure. Here are some of the most common types of bonds you can invest in:
Investors prefer Bonds because of the various advantages they offer in helping to offset the losses and provide periodic income. Here are the advantages of Bonds:
Investors who have a low-risk profile and want to earn good and regular income prefer bond investments over other types of investment instruments. Furthermore, it allows investors to increase their risk profile as they can invest in volatile stocks to earn good profits knowing that their bonds’ investment will pay them a regular interest. If you are looking to diversify your portfolio and earn periodic income, you can open a Demat and trading account by visiting the IIFL website or by downloading the IIFL Markets app.
Yes, bonds are one of the safest investments in the financial market as they provide regular interest payments with the promise of paying the principal amount back. You can invest in G-secs to reduce the risk profile to the lowest level.
Yes, bonds come with numerous risks such as default risk, credit risk, interest-rate risk, inflation risk, liquidity risk etc.
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