What are Bonds?
Bonds are a type of fixed-income security that plays a crucial role in the world of financial markets. They are often considered a stable and reliable investment option, especially for risk-averse investors. In this article, we will discover what bonds are, their different types, and how they work.
What are Bonds?
A bond is a debt/fixed-income instrument issued by various entities to raise capital. It is a contractual agreement between the issuer and bondholders. Under the agreement, the issuer borrows money from the investor and agrees to repay the principal (face value), plus interest, at a specified future date. Fixed-income securities are the largest source of capital for governments, not-for-profit organisations, and other entities that do not issue equity.
Bondholders have a higher right to receive interest payments and repayment of principal than equity shareholders. So if a company goes bankrupt, bondholders will be paid back before equity shareholders.
Basic Terms Related to Bonds:
To understand how bonds work, you need to know a few terminologies related to bonds:
- Issuer: It is the entity that sells or issues the bond to investors. Bonds can be issued by Central Governments, non-sovereign (local) governments (such as municipalities), supranational organisations (such as the World Bank), quasi-govt entities (i.e., agencies that are owned or sponsored by governments) such as postal services, corporations (such as Reliance Industries), and special legal entities (entities that issue asset-backed securities).
- Principal or Face Value: It is the amount that the issuer agrees to repay the bondholders on the maturity date. This amount is also known as the par value, face value, nominal value, redemption value, or maturity value. Bonds can have any par value.
- Coupon Rate: The coupon rate or nominal rate of a bond is the interest rate that the issuer agrees to pay investors each year until the maturity date. The annual amount of interest payments made is called the coupon. For example, a bond with a par value of ₹1,00,000 and a coupon rate of 6% pays ₹6,000 in annual interest or coupon.
- Coupon Frequency: It is the frequency of interest payments in a year. Coupons may be paid annually, quarterly, half-yearly or monthly. A bond paying quarterly coupons has a coupon frequency of 4.
- Maturity Date: It is the date on which the issuer is obligated to redeem the bond by paying the outstanding principal amount. The tenor is the time remaining until the bond’s maturity date. Bond maturity can range from less than a year to more than 30 years.
What are Bond Yields?
Coupon represents the interest payments an issuer makes. In the above example, the bond pays 6% annually on the principal, meaning that the return will be 6% a year. However, in reality, the bond may not always be issued at the par value. It can be issued at a discount to the par value.
For example, a 1-year bond with a par value of ₹1,00,000 and a coupon rate of 6% issued at a discount of 2% will be initially sold at ₹98,000. The bond will pay ₹1,00,000 on maturity, providing the investor with a capital gain of ₹2,000. Yield includes the returns on capital gain and the coupon payments. The above bond’s yield will be ~8.16%.
What are Bond Indentures?
A Bond Indenture is a legal and binding contract or agreement between a bond issuer and the bondholders. It outlines the terms and conditions of bond issuance, as well as the rights and responsibilities of both parties. Bond indentures are essential for ensuring clarity and transparency in the bond market and protecting the interests of bondholders.
Key Elements in a Bond Indenture:
- Issuer Information: This section identifies the entity or organisation issuing the bonds. It includes details such as the issuer's name, address, and legal status.
- Bond Terms: The indenture specifies the details of the bonds being issued, including their face value, maturity date, interest rate (coupon rate), and the frequency of interest payments (e.g., semi-annual).
- Covenants: These are restrictions or obligations that the issuer must adhere to. The covenants can be either affirmative (things the issuer must do) or negative (things the issuer must not do). Common covenants might include limitations on the issuer's ability to take on additional debt, restrictions on the sale of assets, or requirements to maintain certain financial ratios.
- Security Provisions: If the bonds are secured, the indenture will detail the collateral or assets that back the bonds. This provides a level of security for bondholders in case the issuer defaults.
- Default and Remedies: The indenture outlines the conditions under which a default is considered to have occurred and the remedies available to bondholders in such cases. Remedies may include acceleration of the bond's maturity or the appointment of a trustee to represent bondholders.
- Payment Terms: The indenture specifies how and when bondholders will receive their interest payments and the process for redeeming the bonds at maturity.
- Trustee: A trustee is appointed to represent the interests of bondholders. The trustee's responsibilities may include monitoring the issuer's compliance with the indenture terms, ensuring timely payments to bondholders, and taking action in the event of a default.
- Call & Redemption Provisions: If the issuer has the right to redeem (call) the bonds before their maturity date, the terms for such calls are outlined in the indenture. This may include call prices and notification procedures.
How Do Bonds Work?
Here is a basic outline of how a bond works:
- Issuance of Bonds: When an entity wants to raise capital through debt, it issues bonds. Investors purchase these bonds, essentially lending money to the issuer. In return, the issuer promises to pay periodic interest (coupon payments) and return the principal amount (face value) upon the bond's maturity.
- Bond Pricing: The price of a bond can fluctuate in the secondary market. If the bond's price is higher than its face value, it is trading at a premium. If it's lower, it's trading at a discount. The bond's price is influenced by changes in interest rates, the issuer's creditworthiness, and time to maturity (tenor).
