Bonds are investment instruments for investors but similar to loans for issuers. Let us first understand the nature of bonds and loans.
Have you ever taken a loan?
The answer may be a “yes” and if “no” then you may plan to take one in the future.
You may either approach a friend, relative, or bank for a loan.
You always take the loan for a purpose. The purpose may be to purchase your dream house, or your dream car, to set up your business, etc.
When you repay this loan you are also required to pay interest.
Do you know companies and government also to take a loan?
Awww…..
Yes, this is a fact. Companies and governments raise money through “bonds” for the purpose of funding their projects. These projects can be long-term or short-term.
The interest on bonds depends upon the monetary policy stance of the central banks (In India RBI)
Let me explain everything about this fundraising system by the government and companies.
What are the bonds?
Bonds are the instruments issued by companies and governments for the purpose of raising funds to finance their projects.
The government and companies (hereinafter referred to as “issuer” of bonds or “borrower”) pay interest on the bonds issued by them.
Confused……?
Think of the situation when you approached the bank for taking a loan to purchase your dream house.
Suppose the bank gives you a housing loan of Rs 15,00,000 for 20 years at the rate of 8% per annum, in return you need to deposit the papers of your house with the bank as security.
You pay monthly installments to the bank which also include the interest portion, which means you are also required to pay interest on a monthly basis.
Once you paid the installments for 20 years. i.e. when you repay the entire loan amount, the bank returns the ownership papers of your house.
In the above case,
You are the “borrower” because you have taken the money.
The bank is the “lender” because the bank has given the money.
The “purpose” for which you took the loan is “to buy the house”.
Now consider the situation that government needs money for building an expressway.
For raising the funds the government would issue a paper (Bond) that mentions the following things:
- The rate of interest (say 8% per annum) at which the government would pay the interest to the investor
- The time period for which the bond is issued (say 10 years).
- The price at which you can purchase that paper (Bond) from the government. This price of the bond is known as “The face value of the bond”.
Same as you give your money to the bank for a fixed deposit and the bank gives you a paper mentioning the rate of interest, and time period.
Technically,
The rate of interest mentioned on bond paper is called the “Coupon rate”.
The time period for which the bond is issued is called “Maturity”.
The price at which the bond can be purchased is called “Face value”.
The person purchasing the bond is called the “Bondholder”.
Here, the Government would be called “The Issuer or Borrower”.
When the bond matures you give the bond paper back to the issuer and the issuer returns your money this is called “Redemption”, this is the same as when your fixed deposit (FD) gets matured you give back the FD document to the bank and the bank returns with money.
Difference between the bond paper and the FD document
In FD you receive the interest on the maturity date along with the principal amount.
But in the case of a bond, you receive periodic interest. i.e. monthly, quarterly, semiannually, annually, etc, and on maturity, you only receive the principal amount. i.e. the price at which you purchased the bonds (Face Value).
Types of bonds
Corporate Bonds
Corporate bonds are issued by companies.
The purpose of corporate bonds would be to fund the projects of companies, equipment purchases, land purchases, etc.
The period of corporate bonds would be more than one year.
Corporate bonds provide high-interest rates (Coupon rate)
The interest would be taxable for the bondholder (Investors).
Government Bonds
Government bonds are issued by the government.
The purpose of government bonds would be to raise funds for public projects, infrastructure projects, etc.
The period of government bonds would be between 5 years to 40 years because government projects are generally for long terms, for example building a highway.
Government bonds have the lowest interest rates because they are the least risky.
Interest on government bonds is taxable for the holder (Investors).
Public Sector Undertakings Bonds (PSU Bonds)
PSUs are companies in which the government holds more than 51% of shares.
The bonds are issued by PSUs.
The purpose of these bonds is to raise funds for projects, equipment, etc.
The interest rate for these bonds is lower in comparison to corporate bonds and higher in comparison to government bonds.
Interest on these bonds is taxable for the bondholder (Investor).
Tax-free bonds
Tax-free bonds can be issued by PSUs and the government.
The interest received by the bondholder is exempt from tax.
The purpose of tax-free bonds is to raise funds for infrastructure projects and housing projects.
The period for which these bonds are issued is long-term.
Zero-Coupon Bonds
Technically, the rate of interest is called the coupon rate in the case of bonds.
Zero coupon bonds are issued by Corporate, PSUs, and governments.
As the name suggests zero coupon bonds have zero coupon rates. i.e. zero interest rates. Then why do you invest in Zero coupon bonds if there is no interest?
Normally, when a bond is issued, it is issued at the face value. Let’s say the face value is Rs.1000 per bond and the interest rate is 8% per annum (coupon rate) for 10 years.
So you would receive yearly interest of Rs 80 per year for 10 years and after 10 years. i.e. when the bond matures you would get Rs.1000 .i.e. the principal amount invested by you, this is called redemption.
