What are Bonds & How are they Useful?
Before making investments, you must be aware of the various market instruments. If you are about to start your investment journey, then you must have come across the term: bonds. Wondering what are bonds? Well, here is a comprehensive guide about bonds.
Bonds are debt instruments, allowing various entities such as corporates and the government to raise funds from the market. These funds can then be used for the expansion of business or infrastructural development. Besides, entities can use the funds to meet the cost of long-term investments or to finance existing expenditures. While both bonds and stocks are capital market instruments, investment in stocks provides you with part-ownership of the company. But bonds provide you with a credit stake in the company. In other words, the company becomes the borrower and you are the lender.
To understand bond meaning, you must also keep in mind that the borrowing entity repays you the principal amount on a predetermined maturity date. Alongside, the interest payment on the principal amount – known as coupon payment – is made on regular intervals as per the terms of the agreement. The coupon can be paid on a monthly, half-yearly, or annual basis.
After knowing bond meaning, you must also remember that bonds are essentially safe investment instruments, and carry minimal risks.
Types of Bonds in India
To know more about what are bonds and its types, here’s a look at the different types of bonds in the country
These bonds are issued by the state or central government. It is among the safest investment instruments as the risk of credit default is eliminated.
Sovereign gold bond:
These are again government securities issued by the RBI, on behalf of the government. These are an alternative for holding physical gold, and are denominated in grams of gold.
Capital gains bond:
These are also issued by the government. Here, you can transfer your capital gains into the specific bonds. These bonds provide an exemption from the capital gains tax, provided you invest in them within six months from the date of receipt of the capital gain.
These are issued by companies and provide a comparatively higher rate of interest. But they have inherent credit risks.
These bonds can be converted into stocks, as per the predetermined terms and conditions.
To know more about : what is bond? Here is the classification of bonds based on their returns:
Fixed interest bonds:
These have a predetermined interest rate across the bond’s tenure. The advantage of these bonds is that they provide a fixed interest, irrespective of the market conditions.
Floating interest bonds:
These bonds have flexible rates of interest, which in turn, is contingent upon a wide range of market variables.
Inflation-linked bonds :
These bonds are designed to cushion the investor from the effect of inflation on the coupon rate and face value. These, however, have a lower coupon rate as compared to fixed interest rate bonds.
What is bond valuation?
Bond valuation is a complex mathematical procedure to determine the theoretical fair value of a bond. The steps to determine bond valuation include calculating the cash flow of a bond, and the bond’s value on maturity, or face value. The major advantage of bond valuation is that it can allow you to know whether the bond is a viable investment instrument. A key factor for this process is knowing the discount rate, or Yield to Maturity Ratio.
What is Yield to Maturity Ratio?
The coupon/interest rate is predetermined when you buy a bond. For instance, a single bond with the face value of Rs 1,000 and an annual interest rate of 6%, will provide you with an interest of Rs 60. If you have purchased the bond from the primary market (directly from the issuer), the bond is issued at its face value. The rate of return is the same as the coupon rate.
If you, however, purchase bonds from the secondary market, the price of the bonds – being purchased or sold -can be higher or lower than its face value. Contingent upon the face value being higher or lower, the return will also be higher or lower than the original interest rate. This return or yield for bonds is represented through the Yield to Maturity ratio. For instance, a bond selling at a higher price than its face value will have a higher Yield to Maturity Ratio.
Things to keep in mind before investing in bonds
Any discussion on what are bonds and its uses will be incomplete without knowing the key factors to consider, before making investments. Here’s a look:
Assess the pros and cons:
Bonds are long-term investment instruments providing assured returns, and play a key role in portfolio diversification. These are relatively risk free. Bonds, however, have some disadvantages, like providing lower returns as compared to stock investments and the returns being vulnerable to inflation-related risks. What’s more, bonds are not as liquid as stocks. This means that you can find it difficult to sell it – at the preferred price – before maturity.
Assess the risks:
To invest in bonds with minimal risks, you must see the credit rating of a company. For instance, companies with ‘AAA’ ratings by credit rating agencies can be trustworthy. Higher ratings imply that the company has relatively lower risk of reneging on its credit obligations. You should also analyse if there are any call risks, or scenarios where the companies retract their bonds due to negative market factors.
Consider your investment objective:
Your investment objective and risk appetite should be in tune with investment in bonds. To further diversify your investment in bonds, you can consider investing in different types of bonds, having different maturity dates. You can also enter the debt market via debt mutual funds.
Thus, you can choose to invest in different types of bonds, which are essentially debt securities issued by various entities. However, merely knowing what is bond and its uses is not enough. In your investment journey, do remember to rely only on a trusted and worthy stockbroking firm. Look for features such as a paperless opening procedure for Demat and trading accounts, seamless digital platforms powered by cutting-edge technology, comprehensive market reports, expert advisory, and so on.