What Are Bonds? Types of Bonds, Risks and Jargons
What Are Bonds?
A bond is a fixed-income security that a company or a government uses to raise money for a given period of time. In simple words, an organisation can raise debt/borrow money from investors (Mutual Funds, Foreign Investors, Domestic Investors, etc.). Bonds are low-risk investments that give fixed returns to an investor over a period of time.
Bonds are less riskier than shares, provide a higher return than bank deposits and certain bonds are even tax-free or are charged less tax than other instruments. Bondholders hold a greater preference than shareholders in a company. This means that in case a company shuts down, the bondholders will get their money before the common shareholders do.
Companies on the other hand prefer issuing bonds than borrowing money from the bank. This is because they may require strong financials, cash flows, and credit profiles, without which banks may not lend money. In bonds, it is completely at the investor’s discretion to invest money in those which abide by certain guidelines issued by SEBI and RBI.
Some Important Jargons
- Face Value/Par Value- The price or value of a single unit of bond when it is first issued. However, it can be traded at below or above its face value/par value.
- Premium and Discount- If a bond is traded at a price above its face value, it is said to be at a premium. If a bond is traded at a price below its face value, It is said to be at a discount.
- The Principal or Par Amount- The total amount invested in a particular bond.
- Maturity Date- The expiry date of a bond when the bondholder will get back the principal amount along with interest if any.
- Coupon Rate- It is the rate of interest payable at a fixed interval till the expiry date (Annually, Semi-Annually, Quarterly).
- Yield- Coupon Payment or Interest Payment received over one year divided by the face value of the bond. Example: If the face value of a bond is Rs.100 and the interest payment received is Rs.10, then the yield is 10%.
- Yield To Maturity- Yield To Maturity or YTM is the total expected return for an investor if the bond is held till the maturity date.
Factors Affecting Bond Prices and Yield
- Market Interest Rates - When the market interest rates decrease, the price of the bond increases. Let us take an example: If the rest of the market is providing returns at 2% interest and the bond meanwhile is providing 4% returns, then more people would invest in the bond than the rest of the market, and this will increase its demand and its market price simultaneously. When market interest rates increase then the price of the bond decreases.
- Inflation - When inflation increases, the buying power of the interest earned also decreases. For example- If a bond pays 4% interest annually, and the inflation increases from 0% to 2% in a year, then the real return earned would be 4% minus 2%, which would be 2%. So the ACTUAL return received would be just 2%.
- Credit Rating - Based on a company’s performance, its risk, and other factors, Credit Rating Agencies like Flitch and Moody’s rate the bonds according to their risk profile. The riskier the bonds, the lesser is its market price as very few would invest in them.
Types of Bonds
Bonds can be classified into many types based on the requirements of the investor. The bond market is an extremely diverse market with hundreds of different products. Not all bonds have a fixed coupon rate and Not all bonds provide regular coupon payouts. Mainly, Bonds are classified according to their issuer, the coupon rate, purpose, currency, country of origin, and much more.
Broadly speaking, based on the issue of the bonds, they can be classified as follows:
- Government Bonds- Bonds issued by the state or central government
- Corporate Bonds- Bonds issued by private companies
- Municipal Bonds- Bonds issued by local governments or municipal corporation
- PSU Bonds- Bonds issued by Public Sector Undertaking such as SBI, ONGC, etc.
Risks Associated with Fixed Income Securities
Inflation risk – that an increase in inflation might reduce the buying power of the returns received on the security.
Interest rate risk – that increase in overall interest rates shall occur which in turn will decrease the price of the bonds.
Currency risk – that exchange rates with other currencies will change during the security’s term, causing loss of buying power in other countries
Default risk – that the issuer will be unable to pay the scheduled interest payments or principal repayment due to financial hardship or otherwise
Let us say, a company, Spanners Pvt. Ltd. manufactures nuts, bolds, and spanners. They wish to set up a new factory in Bangalore, but they do not have the sufficient capital required to set up the new factory. Spanners Pvt Ltd. decided to issue bonds of face value Rs 1000 per unit, with a coupon rate of Rs 100 paid half-yearly for a period of 10 years.
Kumar is a computer programmer with savings of Rs 10000. He wants to invest 50% of his savings (Rs 5000) in less risky investments. He does not want to invest in bank fixed deposits (FD) since he feels that they do not pay much interest and are illiquid. Kumar decides to buy 5 bonds of Spanners Pvt. Ltd for a par value or principal of - Rs.1000 x 5 Bonds - Rs. 5000.
10 years later, Spanners Pvt. Ltd has become a big company and now it’s time to pay its bondholders. Since Kumar has earned Rs 100 every 6 months as a coupon payout for 10 years, he has earned - Rs 100 x 2 times a year x 10 years - which equals to Rs.2000. Meanwhile, Kumar also gets his principal or par value back which is - Rs.1000 x 5 Bonds - Rs.5000.
In 10 years’ time, Kumar invested Rs 5000 and got back Rs 7000 making a total profit of Rs 2000.