A bond is a debt security. Bonds are fixed income securities which borrowers issue to raise money from investors willing to lend them money for a certain amount of time.
When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it matures or comes due after a set period of time.
Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.
In simple words, a bond is a loan that a person gives to corporates or the government for a pre-determined period of time in return of periodic interest payments and the repayment of principal at the maturity of the bond.
Characteristics of bonds
- Bonds gives a predictable income stream as the amount and time of coupon payments are pre-determined such as semiannually, annually, or monthly.
- Bonds have fixed maturity date
- If the bonds are held to maturity, holders of bond get back the entire principal, so bonds are a way to preserve capital while investing.
- Bonds are much safer than equities
- Tax saving bond also available in the market
Bonds v/s Equities
Bonds represent debt while stocks represent equity. Equity represents a claim on future profits and the value of a stock can rise rapidly for a growing, profitable company. Likewise, the price of a stock can drop to zero in the event of a bankruptcy. Bonds, on the other hand, only pay a pre-determined interest payment and their prices are bound by interest rates, and not by a company’s profitability. If a bankruptcy occurs, bondholders must be repaid from a liquidation in full before any shareholders are paid anything. The upshot for investors is that bonds are therefore lower risk investments, but also do not offer the potential upside that stock can offer.
There are some basic terminologies that are essential in order to understand bond in order to invest in the debt market.
- Face value
The price paid for buying a bond when it is issued is called the face value of that bond. This is the principal amount the issuing company owes the investor at the time of maturity. The investor typically gets a fixed interest for the period he holds the bonds.
The face value of a bond should not be confused with the price of a bond observed in the market. Since bonds are governed by market fluctuations, the price of the bond observed in the market may be lower or higher than the face value. When bonds are traded at a higher price than their face value, bonds are said to be trading at a premium. The ones that are trading below their face value are termed as being traded at a discount.
- Coupon rate
The coupon rate is the predetermined rate of interest on the bond. It is usually a percentage of face value of the bond.
So, for instance, if the face value of your bond is Rs 1,000 and the coupon rate is 9 percent, you are entitled to receive Rs 90 every year on your bond.
- Bond yield/ Current yield
Since bonds can be bought and sold on the secondary market, the ‘market price’ of your bond is likely to fluctuate. In such a scenario, the rate of return on your bond would be different from the coupon rate. This rate of return is known as the current yield.
Example: The face value of your bond, when you invested in it, was Rs 1,000 with a coupon rate of 9 percent. So, accordingly, you receive Rs 90 every year. However, due to volatile market conditions, say its market price goes down to Rs 900. Since you are entitled to receive a predetermined amount of interest, you continue to receive Rs 90. So in this case, the current yield of your bond will be Rs 900/Rs 90 = 10percent.
Hence, Current yield = Annual interest payment/Current market price of the bond
- Maturity value
Maturity value refers to the value of the bond at the time of its maturity. The maturity value of a bond is equal to the face value of the bond which is paid by the issuer of the bond to the investor at the time of maturity.
Some bonds have a maturity period of 10 or even 30 years. Government bonds can be short-term (a few months) to many years (10 or 30 years).
- Credit quality
The credit quality of a bond is an important criterion to consider while investing in a bond. The “quality” of the issue refers to the probability that the bondholders will receive the amounts promised on the due dates. If the issuer has a poor credit rating, the risk of default is greater and these bonds will tend to trade a discount. Credit ratings are calculated and issued by credit rating agencies.
- Yield to maturity
It is the total return expected on a bond if held till maturity. Calculations of yield to maturity assume that all coupon payments are reinvested at the same rate as the bond’s current yield, and take into account the bond’s current market price, face value, coupon rate and term to maturity (term to maturity is the remaining life of a bond).
Model of Cash Flow of Bonds
Following is a model of the cash flow of corporate bonds. Same cash flow applies for government bond as well.
Risk associated with Bonds
There are various risks associated with bonds which are:
- Interest rate risk
The interest rate has a capability to impact the price of the bond largely as interest rates and bond prices have an inverse relationship. As interest rates fall, the price of bonds trading in the marketplace generally rises. Conversely, when interest rates rise, the price of bonds tends to fall.
The price of a bond increases with a fall in the interest rate because investors would want to keep bonds with a higher interest rate. To do this, the investors will buy existing bonds that pay a higher interest rate than the prevailing market rate. This increase in demand leads to an increase in bond price.
The price of a bond decreases with a rise in the interest rate because when the interest rate rises the investor would want to sell the bond with the lower interest rate and buy the one with the higher rate. With this the investors would want to sell the bond with lower interest rate and this will lead to a fall in the bond prices.
An investor owns a bond that trades at par value and carries a 4% yield. Suppose the prevailing market interest rate increases to 5%. What will happen? Investors will want to sell the 4% bonds in favor of bonds that return 5%, which in turn forces the 4% bonds’ price to falls.
- Re-investment risk
The risk of having to reinvest proceeds at a lower rate than the funds were previously earning. All other things being equal, longer-term bonds tend to have higher returns and higher risk than shorter-term bonds. That’s because the longer you hold a bond, the more it could be affected by changes in interest rates and greater would be the re-investment risk.
- Liquidity risk
This refers to the risk that investors won’t find a market for the bond, potentially preventing them from buying or selling when they want.Inflation risk
- Inflation risk
As we know that bonds are fixed income securities and this becomes its advantage as well as its drawback too. Bonds do not adjust themselves to the inflation rates and this makes it a less likely demanded security. When the inflation increases the purchasing power of money reduces, wherein the bond coupon rates remain the same.
