What are Bonds?

With its risk and fluctuations, the stock market is generally preferred by investors looking for a higher risk-to-reward ratio. Conservative investors who do not want to risk their investment capital prefer to invest in bonds. Bonds belong to the debt market investments category, where the lender offers funds to the bond issuer. The bond issuer could be a private sector company or government. The increasing investor interest has resulted in the Indian bond market growing to US$2.59 trillion. Let's explore what are bonds and different ways to invest in bonds to earn higher returns.

What are Bonds?

A bond is a loan to the issuer, which could be a government entity or a corporation. Municipalities, the central government, and various companies issue bonds to finance their projects, and they are the borrowers. The investors are the lenders for the bond issuers. The borrower pays the lender a fixed interest rate and the par value upon bond maturity.

In the past 10 years, the bond market in India has matured significantly with the growth in primary issuance and increasing trading volumes in the secondary market. In India, almost everyone has indirectly invested in bonds, as most insurance companies, pension funds, and mutual funds invest in the bond market. The fintech revolution has made the bond market accessible for retail and individual investors.

The private sector and government organisations need funds for business operations and expansion. These organisations issue bonds to generate funds. Investors can purchase bonds that mature after a certain period and offer returns on the original investment. Thus, bonds are a relatively safe investment option with the potential to be a fixed-income source. Depending on the type of bonds, you may also receive interest annually. Bond Investments are an excellent source of additional revenue that offers portfolio diversification through exposure to the debt market segment.

Overview of the Indian Bond Market

The rising inflation rates and global central bank rate hikes have posed challenges for the Indian bond market. While the pressure extended for 3 years, 2024 has been good for the Indian bond market.

The country is expected to become the second biggest bond market with the introduction of a fully accessible route (FAR) for foreign investors in India. This resulted in an inflow of ₹.90000 crore from October 2023 to June 2024. A Bloomberg Report has also noted that about $20 billion to $22 billion inflows can be expected by March. As Indian bonds are added to the Global index, they can open doors for new-age foreign investors interested in passive investments.

Recently, SEBI has announced lowering the face value of listed bonds from ₹. 1 lakh to ₹.10,000. This move can boost the corporate bond market as more retail investors will be interested in investing.

Features of Bonds

Before investing in bonds, you must learn the features and terminologies of this popular debt instrument.

Face Value

The price of a single bond unit issued is called the face value. It is also called nominal, par value or principal, and the issuer must return this value to the investor at Bond maturity. For example, suppose you purchase a corporate bond at a face value of ₹.10000. In that case, the company from which you purchased the bond must return this ₹.10000 along with the associated interest to you after the bond maturity. Remember, the face value of a bond is different from the market value because the market value of bonds fluctuates.

Coupon Rate

Throughout the tenure, the bonds attract fixed or floating interest rates based on the bond type. These interest rates vary based on the kind of bond and are issued to the investors periodically. In the case of Bond investments, these interest rates are called coupon rates. Multiple aspects of the bond, such as the tenure, reputation of the issuer, and several other factors, determine the coupon rate.

Bond Tenure

The tenure refers to the time period after which the bond reaches maturity. As bonds are financial debt contracts between issuers and investors, they close at the end of the tenure. Bonds that mature within 5 years are short-term bonds, and intermediate-term bonds may have a tenure of up to 12 years. You can also find long-term bonds with more than 12 years of tenure. Long-term bonds indicate that the issuing company has been in the business for a long time and are considered mature investments.

Credit Quality

The confidence of the investors in the organisation's bonds is called credit quality. Generally, bonds are classified by credit rating agencies based on the risk of the company defaulting on a debt repayment. The bonds are categorised into investment and non-investment grade bonds, depending on the grading. Investment grade bonds may have lower returns due to steady market risk, while non-investment grade bonds have a higher return potential at increased risks.  

Tradable Bonds

Investors can transfer ownership of the bonds within a given tenure by selling their bonds to other entities in the secondary market. This can be done when the market price of the bonds exceeds the nominal value.

How Bonds Work?

The bond-issuing company uses the funds raised through bonds to initiate new projects, refine ongoing operations, invest in research and development, and other needs. The terms like rate of interest, type of interest payments, and period of maturity will all be specified at the time of bond issuance. The initial price of the bond is set at the face value. Regardless of the bond's market price, the bond issuer is only obligated to pay the face value of the bond after it reaches maturity.

Benefits of Investing in Bonds

Bonds are one of the low-risk investment options, and investors can depend on the interest and principal returns. It offers the following advantages:

• Stability - Compared to other investment options, bonds are relatively more stable and offer a low-risk avenue for the investor. You can balance out the volatility of equity investments through the interest payments from bonds.
  
