What are Bonds?
A bond is a debt certificate issued by an institution- either governmental or non-governmental. It carries a fixed rate of interest and a fixed tenure. In India, there are many types of bonds issued by the public sector and private sector entities to raise funds for specific purposes. The primary buyer of the bond acts like a lender, who will be paid interest at regular intervals, and the principal amount at the time of maturity. Investment grade bonds(BBB rated or higher) are popular instruments due to features such as guaranteed returns, capital protection and the probability of capital appreciation due to their marketability.
Bonds are essentially issued and purchased in the primary market, and then traded in the secondary market by way of institutional brokers. The market is highly liquid for government bonds and AAA rated bonds. Bonds are an excellent investment avenue to diversify one’s portfolio and balance the equity component.
Types of Bonds
- Government Bonds: These are issued by the Government of India, and hence carry a sovereign guarantee. They are issued to raise money from the general public and fetch risk -free, stable returns. Some of these bonds are tax free, while some are taxable.
- Municipal Bonds: These are issued by State and local governments to raise money for governmental activities. They have a three-year maturity period and are rated above investment grade. Hence, they are also considered a safe and stable investment. These could be taxable or tax-free as well.
- PSU Bonds: These are issued by public sector companies which are implicitly government- backed, and hence are relatively safe.
- RBI Bonds: These are issued by the Reserve Bank of India,in the capacity of being a banker to the government,to borrow money for financing the country’s debt. The interest on such bonds is taxable. The latest RBI Bonds issued in Jan 2018 carry an interest rate of 7.75% and a tenure of 7 years.
- Company Bonds: These are issued by companies and financial institutions to raise money for company specific purposes. They fetch higher returns, but also carry higher risk. They are rated by credit rating agencies to help the investor decide on the stability and credibility of the company and the bond.
- High yield bonds: These are high-risk and high-return bonds issued by start-ups and growing companies, which may not have a track record. Hence one should be careful before investing in these bonds.
- Tax-free bonds: These are typically ten-year-or-more bonds issued by the Central and municipal governments, the interest on which is tax free. Resultantly, there is no TDS deduction. You can invest up to a maximum of ₹5 lakhs in these bonds. However, the initial investment amount in these bonds is not exempt from tax.
- Tax-saving bonds: These are different from tax free bonds, in that the initial investment amount in such bonds is exempt from tax under section 80CCF up to ₹20,000.This is over and above the ₹1.5 lakh limit under 80C. These bonds come with a minimum lock-in of 5 years.Some examples include RBI Relief Bonds, NTPC Bonds, IRFC Bonds, etc. Certain bonds issued by REC and NHAI also provide Capital Gain Tax exemption from sale of assets.
1. How does capital appreciation/depreciation work on the bond?
Once the bond is issued in the primary market, it can be traded in the secondary market. The primary investor may sell his bond to a new secondary investor. If there are new bonds available in the market with reduced interest rates, the price of the old bond will increase, resulting in capital appreciation for the investor. Likewise, if market interest rates increase, then this investor’s bond will sell at a discount.
2. How is the bond price related to the market interest rate?
Simplistically, bond yield is the total return on a bond, comprising of the interest rate it fetches and the capital appreciation on it. The price of a bond is inversely proportional to its yield. If the market interest rates rise, price of a bond carrying a lower coupon rate will have to fall to increase its yield. The converse will happen in case of decrease in interest rates. However, accurate bond yield would also account for the time value of money, maturity value and frequency of payment.
3. How can I invest in bonds?
The procedure for investing in bonds is similar to investing in stock markets. You can invest in bonds via banks or brokers. They can be stored in dematerialized form by having a demat account with any Depository Participant (DP) registered with National Securities Depository Limited (NSDL). Subscriptions for different bonds are open during specific times only, and you have to make sure to invest within that time. However, you can also invest in the bonds in the secondary market after the primary issue is over. This would require you to trade via a bank or a broker.
4. What are the risks associated with investing in Bonds?
Bonds are a great way to diversify one’s portfolio, but there are certain risks associated with bonds.
- Interest rate risk: In case of fixed rate bonds, the market price of the bond will decrease if the market interest rate rises. However, if you are looking to hold the bond till maturity, you need not worry about interest rate risk.
- Credit risk: This is the risk of default on the payment of interest or the principal amount. This risk is higher for junk bonds, which are generally issued by start-up companies or businesses without any track record.
- Prepayment risk: This is when the issuer repays the principal amount earlier than the stipulated maturity of the bond, to refinance his debt by tapping a lower interest rate option. The investor then has to look for another option of investment which may not be as good as the earlier one.
- Other risks include reinvestment risk, liquidity risk, volatility risk, event risk, exchange rate risk, etc.
Terms associated with Bonds
- Principal: Principal is the face value of the bond, i.e. the amount of money invested by the investor, per bond. This amount must be repaid to the bond holder at the end of the term.
- Coupon rate: This is the interest rate that a particular bond carries. It is different from the market interest rate. Market rates may periodically vary depending on the monetary policy, but the coupon rate on a particular bond remains fixed, unless it is a floating rate bond. Coupon (interest) is generally paid out at periodic intervals, generally every 6 months, or annually.
- Maturity: This is the term of the bond, after which the Principal amount is repaid to the investor. There are generally short-term treasury bills (1-5 years), medium term notes (6-10 years), and long term bonds (10 years+)
- Yield: Yield is the total return on a bond, comprising of the interest rate it fetches and the capital appreciation on it. There are two kinds of yield:
a. Current yield: This is the percentage of annual coupon of the bond to the current market price of the bond. This is a lesser used measure as it does not take into account the tenure of the bond.
b. Yield to Maturity: YTM is calculated on the basis of the current market price of the bond, the coupon amount on the bond, the number of coupon pay-outs remaining, and the maturity repayment amount. It is the same as the Internal Rate of Return (IRR) of the bond.
- Credit rating: This is the rating given to a bond by a credit rating agency on the basis of the repayment probability of the bond. This depends on the entity issuing the bond, the purpose for which bond is issued, and many other factors. High-yield bonds, or junk bonds, are those which are rated below investment grade, and hence are riskier. To compensate for this, they carry a higher coupon rate. Investment grade bonds have a rating of BBB and above, carrying lower risk and hence lower coupon rates.
- Market price: The market price of a bond depends on the difference between the market interest rate and the coupon rate of the bond. Bonds with higher coupon rate than the market will sell at a higher market price, while the ones with lower coupon rate than the market will sell at a lower market price.
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