What are Bonds?
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.
Some terms to understand bonds
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:
Face Value: Also known as a par value, face value is the value of the company as listed in its books and share certificates. It is fixed by the company, once it decides to issue its shares and bonds. There are no specific criteria for fixing the face value of shares by a particular company. Typically, they are arbitrarily assigned by the company.
Coupon Rate: The coupon rate or bond rate is the percentage rate based on which the bond issuer pays the interest to the bondholders at regular intervals. For example, if you purchase a 10-year bond of Rs 10,000 with a coupon rate of 5%, the bond will pay you interest of Rs 500 every year.
Bond Tenure: The bond tenure is the time period after which the bonds mature or expire. It is at this time that the bond issuer is legally obliged to repay the principal amount to the bondholder. After the bond tenure is over, the issuer is no longer obliged to pay regular interest payments.
Credit Quality: As the bond issuers must have enough money to provide regular interest payments and repay the principal amount, they are rated based on their financial condition to fulfil the payment promises. Hence, credit rating agencies rate bonds based on their creditworthiness and the included risk of default.
Features of Bonds
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:
- Bonds are a good way of setting off the fluctuations in riskier avenues of investments, such as equities and derivatives.
- Often, bonds provide a secure stream of cash flows throughout their life, while also preserving the entire capital invested.
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?
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.
Types of Bonds
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:
Government Bonds: The government bonds, also called G-Secs, are types of bonds that are issued by the central or the state government of a country. When governments want capital for various development measures, they issue government bonds. G-Secs are considered to be the safest investment option as the risk of default by the government is highly unlikely.
Corporate Bonds: Corporate Bonds are debt instruments that a private firm or company issues to raise money from the public. Corporate bonds are slightly riskier as the promise of interest payments and principal amount repayment is kept as long as the company has positive cash flow.
Zero-coupon Bonds: Zero-coupon bonds do not pay regular interest to the bondholders but are available at a discount. The only payment done is for repaying the principal amount at the time of maturity.
Convertible Bonds: Convertible bonds are hybrid bonds that have the option to be converted to stocks based on the underlying asset of the bond. Once the bonds are converted to regular shares, the bondholders become shareholders.
Floating Rate Bonds: Floating rate bonds have fluctuating interest rates and provide different interest payments to the bondholders every time.
Advantages of Bonds
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:
Systematic Income: Apart from a zero-coupon bond, all other types of bonds provide regular interest payments to the bondholders. The regularity and the fixed-coupon rate ensure that the bondholders receive regular predetermined income.
Risk Profile: Bonds, especially government bonds, come with a considerably low-risk profile in comparison to other investment instruments. With assured interest, investors can earn regular income without a high chance of default.
Diversification: One of the most important advantages of bonds is their ability to allow portfolio diversification and offset the losses incurred in other asset classes. If the equity market is going through a bear trend, the bonds still provide regular interest payments.
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.
Frequently Asked Questions Expand All
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.