Suppose that an investor earns a rate of return of 3% on a bond. If inflation grows to 4% after the bond purchase, the investor’s true rate of return (because of the decrease in purchasing power)
- Credit risk
Credit risk is the risk associated with not getting the money back from the issuer. Sometimes the issuer is in a situation where he is unable to pay even the interest payments to the investors. There are some corporate bonds that are not guaranteed and can result you to lose your money.
- Prepayment risk
It is the risk in which issuer redeems the bond before the maturity period. The companies may redeem the bond when the interest rate goes down and the prices rise. You may lose out the future interest payments in case the companies redeem the bond before the due date.
Relationship between Price of a Bond and the Prevailing Interest Rate
If you hold the bond until maturity, you are entitled to receive the face value of the bond, irrespective of the prevailing interest rate. The change in interest rate affects the price of your bond only if you decide to sell it in the secondary market before maturity.
We can understand the relationship between the price of a bond and the interest rate with the help of an example.
A person buys a bond with face value of Rs 10,000 with a coupon rate of 10 % annually and maturity of 8 years. This means you should get Rs 1,000 as interest every year, and Rs 10,000 on maturity. However, if the prevailing interest rate increases after 4 years of investment, the new bonds issued by same company would offer a higher rate of return, say for instance 12%. If you decide to sell your bond (that offers 10 % interest) in the secondary market at this point of time, not many investors would be interested in buying it, since they would prefer newly-issued bonds at 12%.
If you still want to sell your holdings, you would have to sell them at a price below the face value in order to attract buyers, effectively reducing their price. The value of a bond hence decreases if the interest rate increases and vice versa. Therefore it can be said that there is an inverse relationship between the price of a bond and the prevailing interest rate.
So if the interest rate falls then the bond prices will rise. We can understand this relationship with the help of the above example.
If the rate of interest falls from 10% to 8% after 4 years and the holder of 10% bond wants to sell his bond in the secondary market then the price of the bond would increase. The increase in bond price happens because the investors would want to purchase a bond with the higher interest rate (8%) instead of the lower one (8%). As the coupon payment of a Rs.10000 bond at 10% interest rate would give Rs.1000 as coupon payment and the bond with the same value but a lower rate of 8% will give only Rs.800. So the demand for the 10% bond would increase and the bond price rises.
TYPES OF BONDS
- Fixed Rate Bonds
In Fixed Rate Bonds, the interest remains fixed throughout the tenure of the bond. Owing to a constant interest rate,
- Floating Rate Bonds
Floating rate bonds have a fluctuating interest rate (coupons).
- Government Bonds
The government of India also issues bonds at a fixed rate. For this, the government also employs an investment banker who acts as a middleman between the investors and the government. However, it is difficult for retail individuals to invest directly in these bonds as the minimum investment amount is very high. These bonds have the lowest credit risk as the chances that the government would default on the payment of the principal and interest payment of the bond is very low.
- Corporate bonds
These bonds are issued by the corporate houses. Investment in these bonds is easier for even small investors as the minimum investment in these bonds is not high. However, these bonds are not as safe as government bonds as the issuing companies are subject to market volatility, industry ups and downs, etc.
- Junk bonds
These bonds are issued by unstable companies. The issuers provide high interest but still investing in these bonds is risky. Even the credit risk in these bonds are high.
- Tax saving bond
Tax savings bond help you to get tax exemption on the tax payment for the period of time one holds the bond or until the maturity of the bond.
Tax saving bonds enjoy special privileges under Section 80CCF of the Income Tax Act which states that individuals enjoy tax deductions up to Rs 20,000 on the bonds owned by them. The deduction is excluding the Rs.150000 provided in Section 80C
- Inflation-indexed bonds
The major drawback with bonds is that they are not linked with inflation. So the RBI came up with a solution to solve this problem by bringing up Inflation-indexed bonds. Inflation-indexed bonds provide protection to both the interest payments as well to the principal payments. The interest rate on Inflation-linked bonds is generally lower than on fixed-rate bonds.
- Perpetual Bonds
Bonds with no maturity dates are called perpetual bonds. Holders of perpetual bonds enjoy interest throughout.
- Zero coupon bonds
Zero coupon bonds do not have any specific interest rate or coupon rate. They are offered at a discount on the face value, and on maturity, investors get the face value back. The difference between the two is the interest income.
Eg. If a bond with face value of Rs 2,000 is issued at a discounted rate of Rs 1,500 for a period of two years, one would still get Rs 2,000 at the end of two years. The additional Rs 500 is the interest income.
- Convertible/Non-convertible bonds
Convertible bonds are bonds that give the investors an option to convert them to shares after a specified period of time. The rate at which investors can convert bonds into stocks, that is, the number of shares an investor gets for each bond, is determined by a metric called the conversion rate.
Non-convertible bonds are those that cannot be converted to equity shares.
- Callable bonds
Bonds which give the issuer right to buy back the bonds before its maturity are called callable bonds. Callable bonds usually come with an initial lock‐in period. Since investing in such bonds exposes the investor to the additional risk of buyback they usually offer a higher rate of interest as compared to bonds without such options.
- Puttable bonds
Bonds which give the investor the right to sell the bonds back to the issuer before the maturity of the bond is called puttable bonds. Since such bonds give the investor a right to sell before maturity, they usually offer a lower rate of interest as compared to bonds without such options.