Bonds: Meaning, Types and Benefits

In this chapter, we’ll look at what bonds are, the types of bonds, how they work, and the benefits and risks associated with bonds. This will help you evaluate if you can invest in bonds to achieve your financial objectives. 

Introduction to Bonds

Bonds are long-term debt instruments governments, corporations, and other private entities use to raise capital. Issuing a bond is a promise by an entity to pay defined periodic interest payments, which are called coupon payments to the bondholders. On the date of maturity of the bond, the issuer also undertakes to return the value of the bond. In return, the entity receives capital from investors to cover the costs of projects and activities.

Bonds are a vital source of capital around the world. Governments rely on bonds to fund infrastructure projects, corporations issue bonds to expand their businesses, and bonds fuel global economic growth. For investors, bonds can provide steady income, diversification benefits for their portfolios, and lower risk than equities. 

Types of Bonds

There are several major types of bonds issued to meet the needs of different issuers and investors:

Treasury Bonds

Treasury bonds, considered one of the safest bond types, are issued by central governments to fund public spending. In India, the Central Bank, i.e., the  Reserve Bank of India, issues treasury bonds on behalf of the central government. These bonds carry virtually no risk of default, given the sovereign backing. Treasury bonds have long-term maturities, usually 10-30 years, and offer fixed interest.

Corporate Bonds

Companies issue corporate bonds to raise funding for business operations, expansion projects, acquisitions and other corporate purposes. Corporate bonds are generally considered riskier than government bonds because they rely on the creditworthiness of the issuing company rather than sovereign backing. However, they compensate for this higher risk by offering higher yields. Corporate bonds have varying maturities, yields and credit ratings based on the company’s financial strength.

Sovereign Gold Bonds

Sovereign Gold Bonds (SGBs) are a safe investment option issued by the Indian government. Instead of physical gold, you invest in grams of gold with the security of government backing. SGBs offer interest payments and redemption at maturity based on gold prices, eliminating storage risks.

Municipal Bonds 

Local and state governments can issue municipal bonds for development projects. Typical uses of municipal bond funding include building schools, highways, hospitals and other public infrastructure. Municipal bonds offer tax exemptions on interest income, making them attractive to investors in higher-income tax brackets. They are available in both short and long-term maturities.

High Yield Bonds

Also known as junk bonds, companies with lower credit ratings issue these types of bonds. These bonds compensate investors for their higher default risk by offering higher interest rates. High-yield bonds become attractive when favourable economic conditions and default risk remain low. However, they can underperform when default rates spike during periods of economic stress.

Mortgage Backed Securities 

Mortgage-backed securities are created by pooling together numerous mortgage loans and issuing bonds backed by the cashflows from the underlying mortgages. The diversification provided by combining many mortgages increases the safety for mortgage bond investors. Government agencies often guarantee timely payment of mortgage bonds' principal and interest, adding an extra layer of security. 

Floating Rate Bonds

Unlike regular fixed-rate bonds, floating-rate bonds carry a variable interest rate that resets periodically based on a benchmark rate. In India, benchmarks like MIBOR, INBMK, the RBI’s repo rate, etc., serve as reference rates. The variable coupon protects investors from interest rate risk. The floating rate bond's interest payments will rise if market rates rise. However, the flip side is that payments fall when market rates decline.

Zero-Coupon Bonds

As the name suggests, zero-coupon bonds do not make regular interest payments as their coupon rate is zero. Instead, they are issued at a deep discount to face value to compensate for the lack of coupon payments. The difference between the issue price and the face value paid out at maturity represents the investor’s return. Zero coupon bonds appeal to investors looking to lock in yields for a specific duration or prefer fewer cash outflows.

Callable Bonds 

Callable bonds contain a call provision allowing the issuer to redeem or ‘call back’ the bonds before maturity. Issuers will typically call bonds when prevailing interest rates have fallen below the bond’s coupon, then issue new bonds at lower rates to reduce interest costs. Callable bonds carry reinvestment risk as investors may have to reinvest their returned principal at lower rates.

Convertible Bonds

Convertible bonds contain an option that allows bondholders to convert their currently invested bonds into equity shares at a predetermined conversion price. This conversion feature will enable investors to gain if the issuer’s share price rises while getting regular interest payments. Companies may issue convertibles if they expect their share price to do well or use them as cheaper financing than equity issuance. 

Inflation-Protected Securities

Inflation-linked bonds issued by governments help shield investors’ interest income and principal from inflation. The coupon and/or par value rises and falls in line with price indexes like the Consumer Price Index to preserve the real rate of return after factoring in inflation. In India, the RBI issues Inflation Indexed National Saving Securities linked to CPI.

Features of a Bond

Some key features that impact bonds’ risk-return profile are:

Interest Rates/Coupon Payments  

The coupon rate determines the interest income bondholders earn annually, semi-annually or at other regular intervals as a percentage of the face value. So, a ₹1000 face value bond with an 8% coupon will pay ₹80 interest annually. Coupons compensate bondholders for loaning funds to the issuer, impacting the bond's price. 

