There are many investment options available across the financial markets, Bonds are one of them. Though the hard to believe moves of stock market, which make few people rich overnight, always keep stocks in the limelight, the bond market is way bigger. At core, bonds are simple to understand. I lend you my money and you promise me to give it back with some interest on it. I put certain terms and conditions for lending, and you agree on them. We can call this agreement as bond, but if instead of you and me, the parties involved in this agreement are bank and its customer, then this agreement is called loan agreement. Similarly, the parties can be anyone from an individual to a country’s government and this agreement can take different name according to the context, but the concept remains same. In this article, I will refer to all such agreements as bonds for sake of explanation.
Investors think of bonds as a safe investment option compared to stocks and usually ignore the risk involved in them. This article will deal with the terminology related to bonds, different bonds available in the market, and the basics of the bond investments. Keep in mind that bonds have more depth than this, as you will dig deeper, it will keep getting much more complex.
Let’s start with a little technical definition of bonds, and various terminologies involved in it.
“A bond is a fixed income security that promises to make a series of interest payment in fixed amounts and to repay the principal at maturity.”
Following are the terms used in the definition-
1. Fixed Income-Unlike stocks, the bonds provide a regular income to the holder that is why it is called fixed-income securities.
2. Maturity-The Maturity of a bond is the date on which the borrower will return the money to lender. There is a wide range of bonds available with different maturity, ranging from a day to 100 years.
3. Principal Value-It is the amount that a borrower will pay to lender at the maturity. This is also called par value. A bond after issuance can trade above the par value, known as trading at premium; can trade below the par value, known as trading at discount; and can trade at the par value, known as trading at par.
4. Coupon Payment–The fixed interest payment that a borrower will have to pay is called coupon payment, and it is based on the borrowed principal amount, as the percentage of total amount which is called coupon rate. The payment can be done monthly, semi-annually or annually.
Types of Bonds: -
There are hundred of ways in which you can classify the bonds and that too is different for different regions or countries. Some are available in a particular region but not in any other and some are non-taxable in one jurisdiction while the same type of bond can attract tax in other. Broadly you can classify bonds in following categories on the basis of who is raising money by issuance of the bond-
1. Government Bonds-Government issue these bonds to fund the day-to-day operations of the government and country. The repayment is done by the taxes and other revenue sources of the government.
2. Corporation Bonds-These bonds are issued by the companies, they can be public listed company, a private entity or public sector undertaking enterprises for either expansion or to meet daily expenses. These bonds are repaid by the revenue generated by the company. In India these bonds are known as debentures.
3. Central Bank Bonds-These bonds are issued by the central banks majorly for the controlling the liquidity of currency. These bonds can be classified as government bonds, but it depends on how the government and central bank are related to each other. In India, RBI can issue bonds for itself and on behalf of the government. These are one of the safest investments, as RBI can print money to fulfill the interest and principal obligation. Sovereign gold bonds are the example of these types of bonds.
There are many other different bonds which are more sort of amalgamation of these three categories with little modifications. For example, a company or government can issue a bond specific to a project like an airport, a commercial complex, or a hospital. A credit card company can pool several credit card accounts and can issue a new bond which can be serviced by the fees and interest payment by the cardholder. The crux here is that these all are the different iterations of the same concept but with unique properties and risks associated with them.
The other way to classify the bonds is to look on the properties of the bonds. We can classify the bonds in following categories-
1. Zero-Coupon Bond-As the name suggests, the bonds do not pay any coupon payment for entire tenure, rather they are issued on discount from the face value.
2. Conventional Bonds-Bonds with fixed coupon payment are called conventional bonds. These bonds are also called plain vanilla bonds.
3. Callable Bonds- These bonds can be called back or redeemed by the issuer before the maturity period ends. The call dates are pre-specified in the bond agreement.
4. Putable Bonds- These bonds can be redeemed by the buyer of the bond before the maturity period ends. There can have a specific date or period when the buyer can redeem the bond.
5. Convertible Bonds- These bonds are issued by the corporations and can be converted to shares of the company before maturity.
Investment in Bonds-
Risk Involved
Though a little safer than stocks, all bonds carry default risk. If a company or corporation declares bankruptcy, then it is unlikely that it will pay the debt obligation. Government Bonds are safer to bet and a must have in one’s investment portfolio.
In India, bonds market is not mature and there is an issue of liquidity when anyone tries to sell these bonds before maturity. So, investors buy bonds to keep till maturity.
Other thing to keep in mind when investing in bond is duration risk. It is the measure of the change of the yield with respect to change in interest rates. Bonds rarely trade on the par value but depend on the demand and supply. With huge demand, bonds can trade at premium while at low demand one can get it at discount and these dynamics change the actual return of the bond called, yield. Price has an inverse relation with the yield. Higher the price, lower the yield and vice versa. Yield depends on the interest rates, which depend on the various factors like market confidence, liquidity, economy, etc. So, Duration Risk provides a measure to relate them both. It is the percentage of change of bond yield with one percent change in the interest rates. Yield of Bonds with long maturity are more sensitive to interest rate changes, thus have higher duration and volatile returns.
How to invest?
There are a variety of ways by which we can invest in the bonds. Few are mentioned below:-
1. Primary Market-Primary market refers to the market when bonds are newly issued, and buyers buy them. It is just like stocks initial public offering. We can apply for the new offering in banks or via trading account.
2. Secondary Market-In secondary market already invested investors sell their bonds to the different investor. Many brokers facilitate the service of buying and selling of bonds.
3. Mutual Funds-Mutual funds enjoy the biggest chunk of the retail investor’s money in bond market investment space. This is the best way to gain exposure of the bond market. A fund manager will invest on your behalf, and mutual fund usually has ample liquidity to respect your redemption request before maturity. But be aware of the signs of uncertainty. Even big managers can create a blunder. We have seen this in the recent saga of Franklin Templeton. I have covered this story in one of my earlier article, to read it, Click here.
4. Bond Exchange-Traded Funds-ETFs are like mutual funds but cheaper and can be sold and bought like stocks on the exchange.
Bonds have their own benefits and disadvantages, but with proper analysis and research, investment in bonds can help in diversification of risk of one’s portfolio. These must be a core part of your investment strategy.
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