- Coupon Payments: The bond issuer makes periodic interest payments to bondholders. These payments are typically made semi-annually based on the bond's coupon rate, which is expressed as a percentage of the bond's face value.
- Bond Maturity: On the maturity date, the issuer retires (cancels) the bond by repaying the principal and pending interests. Maturity periods can vary widely, from short-term bonds with maturities of less than a year to long-term bonds with maturities of 30 years or more.
What are the Different Types of Bonds?
There are many different types of bonds, but they can be broadly categorized into three main groups:
- Government bonds: These bonds are issued by governments to raise money to finance their operations. Government bonds are considered to be very safe investments, as they are backed by the full faith and credit of the issuing government. To learn more about the Government Securities Market in India, click here.
- Corporate bonds: These bonds are issued by corporations to raise money to finance their operations or to expand their businesses. Corporate bonds are riskier than government bonds, as they are backed by the assets and earnings of the issuing corporation.
- Municipal bonds: These bonds are issued by state and local governments to finance public projects, such as schools, roads, and bridges. Municipal bonds are typically exempt from federal income tax, making them a popular investment for high-income taxpayers.
Other Types of Bonds:
- Zero-coupon bonds: These bonds do not pay regular interest but are sold at a discount to their face value. Investors receive the face value at maturity, which makes them attractive for long-term investors.
- High-yield bonds: These bonds are also known as junk bonds and are issued by corporations with poor credit ratings. High-yield bonds offer higher interest rates than investment-grade bonds, but they are also riskier.
- Convertible Bonds: These bonds can be converted into shares of the issuing company's stock at a predetermined price.
- Floating-rate bonds: These bonds have interest rates that reset periodically, typically every quarter or six months.
Benefits of Investing in Bonds
The benefits of investing in bonds are:
- Income generation: Bonds typically pay interest regularly (monthly, quarterly, or annually), which can provide investors with a steady stream of income. This can be especially beneficial for retirees or investors who need to generate income from their investments.
- Capital preservation: When you invest in bonds, you receive the assurance that the issuer will return the bond's face value at maturity. High-quality bonds are generally considered low-risk and are often used to preserve capital. They can be a safety haven/cushion during times of economic uncertainty.
- Diversification: Bonds can help to diversify an investment portfolio and reduce overall risk. This is because bonds tend to perform differently than stocks, so they can help offset losses in the stock market.
- Lower Volatility: While bonds can carry some risk, they are typically less volatile than stocks. They provide stability to a diversified portfolio.
- Tax Advantages: Tax saving bonds enjoy special privileges under Section 80CCF of the Income Tax Act which states that individuals enjoy tax deductions up to ₹20,000 on the bonds owned by them.
Risks Associated with Bonds
While bonds offer numerous benefits, it's essential to be aware of the risks:
- Interest Rate Risk: Interest rates can fluctuate over time. When interest rates rise, the value of existing bonds can fall. This is because investors can buy new bonds with higher interest rates, making existing bonds with lower interest rates less attractive.
- Credit Risk: It is the risk that the issuer may default on interest payments or fail to repay the bond's face value at maturity. A bondholder may lose money if the issuer encounters financial difficulties or goes bankrupt. Credit risk is higher for corporate bonds than for government bonds, as corporations are more likely to go bankrupt than governments. Rating agencies provide insights into a bond issuer's creditworthiness.
- Inflation risk: Inflation is the rate at which prices for goods and services are rising. It erodes the real value of fixed-interest payments. If inflation is higher than the interest rate on a bond, the bondholder will lose money over time.
- Liquidity risk: It is the risk that investors may not be able to sell their bonds quickly or at a fair price. Liquidity risk is higher for less common types of bonds, such as high-yield (junk) bonds and municipal bonds.
What are Bond Ratings?
Bond ratings are a measure of the creditworthiness of a bond issuer. It indicates the issuer's ability to meet its interest and principal payment obligations. Credit rating agencies such as Moody's, Standard & Poor's, and Fitch assign these ratings. It helps investors understand the risk associated with a particular bond.
Credit rating agencies use a variety of factors to assess the creditworthiness of a bond issuer, including its:
- Financial strength
- Industry and competitive landscape
- Management team
- Debt levels
- Future cash flow prospects
Investment-Grade Bonds: These bonds have higher credit ratings, typically ranging from AAA to BBB- (S&P and Fitch) or Aaa to Baa3 (Moody's).
Junk Bonds: They are also known as high-yield or speculative-grade bonds. Junk Bonds have lower credit ratings, often rated BB+ and below (S&P and Fitch) or Ba1 and below (Moody's). They carry higher risk due to the issuer's weaker financial condition.
How Do Bond Ratings Impact Bond Prices?
Investment-grade bonds tend to have higher prices and lower yields because of their lower perceived risk. Investors are willing to accept lower returns for greater safety. On the other hand, junk bonds generally have lower prices and higher yields. To compensate for the higher risk, investors require more significant returns, which results in lower bond prices.
In conclusion, investing in bonds can be a great way to diversify your investment portfolio. However, bonds typically have a high minimum investment, making them unsuitable for retail investors. You can invest in debt mutual funds to gain indirect exposure to the bond markets. You can also invest directly in bonds through your broker (Zerodha, Groww, Fyers, etc).