In the case of zero coupon bonds if the face value of the bond is Rs.1000 per bond and the time period is let’s say 10 years. No interest would be paid to you by the insurer.
But to purchase the zero coupon bond you are not required to pay Rs.1000 but you would pay Rs.900 (Rs 900 is taken as an example only, in reality, this amount can be anything less than Rs 1000) and on redemption, you would receive Rs.1000 .i.e. zero coupon bonds are issued at discount but redeemed at face value.
So the difference between redemption value and investment value is the profit for investors.
In our above example, redemption value (Rs 1000) less purchasing value (Rs 900) is equal to Rs 100, which is the profit.
Convertible Bonds
Now you know that bonds are a form of loan given by an investor to the issuer.
In the month of February 2023, the Government of India converted its AGR dues of Rs. 16,123, crores due towards Vodafone Idea, into equity shares.
Vodafone Idea had to pay 16,123 crores to the government but due to its inability to pay Vodafone Idea issued equity shares to the government instead of payment of AGR dues. So now the government also became a shareholder of Vodafone Idea.
The same happens with convertible bonds. Convertible bonds are those bonds that can be converted into equity shares of the issuer on the basis of certain conditions.
The holder of these bonds gets the interest up to the date of conversion into equity shares.
Sovereign Gold Bonds (SGB)
Sovereign Gold Bonds are issued on behalf of the Government of India by the reserve bank of India.
Sovereign Gold Bonds are linked to the price of gold.
Interest on Sovereign Gold Bonds is paid at the rate of 2.5% per year/annum.
The maturity period of Sovereign Gold Bonds is eight years.
Green bonds
Green bonds are issued to raise funds for environment and climate-related projects.
Like projects for the prevention of pollution, management of water, preservation of forests, etc.
These bonds can be issued by companies as well as the government.
Perpetual bonds
These bonds have no specific maturity period.
These are issued for an infinite period of time.
These bonds are redeemed at the option of the issuer. i.e. the issuer can redeem these bonds as and when it deems fit.
These bonds provide a higher rate of interest due to the fact that as an investor you are taking the risk for an infinite period of time. The risk is whether the company would be able to pay the interest or not.
State Development Bonds
These bonds are issued by the State Governments.
Have you heard about “Fiscal Deficit”?
When the yearly expenses are more than the yearly income, the difference is called a “Fiscal Deficit”
When the yearly expenses of India exceed the yearly income of India it is called “Fiscal Deficit of India”.
Similarly, when the expense of a State Government exceeds the income of the state government in a year, it is called “Fiscal Deficit of State”.
State Development Bonds are issued by the state governments to raise funds for various purposes.
Since when the state is in a fiscal deficit that means the income of the state is less than expenses, therefore these bonds are issued to raise funds to meet expenses.
Advantages of investment in bonds
Bonds provide stable income to the bondholders.
As you know that bonds provide a fixed percentage of income, this gives assurance to the investor regarding the income he would receive on his investment.
Bonds help to diversify your portfolio and reduce the risk in your portfolio.
Types of Bond market
Primary bond market
The market where the bonds are initially issued to investors for the purpose of raising capital by the issuer is called the primary bond market.
When the new bonds are issued the investors can purchase them directly from the issuer.
This is the same as the initial public offering (IPO) in the case of equity shares.
Secondary bond market
If you have not subscribed to the bonds issued initially by the issuer. i.e. from the primary market, then you can purchase them through a marketplace which is called the secondary bond market.
Secondary bond markets are a marketplace where bonds are purchased and sold between the investors.
The transactions in secondary bond markets are done through brokers.
Is the investment in bonds safe?
There is nothing that is considered safe.
But you can say that investment in bonds is safe in comparison to investment in equity shares because investment in bonds provides a fixed rate of interest.
But, how do you decide to invest in bonds of which companies?
There are various rating agencies like Moody’s, S&P (Standard and Poor), ICRA, CRISIL, CARE, etc.
These rating agencies analyse the bonds on various parameters like the history of lending and borrowing of the issuer, capacity to redeem the bonds, loans (debt) taken by the issuer in past, financial statements (balance sheet, profit and loss account), etc.
These agencies categorise the bond in the following categories:
- “D” Category: The bonds in this category are not considered investment-grade bonds. Investment in these bonds has to be avoided.
- “C” and “B” Category: The bonds in this category are considered very risky because these bonds have a high risk of default, which means it is possible that the issuer may default in payment of interest or maybe even principle as mentioned in the bond. But the “C” category has more risk than the “B” category bonds.
- “BB” Category: The bonds in this category are considered to be less risky in comparison to the above two categories but they have a moderate risk of default by the issuer.
- “BBB” Category: The bonds in this category have no risk of default but they may have some issues with the timely payment of interest.
- “A” Category: These bonds are considered relatively safe in comparison to the above categories of bonds.
- “AA” Category: The bonds in this category have a very high degree of safety.
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