Bonds: Meaning, Type, Benefits and Risk

Moving on from our last chapter about derivatives, let's now talk about bonds. Unlike the dynamic world of derivatives, bonds offer stability and income. They are like a bedrock for steady investments. In this chapter, let’s delve into the fundamentals of bonds - what they are, how they work, their types, and more.

What Is a Bond?

A bond is a debt security representing a loan from an investor to a borrower, typically corporate or government. When you purchase a bond, you lend money to the issuer in exchange for periodic interest payments and the return of the principal amount when the bond matures. 

Bonds are considered fixed-income securities, providing a predictable stream of income for investors. They are valued for their stability and are often seen as a conservative investment option compared to more volatile assets like stocks.

Working of Bonds

When a company or an entity wants to raise money for various reasons, such as to finance new projects, refinance existing debts or maintain ongoing operations, they may issue bonds directly to investors. The borrower (issuer) issues a bond with details like the loan duration, interest payments, maturity date, etc. 

The interest payment (the coupon) is part of the return bondholders earn for lending their funds to the issuer. The interest rate that determines the payment is called the coupon rate. After the maturity of the bond, the face value of the bond will be paid back to the lender.

What Are the Types of Bonds in India?

• Capital Gains Bonds

Capital gain bonds are specialised financial instruments issued by government-backed or public-sector companies. These bonds are also known as capital gains tax exemption bonds. 

The main objective of capital bonds is to help you, an investor, save on long-term capital gains tax that arises from the sale of immovable assets like real estate. When you sell such assets, certain taxes are levied on the profit earned, which is known as capital gains tax. To avail of the tax-saving benefits these bonds offer, you must invest the capital gains amount you earn after selling the asset in these bonds. The gains must be invested within a specified period after the sale. The Finance Act of the respective financial year determines the eligible bonds and the time frame for investment.

• Corporate Bonds

As the name suggests, Corporate bonds are issued by various companies for their financial needs. The bondholder earns regular interest income and is provided the principal amount at maturity. These bonds can pay higher interest when compared to the Government Bonds or Fixed Deposits.

• Government Securities

The Central and State Governments issue these bonds. Government bonds are considered to be one of the safest investment options in India. These bonds pay interest on a semi-annual basis.

• Inflation-Linked Bonds

Inflation-indexed bonds are an efficient way to counter inflation risks. In such bonds, both principal amount and interest payments are indexed to inflation. 

• Convertible Bonds

This bond provides the bondholder an option to convert it into equity as per the pre-specified terms.

• Sovereign Gold Bond (SGB)

SGBs are issued by the Government of India. Gold bonds are in the form of security, similar to the Government of India stock. It provides interest that is paid regularly and comes with zero risk, unlike physical gold.

• RBI Bond

RBI Bond is also known as the Government of India Savings, which is a floating-rate saving bond. Any Indian citizen can invest in it. These bonds can be purchased from any government or private bank. The interest on this bond is determined half-yearly. 

Factors Affecting Bond Prices

• Interest Rates:

Bond prices move inversely to interest rates. When interest rates rise, existing bonds with lower yields become less attractive, causing their prices to fall.

• Credit Quality:

The creditworthiness of bond issuers impacts prices. Bonds from financially stable entities are more desirable, leading to higher prices.

• Maturity Date:

Longer-term bonds face greater interest rate risk. Investors demand higher returns for locking in funds for an extended period, affecting prices.

• Issuer's Financial Health:

The financial stability of bond issuers influences investor confidence. Bonds from financially sound entities command higher prices due to lower default risk.

• Economic Indicators:

Economic factors, like GDP growth and employment rates, impact bond prices. A healthy economy tends to increase investor confidence and demand for bonds.

Benefits of Bonds

• Relatively safe:

Bonds are generally considered less volatile and risky. This is because they offer a pre-determined return and are backed by the issuer's promise to repay the principal at maturity.

• Offers fixed-income:

Bonds typically pay regular interest, known as coupons, providing a predictable income stream. This can be especially attractive for those seeking stable income generation. 

Risks of Bonds

While bonds offer valuable benefits like stable income and portfolio diversification, they also come with a set of risks as follows:

• Interest rate risk:

When interest rates rise, the prices of existing bonds fall as newer bonds with higher interest rates become more attractive. This can lead to losses for investors who sell their bonds before maturity.

• Credit risk:

This refers to the possibility that the bond issuer may default on their repayment obligations. While government bonds carry low credit risk, corporate bonds are subject to the financial health of the issuing company. Default can lead to significant losses for bondholders.

Now that you have an idea about bonds, in the next chapter, learn about currency, how to invest in it and more.