Maturity Period  

The maturity period - whether short-term (up to 1 year), medium-term (1-5 years) or long-term (over 5 years) – impacts a bond's price changes from interest rate fluctuations. Long-dated bonds see greater price volatility from rate changes compared to short-term paper. The term also determines the duration till the investor receives their principal back.

Face Value 

The face or par value denotes the amount repaid by the issuer to bondholders at maturity, usually ₹1000 per bond. Bonds can trade at par (equal to face value), at premiums above par, or discounted below par based on economic conditions. The face value also determines the base on which coupon is decided.  

Yield 

A bond's yield equals its annual coupon interest payments as a percentage of the purchase cost, including any premium or discount. Yield changes based on market price and helps determine investor returns. Bond yields must compete with prevailing bank fixed deposit interest rates and other income alternatives to attract investor interest.

Credit Ratings

Credit rating agencies assign ratings like AAA, AA, etc, reflecting issuers’ creditworthiness and probability of default. Higher-rated issuers offer lower yields but are more assured of making timely coupon and principal payments. Lower-rated bonds compensate investors with higher yields for higher perceived default risk.

Liquidity  

Liquidity determines how easily a bond can be bought or sold in secondary markets before maturity without substantially impacting its price. Actively traded government bonds remain highly liquid compared to more minor issues by less-known companies. Bond liquidity is essential for investors who may need to sell prematurely.

Benefits of Investing in Bonds

Bonds offer investors several benefits, including:

Steady Income Stream  

The regular coupon interest payments provide investors with a steady income source compared to more volatile stock dividends. This makes bonds attractive for risk-averse investors, retirees and others desiring income stability. Some bonds with higher yields allow investors to replace fixed deposit interest earnings effectively.

Portfolio Diversification

Adding bonds to an equity-heavy portfolio diversifies risk since bonds have a lower correlation to stocks. Bonds can stabilise overall portfolio value during stock market crashes when they act as a haven. Diversification improves risk-adjusted returns for a given portfolio target return.

Lower Risk  

Bonds carry lower price risk than equities and offer greater recovery assurances in case of default. Bondholders get priority over equity investors to make claims on the issuer’s assets in case of bankruptcy. This limits investors’ potential downside. Government bonds, in particular, are considered virtually default-free and hence safe. 

Transparency and Predictability

Bonds offer greater transparency and certainty of returns relative to other assets. At issuance, investors know the fixed coupon rate, payment frequency, maturity period, and expected principal repayment, which clarifies cash inflows. This predictability allows precise return calculations and planning around known future payments.

High Customisation and Flexibility 

Companies can structure bond offerings in different forms, currencies, and combinations of terms to meet specific funding needs optimally. Features like callability, conversion options, etc., add further cost and risk management flexibility for issuers of such bonds. The high customisability makes bonds a versatile capital-raising tool.

Risks Associated with Bonds

While bonds have their merits, they also come with distinct risks, such as: 

Interest Rate Risk

Bond prices share an inverse relationship with market interest rates. Rising benchmark rates make existing bonds with lower fixed coupon rates less attractive, causing their market values to decline. The longer the bond tenure, the more sensitive its price is to interest rate fluctuations. Duration metrics quantify this risk.

Inflation Risk 

Inflation erodes the purchasing power of bonds' future cash flows. A 3% annual inflation would reduce ₹100 to a real value of ₹74 after ten years. Steady coupon earnings may lose value relative to rising prices unless the bonds have specific inflation protection features.

Credit or Default Risk

Any deterioration in issuer creditworthiness due to poor management, industry/economy-wide issues, etc., heightens the risk that they may default on bond obligations. Lower-rated junk bonds are more prone to this risk. Defaults result in non-payment of coupon or principal dues, causing investor losses.

Liquidity Risk           

Investors may need help finding buyers quickly to sell certain thinly traded or niche bonds at short notice. As a result, they may have to accept a discount to expected value to offload holdings. Forced sales often involve steep haircuts eroding realised bond returns.

Limited Upside Potential  

Unlike equities, bonds generally have limited potential for capital appreciation even under favourable circumstances due to narrow spreads between coupon and yield ceilings. The predetermined coupon payments also cap earning potential from the underlying entity’s exemplary performance.   

Key Considerations Before Investing in Bonds

Investing in bonds requires evaluating multiple aspects, some of which are:

Credit Ratings

Rating agencies assess the probability of default and timely repayment capacity through credit ratings. Ratings range from highest quality AAA securities to medium A and BBB grade papers to more speculative BB, B, and CCC-rated bonds. The higher the credit risk,  the higher the yield bond issuers must offer investors compensation with higher yields. Conservative investors should stick to investment-grade bonds.

Interest Rate Direction

Prevailing interest rates and their anticipated trajectory critically impact investor returns. Rising rates will lower existing bond values, triggering mark-to-market losses for holders. Conversely, declining interest rate environments boost bond prices and investor gains. Investors must gauge rate direction before taking positions. 

Inflation Outlook

Inflation eats into effective bond returns, with ultra-low inflation periods optimal for bondholders. Even as nominal coupon payments remain steady, the real income stream declines as inflation rises over the holding period. Investors should factor in inflation projections and opt for inflation-indexed bonds if a high consumer price rise is forecasted.

