What is a Bond?

Bond is a fixed-income instrument that represents a loan from an investor to a borrower. It is a contract between the investor and the borrower, where the borrower uses the money to fund its operation and the investors receive interest on the investment.

Bonds are high-security debt instruments that fall under the fixed income asset class. It enables an entity to raise funds to fulfill the capital requirement for funding various projects. It is a debt that borrower’s avail from individuals for a specified tenure.

These are issued by the government, corporates, municipalities, states, and other entities to fund their projects. These bonds have a maturity date and when once that is attained, the issuer needs to pay back the amount along with a part of the profit to the investor.

With this understanding of Bonds meaning in finance, let’s take a look at the features and working of this debt category.

Who are the issuers of a Bond?

The issuers of bonds are:

  • Government: The government raise funds to sponsor roads, dams, schools and other infrastructure projects. The government institutions at all levels need funds to sponsor roads, dams, schools, and other infrastructure projects and to complete projects and hence raise funds through bonds.
  • Corporations:Businesses or corporations often borrow money to grow their business. The browning can be for buying equipment, for research and development, undertaking profitable projects, etc. Large corporations usually need far more money than what a bank can typically lend.

How does a Bond work?

Bonds have three components that are used to calculate a bond yield:

  • The principal
  • The coupon rates
  • The maturity dates

  • When the borrower issue bonds, an agreement is made between the borrower and the lender where the issuer of the bond promises to pay back the principal amount on the maturity date. The issuer also pays the interest on the money borrowed (Coupon) throughout the tenure.

Features of a Bond

  • Issue Date: The issue date of bonds is the date from which the interest starts accruing.
  • Coupon Rate: The interest rate at which a bond is issued, which the company is liable to pay to the investors is referred as the coupon rate. Coupon payments are made semi-annually or annually.
  • Maturity Date: It is the date on which the issuer pays back the Bonds’ face value to the investor. Before investing, check the maturity period of the Bond and invest as per your financial goal.
  • Taxation: Certain Bonds provide tax benefits, while there are few corporate bonds that levy tax on their Bonds. Also, certain Bonds issued by the government, municipality Bonds, and a few more don’t impose a tax on the profit earned.

Advantages of Bonds

  • Portfolio Diversification: Diversification can provide you with better risk-adjusted returns. Also, diversification with bonds can help preserve capital for equity investors during times when the stock market is slump.
  • Lower Risk: Bonds are long-term investment instruments with low-risk associated.
  • Fixed Return on investment: Bonds pay interest at regular intervals and also, when Bonds mature, the investor receives the principal amount. In Bonds, the investor knows the exact return he/she will be getting.

What are Different Bond Categories

  • Government Bonds: These are the bonds issued by the Central and the State Government of India. RBI (Reserve Bank of India) manages and regulates these bonds. Government bonds generally have a low-interest rate.
  • Municipal Bonds: These are issued by municipalities or government bodies. When compared with Government bonds, these carry comparatively more risks.
  • Corporate Bonds: These are bonds that are issued by private companies. The companies issue both Secured Bonds and Non-Secured Bonds. The companies issue them to raise capital at a low-interest rate. Certain Corporate Bonds pay higher yields than Government Bonds.
  • Asset-Backed Securities: Asset-Backed Securities are Bonds that are issued by banks or other financial institutions.

Different types of Bonds

There are varieties of Bonds available for investors. These can be divided by the rate, type of interest, or coupon payment. Below is the list of the most common variations:

  • Callable Bonds: When a Bond issuer calls out his right to redeem the Bond even before it reaches its maturity, it is referred to as a Callable Bond. This option is exercised by the Bond issuer. An issuer can convert a high debt bond into a low debt bond.
  • Fixed-rate Bonds: Bonds whose coupon rate remains the same through the course or tenure of the investment, it is referred to as Fixed-rate Bonds.
  • Floating-rate Bonds: Bonds whose coupon rate vary during the tenure of the investment, then it is referred to as Floating-rate Bonds.
  • Zero Coupon Bonds: Zero coupon bonds When the coupon rate is Zero and the Bonds issuer pays only the principal amount to the investor on maturity. It is called as Zero-coupon Bonds.
  • Puttable Bonds: These are those Bonds where an investor sells their bond and get their money back before the maturity date, then it is called as Puttable Bonds.

Things to Consider Before Investing in Bonds

An investor must consider the following factors before investing in Bonds:

  • Do the Bonds fit into your financial plans
  • Do the Bonds carry the risk of default
  • What will be the price risk of these Bonds
  • What is the exit option

What is YTM?

YMT (Yield To Maturity) is one of the ways through which one can price Bonds. It is the total of expected return for an investor if the bond is held till maturity. It is a long-term yield but represented as an annual rate.

Who should invest in bonds?

Investors who are risk averse and looking for fixed returns on investment should consider bonds.

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Frequently Asked Questions

The first rule for any prudent investment strategy is to diversify the portfolio and bonds can help diversify your investments alongside equities. It is a fixed income instrument and can give stability and regular returns.

Company ABC issue a bond with Face value of Rs. 1000 and a coupon rate as 10%. Bond will get mature in 10 Years.

An investor will lend Rs. 1000/ bond at 10% interest for the next 10 years and at the end of 10th year, the issuer will pay back the entire principal along with the interest, to the investor.