What is a bond?
A bond is a loan agreement under which an investor gives a loan to a borrower, usually companies or governments. A bond is issued by the borrower to raise capital and use it for funding its operations. The investor, against the money lent, earns returns in the form of interest payments.
A bond is:
- a type of fixed-income instrument
- its market value changes over time
What is a bond agreement?
In a loan agreement:
- the bond issuer promises to pay regular interest to the investor
- Interest or coupon rate is paid at a predetermined rate
- Interest is calculated as a percentage of the amount borrowed or face value
- The coupon is paid until a specified maturity date.
At the time of bond maturity, the issuer stops the interest payments and repays the principal amount back to the investor. Since the interest payments are made at set intervals and are fairly predictable, bonds come under the fixed-income securities category.
Types of bonds
Bonds can be classified into different types depending on the returns and legal obligations surrounding them. Here are some of the commonly available types:
1. Fixed-interest bonds
Fixed-interest bonds accrue steady coupon rates until maturity. Investors can benefit through predetermined interest rates as returns are predictable, irrespective of fluctuations in market conditions.
2. Floating-interest bonds
The coupon rates on these bonds keep changing throughout the tenure as per market fluctuations. Therefore, the return on investment is inconsistent and is influenced by market factors like inflation, economic situation, investor confidence, etc.
3. Inflation-linked bonds
Inflation-linked bonds are designed to control the inflation impact on the bond’s face value and interest. The coupon rates on these bonds are generally lower as compared to fixed-interest bonds. The idea is to adjust coupons as per prevailing market rates.
4. Perpetual bonds
As the name suggests, perpetual bonds pay interest for perpetuity with no maturity period attached. These fixed-security bonds do not require issuers to return the principal amount to the investor.
Benefits of investing in bonds
Some of the key benefits of investing in bonds are:
1. Predictability of returns
Investors who want to maintain a steady and predictable income level within their investment portfolio should consider investing in high-quality bonds. Such bonds can fetch regular and predictable cash flows while minimising risk of losing the invested capital.
Bonds may offer some certainty as far as interest earnings and principal repayment are concerned. This depends on the quality of the bond and the credit rating of the issuer.
Portfolio diversification can be achieved by including a mix of asset classes within the portfolio. Fixed-income investments, like bonds added to an equity portfolio, can help in achieving diversification while reducing the overall portfolio risk. With the right level of diversification, an investor can potentially increase portfolio returns in the long run. This is because even if one asset’s value goes down, it still leaves an opportunity to see an increase in another asset class within the portfolio.
The market is flooded with a number of bond issuers who offer a variety of bonds with different coupon rates and maturity dates. This allows investors to invest in a bond with cash flows that meets their income needs and investment portfolio goals.
How are bonds different from stocks?
The table below presents the key factors that differentiate bonds from stock investments:
|Debt v/s equity||Bonds are debt instruments||Stocks are equity instruments|
|Ownership||Bondholders do not enjoy ownership stake in a company and therefore no voting rights||Stockholders are considered part owners in a company and enjoy voting rights|
|Share in profits||No share in profits of the company||Entitled to get a portion company profits|
|Earnings||Earnings are through interest payments and are fixed, except for floating coupon bonds.||Capital appreciation and dividends (if any). Returns are not fixed or guaranteed.|
|Impact of price fluctuations||Bond holders may see capital losses since prices may fluctuate.||Share price movements can result in capital losses for investors.|
|Claim on assets||Bondholders are creditors and therefore enjoy higher claim on assets in case of company liquidation or bankruptcy||Common stockholders are part owners. Therefore, they can claim a share of assets during liquidation – only after creditors and preferred shareholders have been paid off.|
|Trading||Mostly through the over the counter / OTC market.||Through stock exchanges.|
How to invest in bonds?
There are three primary ways in which an investor can invest in bonds:
1. Broker / Stock exchange
Investors can buy/sell bonds through a broker on any major stock exchanges in India. Like all other securities, the exchange lists all the corporate bonds available for investment. There are also online investment platforms for investing in bonds.
2. Mutual funds:
Debt or balanced mutual funds allow investors to gain exposure to bonds. These involve professionally managed portfolios with exposure to a basket of debt securities or a mix of debt and equities. Unlike direct bond investments, debt mutual funds will not have a specific maturity date or coupon rate since it includes a variety of bond investments.
3. Exchange-traded funds (ETFs):
ETFs are mutual fund trusts. The units of these funds are traded on stock exchanges. Some ETFs offer exposure to a bond market index, while some may only track the performance of a benchmark government bond. ETFs can be an economical option for gaining exposure to bonds since these are not actively managed and therefore have very low expense ratios.
Investors must note that although bonds can be traded, they have some limitations as far as investment withdrawal is concerned. Since there are fees / penalties associated with premature withdrawal from bond investments, these may offer lower liquidity when compared to equities. Also, while the returns in this case may be predictable, they are generally lower than returns from equity investments.
Bonds are best suited to risk-averse investors due to predictability of returns. Investors who want to balance the overall risk within their portfolio can also consider investing in bonds.
Call risk in bond investment arises when an issuer recalls the bonds before maturity. This could be mostly due to rising prices and falling interest rates. Call risk can impact an investor’s financial planning, especially in the long run.
Every bond comes with a credit rating, which indicates the level of confidence that creditors have in the issuer’s bond. It is used to study the risk of default on debt repayment by the issuer. Before investing in bonds, investors must make sure to check its credit quality / rating.
Zero-coupon bonds are bonds that are available to buy at a discount on face value. In these, there are no payments made at regular intervals. However, the principal and interest is paid out at maturity.
The face value of a bond refers to the principal amount borrowed by issuers and invested by investors. Issuers are obligated to return the face value or par value of the bond at maturity to the investor.