Investment Horizon

Short-term bonds have negligible interest rate sensitivity and provide greater interim income stability suited for temporary cash parking needs. Long-term bonds can offer higher yields but carry greater price volatility risks. Investors must align bond investment tenors with future liquidity needs and risk tolerance.   

Tax Implications

Coupon earnings on government and corporate bonds face income tax as per the investor’s tax slab. However, municipal bond interest and appreciation gains are usually tax-free, enhancing post-tax returns for bond investors in high tax brackets. One must consider tax treatments before opting for bond exposures.

Investing in Bonds in India

Indian investors have several avenues to invest in bonds:

Direct Purchase from Issuers

Most government bonds can be purchased directly during issuance in primary markets through the RBI Retail Direct portal. Corporate bonds require having a demat account with online trading access to directly participate in public issues by companies and subscribe to bonds. Know Your Customer formalities must be completed beforehand, and issuers or brokerages must facilitate this.

Secondary Market Purchase

Besides primary markets, corporate bonds, state development loans, and government securities are actively traded in secondary markets post-issuance. Investors can buy/sell bonds on stock exchanges through full-service or discount brokerages, charging competitive brokerage rates and offering trading platforms alongside equities.

Mutual Funds

Retail investors can take bond market exposure through debt mutual funds that invest predominantly in bonds rather than direct purchases. Fund houses offer various bond fund categories based on maturity, duration, credit risk, and rate sensitivities that suit every investor profile. They provide diversity along with professional fund management.

While bonds carry risks like interest rate, inflation and default exposures, they compensate investors through regular income and portfolio diversification benefits. Evaluating one’s return objectives, risk tolerance horizons and investment amounts facilitates informed decisions for bond investing.

How To Invest in Sovereign Gold Bonds on Angel One?

1. Open the Angel One App and go to ‘Portfolio’.
2. Slide to open SGBs on the Portfolio page. Click on ‘VIEW ACTIVE SGBs’.
3. This will open the SGB portal. Choose the active SGB that you want to invest in. 
4. Complete the payment to become an investor in the SGB.

Bonds Trading and Settlement Mechanics

Bond Lot Size

Exchanges define minimum trade or lot sizes for bonds similar to those existing for equities. For corporate bonds, one lot typically equals one bond, so buyers must purchase bonds in multiples of face values like ₹1,000, ₹5,000, etc. This helps improve marketability and liquidity in the secondary markets through higher retail participation enabled by affordable investment sizes. 

Settlement Process

The settlement schedule varies across bond categories. Government securities follow the T+1 settlement cycle, with pay-ins and pay-outs happening a day after trades. Corporate bond settlement occurs on a T+2 basis in line with equity market timetables, while state government loans follow longer T+3 settlements due to logistical issues.

Settlement Amounts 

Bond settlement values incorporate an accrued interest component, also called cum-interest settlement. The accrued interest represents interest accumulated from the previous coupon payment date up to the transaction date. It compensates the existing bondholder for holding it during that residual period. Hence, the settlement amount equals the traded price plus these accrued interest differentials to be factored in.

Odd Lot Bonds

Odd lots refer to the quantity of bonds smaller than prescribed market lots in the secondary market. Odd lots often trade at slight premiums or discounts owing to associated illiquidity concerns and higher friction costs. Market makers facilitate odd lot transactions by combining orders across client trades, subject to price variances from round lot rates.

Bond Market Timings

The bond trading window spans Monday to Friday market hours across exchanges, in sync with the equity segment. Government bonds remain accessible for extended sessions tracking US time zones owing to the international investor base and global macro event linkages determining sentiment. Corporate bond trading activity, though, is predominantly concentrated during conventional daytime hours in the Indian markets.

Yield to Maturity 

A bond's Yield To Maturity (YTM) metric represents the total expected internal rate of return an investor would earn from holding the bond till it matures and repays face value. It equates the initial investment amount to annually compounded future cash inflows from coupons and principal repayment. The YTM adjusts the bond's current market price levels, coupons, residual duration and face value at maturity. 

Higher YTMs relative to a bond's coupon rate reflect current trading discounts and, hence, a higher returns scope left for prospective buyers. Declining interest rate scenarios trigger bond price rallies, lowering YTMs since investors must pay premiums over par values, which they recoup only at maturity. The dynamic economic backdrop makes gauging realistic return potential using YTMs crucial before committing investments.

Conclusion

Bonds play an integral role in global debt capital markets, facilitating issuers to raise financing for myriad needs while providing investors opportunities for steady cash flow income and diversification benefits. Investors should evaluate various bond types available in aspects like liquidity, credit ratings, and risks besides target returns to make informed decisions. 

With an accommodative global rate environment and India offering positive growth differentials, bonds are attractively positioned as portfolio and strategic allocation constituents.

However, it may not be necessary to have bonds as a part of your portfolio. Choosing the correct asset classes requires an understanding of your risk appetite and investment objectives. Therefore, invest wisely and rebalance your asset mix to meet your goals. 

With that said, in the upcoming chapter, we’ll learn about G-secs or government securities. We’ll look at the types of G-secs, how they work and how you can invest in them.