What are Bonds?
A bond is a debt security representing a loan to the issuer,
typically a government entity or corporation. Bonds are generally
issued by an organisation falling in the private or government
category to raise funds to accomplish one or more purposes.
Bonds have been around for more than a century and have proven
to be a reliable way to invest money for a certain period.
Bonds are relatively safe investment options that yield a fixed
income. It works as an additional source of income for an investor.
The rate of interest is paid annually. In some case, the interest is
also paid monthly.
Bonds are used by companies, central government, and
municipalities to finance their projects. The borrower pays the
lender a fixed interest rate and the par value upon maturity.
Consider it like taking out a personal loan from a bank, but you
are the lender (investor), and the borrower is usually a government
or organisation (issuer).
Types of bonds:
There are many different types of bonds
available in the Indian
market. They are classified based on issuer, coupon rates, and
tenure. Depending on the issued bonds, bonds come with varying
interest rates and risks.
- ● According to the issuer, bonds can be categorised into government, public sector undertakings (PSU) or corporate bonds.
- ● According to the coupon, they can be fixed, floating or zero- coupon bonds.
- ● Further, according to tenure, they can be categorised into short-term (1 to 5 years), intermediate term (5 to 12 years), and long-term bonds (more than 12 years).
Below are the five best types of bonds:
- 1. GOVERNMENT BONDS
The Indian government, either the central or state governments, may require funds for their operations, such as infrastructure, public projects, etc. thus, they issue bonds known as government bonds.
The government (issuer) guarantees principal repayment as well as interest payments. As the government (central or state) backs them, they are considered the safest. Government bonds have a long maturity, usually between 5 and 40 years. These bonds pay a fixed/floating interest rate; however, they provide lower returns as they carry less risk.
Investors who are wary of taking risks, sometimes known as risk- averse investors, and who want to ensure the highest level of protection for their money might invest in government bonds. - 2. CORPORATE BONDS
Companies issue corporate bonds to fund their needs, such as expansion, equipment purchases, land purchases, construction of a new factory, etc. These bonds are often medium to long-term investments with more than one year of maturity. Companies pay investors monthly interest payments at predetermined intervals and their principal amount when the bonds mature.
Companies issue debt because it allows them to raise funds at a reduced cost and without diluting their stock. Corporate bonds have a larger default risk than government bonds and provide a higher yield. - 3. PSU BONDS
PSU bonds are issued by public-sector companies, such as PSU banks, power sector companies, railways, etc., with a government stake of more than 51%. As the government backs these bonds, they carry less risk, thus lower return than corporate bonds. It’s come with medium to long term obligations. Continue to invest in PSU bonds for a longer period since you will get better returns despite market price swings. - 4. TAX-FREE BONDS
Tax free bonds are exactly what their name implies: It is tax-free. As a result, the interest generated by investors on these securities will be tax-free under section 10 of the Income Tax Act. The government issues these bonds for a specified purpose, such as infrastructure or housing projects. Municipal bonds are an example of this type of bond. Tax-free bonds have a 10-year or longer maturity and have very low default risk. Thus, they provide a lower rate of return than corporate bonds. Further, because they have a long lock-in time, they are non-liquid. - 5. ZERO-COUPON BONDS
Bonds that pay no interest to the investor are known as zero coupon bonds. Why would an investor invest in such an instrument, you might wonder? - ● Zero-coupon bonds (deep discount bonds) are issued at a discount to their fair value but are redeemed at par.
- ● The investor’s profit is the difference between the price at which the bond is issued and the price at which it is redeemed (par value). For instance, if the bond’s par value is Rs. 1000, the issue price is Rs. 800, and then the difference of Rs. 200 is the investor’s profit.
- ● Governments, private companies, and public corporations could all issue zero-coupon bonds.
- ● Zero-coupon bonds come with a maturity of 10 to 15 years.
The bond market in India plays an essential role in the country’s
economic development, and the government is taking steps to
enhance the bond market. Earlier, foreign investors did not have
full access to the government bond market.
However, the Indian government has announced a plan which will
allow international investors to buy government bonds with no
restrictions. The inclusion of India in the global bond index came
because of this new strategy. Furthermore, allowing foreign
investors to invest in government bonds is a good decision that
demonstrates India’s confidence in its stability.
A market-making institution for corporate bonds was proposed in
the most recent budget. This will have several advantages,
including providing much-needed liquidity to the bond market and
allowing investors to feel more comfortable with bonds.
The Indian bond market has diversified dramatically during the
previous two decades, contributing significantly to the
development of the country’s infrastructure. However, compared to
the equity market, India’s bond market is still in its early
phases, with much room for expansion.
How the bond market works in India?
There are two types
of markets in the Indian bond market.
- 1. PRIMARY MARKET
The primary bond market is a bond market segment where new and seasoned issuers, including corporations, municipalities, and governments, sell securities to investors. - 2. SECONDARY MARKET
The secondary bond market includes bonds that have already been issued. These bonds can be traded between investors on exchanges or over the counter. Secondary bond markets are used by investors to trade existing bonds, instead of purchasing newly issued bonds.
The Indian bond market includes both government and private- sector bonds, but the government bonds dominate the Indian bond market.
Government bonds are believed to be quite safe and have a lot of liquidity.. - Benefits of Investing in
Bonds
STABLE & SECURE
Bonds are considered a safe investment since they are stable and secure. This is because they provide a consistent return. - PREDICTABLE INCOME
Bonds provide predictable income, i.e., investors know what they will receive (interest and principal amount). - DIVERSIFYING THE PORTFOLIO
It can help diversify a portfolio & reduce risk as the correlation between bonds and other investment options are less. - CREDIT RATINGS
Bonds are rated by credit rating agencies which provide further assurance to investors regarding the investments.
Further, investors who do not have the time or knowledge to acquire bonds directly can do so through debt mutual funds.