• Indentures - Bonds are legally binding contracts that the borrower is expected to fulfil even before paying its shareholders in the event of the entity's bankruptcy. So, generally, companies with a solid financial history are known to issue bonds as they are highly unlikely to default on interest payments.
  
• Portfolio diversification -  bonds offer excellent risk-adjusted returns on the investment as they are fixed-income debt instruments. Through bond investments, investors can reduce the possibility of short-term losses and rely less on equity returns.

If you are wondering how to buy bonds, remember they are not traded on an exchange like stocks. You must register with a broker and make a purchase from them. The broker may offer access to primary and secondary bond markets for hassle-free investments in bonds.

The biggest risk with bond investment is the default risk. When the bond issuer becomes unable to make the required interest or principal payment to the debtors, it can cause setbacks for the investors who purchased those bonds. So, understanding the bond rating is crucial. A higher bond rating implies reduced risk for the investors.

Types of Bonds

Based on the features of the bonds, they are classified into several types:

Fixed Interest Bonds

These provide a constant coupon rate throughout the bond's tenure. The predetermined interest rates offer predictable returns regardless of the market conditions. With fixed-rate bonds, you can know the periodical interest amount you may receive.

Floating Interest Bond

The coupon rates of floating interest bonds fluctuate based on market conditions and are highly elastic. Inflation, economic conditions, and investor confidence determine the floating rate of such bonds.

Inflation Link Bonds

These special debt instruments offer hedging against economic inflation on the interest return and face value.

Perpetual Bonds

These security investments do not require the issuers to return the principal amount to the purchaser. They generally don't have a maturity period, and investors can generate study interest payments associated with perpetuity.

Government Security

The bonds issued by the central and state governments carry no credit risk; they are called government securities. You can earn periodical interest and get back the principal on maturity. These bonds generally pay interest semi-annually.

Corporate Bonds

When private corporations issue bonds to meet their financing needs, they are called corporate bonds. Corporate bonds pay a higher interest rate than government bonds and FDs.

Convertible Bonds

With convertible bonds, investors can choose to convert the investment into equity-based investments subject to pre-specified bond terms.

Sovereign Gold Bond

The Government of India issues sovereign gold bonds in the name of Government of India stock. Such bonds pay regular interest and have zero risk of handling associated with physical gold.

RBI Bond

The 7.75% taxable bonds issued by the government of India allow resident citizens and HUF to invest in different types of taxable bonds without any monetary ceiling.

Here is a quick overview of the risks associated with different bond types:

How to Buy Bonds?

The following steps are crucial to start investing in bonds:

• Explore the different types of bones and understand the risks and associated costs. Government bonds have lower risks, but corporate bonds offer better yields for more risk.
  
• Choose your investment platform based on your needs. Online stock brokers and banks offer direct bond access and investment services,
  
• Open an investment account by creating your Demat account to hold your bonds electronically. You also need a training account for bond transactions.
• Spend your time researching and selecting bonds to find high-rated bonds with better yields. Understand maturity dates and ensure alignment with your investment goals.
  
• You can purchase bonds from the primary or secondary market. Apply for bonds directly during issuance when buying in the primary market.  The secondary market allows purchasing existing bonds through a trading account. Use these platforms to access a range of bond options and complete transactions.
  
• Tracking market prices and bond performance enables you to optimise bond investments based on changing interest rates.
  
• Tax implications differ with the type of bonds. Interest from government bonds is usually tax-free, but corporate bond yields may incur tax. Additionally, capital gains from bonds may also be taxable.  

Investing in Bond Funds

It is possible to invest in bonds without purchasing them from a primary or secondary market. You can invest in debt instruments, including government and corporate bonds, through bond funds. These are a type of exchange-traded funds (ETF) or mutual funds that invest primarily in several fixed-income debt securities. Such mutual funds include bonds from different companies, governments, municipalities, money market instruments, and other debt securities, thus offering excellent diversification.

During the entire holding period, you can get returns in the form of fixed-interest payments from the best bond funds. You can also get capital appreciation to a certain extent based on the performance. Professional fund managers actively monitor the market and optimise fund portfolios, effectively managing risk.

Conclusion

Purchasing bonds in the primary market is simple, as the government and corporations offer several types. You can also buy from the secondary market by participating in the bond trading exchanges. Generally, bonds are illiquid until the bond matures. However, if you need to capitalise on the bond before the maturity period, you can sell it in the secondary market. Bonds are relatively safe investment options suitable for risk-averse investors.

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