7 Basic Things To Know About Bonds
The bond market is by far the largest securities market worldwide. However, its Indian counterpart is still in a nascent stage due to unawareness about bonds and limited ways of investing.
Luckily, with the emergence of online platforms, individuals are becoming more familiar with this investment instrument and gaining means to invest in it in a hassle-free way.
Nonetheless, investors should first familiarise themselves with a few aspects of this investment instrument to make an informed choice. To that end, it’s judicious to start with the basics.
What Are Bonds?
These are debt instruments that entities issue to raise funds for various needs. In bonds, entities/issuers borrow finance from investors (lender) and repay a bond’s face value within a specified maturity period. In exchange, borrowers pay interest (coupon) to investors, either semi-annually or annually, per the loan details.
In simple words, investors can lend funds to an entity by purchasing bonds raised by an issuer. The issuer can be GOI, a corporation, a governmental, civic body, or any other entity. In return, an issuer is obliged to pay interest at a specified rate during the term period.
The Basics Of Bond
Bond maturity refers to when the borrower must pay back the principal/original value of the bond to the investor/bondholder. Once the issuer repays, its bond obligations end. The maturity date is determined at the issuance and stands for its lifetime. The maturity period is divided into three terms –
- Short-term – Short-term bonds mature within one to three years.
- Medium-term – These bonds mature over ten years.
- Long-term – Long-term bonds come with a maturity period of up to 40 years.
It is the interest payment paid to investors/bondholders, generally semi-annually or annually. The coupon rate is also called the yield rate. It is calculated by dividing the annual interest payment by the bond’s principal value.
3. Secured And Unsecured
Bonds are either secured or unsecured. In a secured bond, the bondholder is obliged to receive specific assets (collateral) if the issuer goes bankrupt. If the borrower fails to repay, such asset’s ownership gets transferred to the investor.
An unsecured bond, on the other hand, is not backed by any collateral or security. The interest payment on such bonds is comparatively higher than that of its secured counterpart. In case the borrowing company goes bankrupt, investors will receive a small portion of the bond value. The risk involved in an unsecured loan, therefore, is always higher than in secured loans.
4. Liquidation Order
When a company goes bankrupt, it sells off all its assets to clear its debts. In such scenarios, the company primarily pays investors per the seniority of the debt. First, the senior debt is cleared, followed by junior and subordinate obligations. The last in line are shareholders, who receive whatever remains.
Bonds may come with call and put provisions, wherein the issuer can pay off the bond before maturity. A company can call its bonds if the interest rate permits them to borrow at a better interest rate. Investors can exercise their put option to sell bonds back to the issuer prior to maturity at a prespecified price.
6. Tax Status
Most bonds are taxable. However, government and municipal-backed bonds are tax-free in most cases. In such bonds, both the principal and the interest payment are not liable for tax deductions. But, tax-free bonds come with lower yields.
7. Bond Issuers
Generally, there are three types of bond issuers in the Indian bond market. Investors may at times find foreign bonds on some platforms.
- Government – Such bonds are issued by Central and state governments to obtain funds for infrastructural development projects. These bonds are issued under RBI’s supervision, wherein GOI pays the principal after the maturity period and is obliged to pay a specific interest during it. Government bonds are usually tax-free, and investors falling under a higher tax bracket can buy such bonds.
- Corporate – Companies issue bonds when they need investors to fund their business operations, expansion, machinery purchasing, etc. These bonds usually offer higher returns than their government counterparts. Moreover, a bond with a lower credit rating offers higher returns.
- Municipal – Muni bonds or Municipal bonds are issued by the Urban Local Bodies of the State to fund projects for socio-economic infrastructural developments and building bridges, roads, hospitals, educational institutes, libraries, and other public facilities. Investors can choose either General Obligation Bonds (GO) or Revenue Bonds.
Investors can consider reliable online platforms to buy such bonds in small quantities and diversify their portfolio.
Bonds add safety and provide a fixed source of income to investors. The profit may not be as high as investments in stocks, but there is a minimal risk of losing investments. Even though companies may default, there is always the surety of receiving a significant portion back. Government and municipal bonds rarely default. Investors must also peruse the other factors before investing to decide which option is most suitable to their requirements judiciously.