What are bonds?
Bonds are fixed-income instruments that signify a loan forwarded by an investor to a borrower. The issuer promises to pay a specific interest for the life of the bond and the principal amount or the face value at maturity. Bonds are generally issued by governments, corporations, municipalities and other sovereign bodies. Bonds can be traded, just like securities.
What is the bond market?
The market for trading debt securities like government bonds, corporate bonds and tax-free bonds is known as a bond market. A bond market is generally less volatile than an equity market and is more suitable for investors with lower risk tolerance. Investing in bond markets is an efficient way to diversify your portfolio. The primary role of a bond market is to help the government and large private entities access long-term capital.
Types of bond markets
There are different types of bonds markets depending on the type of bond and the type of buyers. On the basis of buyers, there are two types of bond markets – primary market and secondary market. The primary market is the one where the original bond issuer directly sells new debt securities to investors. The bonds bought in the primary market can be further traded in the secondary market.
Types of Bonds:
1. Convertible bond
Unlike regular bonds that are redeemed upon maturity, a convertible bond gives the purchaser a right or an obligation to convert the bond into shares of the issuing company. The quantum of shares and the value of the shares are usually predetermined by the issuing company. However, an investor can convert the bond into stock only at certain specified times during the bond’s tenure.
It features a fixed tenure and pays out interest payments periodically at predetermined intervals. Convertible bonds can be further classified as:
Regular convertible bonds
Regular convertible bonds come with a fixed maturity date and a predetermined conversion price but they give the investor merely the right, and not an obligation, to convert. Companies generally prefer to issue these types of convertible bonds to the public.
Mandatory convertible bonds
Unlike regular convertible bonds, these bonds obligate the investor to convert them into equity shares of the issuing company upon maturity. Since investors are essentially forced to convert their bonds, companies usually offer a higher rate of interest on mandatory convertible bonds.
Reverse convertible bonds
With reverse convertible bonds, the issuing company holds the right to convert them into equity shares upon maturity at a predetermined conversion price.
Advantages of convertible bonds:
For the investor
In addition to receiving a fixed rate of interest on their investments till the time of maturity, investors also get to enjoy the benefits of stock value appreciation.
In the event of liquidation of the issuing company, bondholders tend to get first preference on the liquidation proceeds of the company.
For the issuing company
The issuing company gets to raise capital right away without having to dilute their shares immediately.
Since the investor gets to take part in the share value appreciation process, issuing companies generally offer a slightly lower rate of interest on convertible bonds when compared to the rate on traditional corporate debt securities.
2. Government Bonds
Bonds can be issued by the central as well as state governments of the country when the issuer is faced with a liquidity crisis and is in need of funds such that they can develop infrastructure. Serving as long-term investment tools they can be issued for periods that range from 5 to 40 years.
Government bonds form a bulk of the Indian bond market. Government bonds generally offer stable returns and are considered extremely safe as they are guaranteed by the Indian government. The interest rate on G-sec varies between 7% and 10%.
G-Secs nowadays target not just large investors ranging from companies to commercial banks, but also individual investors and cooperative banks.
Types of Government Bonds
Fixed-rate bonds – The interest rate applicable on these government bonds is fixed for the entire tenure of the investment regardless of fluctuating market rates. The lock-in period for such bonds is usually one to five years.
For example, 6.5% GOI 2020 implies a rate of interest applicable on the face value amounting to 6.5%, with the government of India being the issuer and the year of maturity being 2020.
However, premature withdrawal of bonds can lead to penalties for investors. Also, due to the year-on-year rise of inflation, the higher the bond term, the more it runs the risk of reducing bond value.
Floating rate bonds (FRBs) – These bonds have variable interest rates based on periodic changes experienced by the rate of returns. The intervals within which these changes occur are made clear prior to the bonds being issued.
These bonds can also exist with the rate of interest being split into a base rate and a fixed spread. This spread is determined via auction and remains stable right up to maturity.
There are a few essential things to be considered in floating rate bonds: the benchmark rate, the spread, the amount of shift in rate over and above the benchmark rate, and reset frequency at which period one is going to reset the benchmark.
Floating rate bonds help to mitigate interest rate risk to a great extent as a high floating rate means high returns. So, the best time to buy such bonds is when their rates are low and are expected to increase. The change in the interest rate is heavily dependent on the performance of the benchmark rates.
Sovereign Gold Bonds (SGBs) – Under this scheme, entities are allowed to invest in digitized forms of gold for an extended period of time without having to avail of gold in its physical form. Interest generated via these bonds is tax-free. Ordinarily, the nominal value of an SGB is arrived at by calculating the simple average of the closing price of gold that has a purity level of 99 percent three days prior to the issuance of the bond in question. There exists limits that are imposed on what amount of SGB an individual entity may hold. Liquidity of SGBs is possible following a period of 5 years. Redemption, however, is only possible based on the date of interest disbursal.
Inflation-Indexed Bonds – the principal and interest earned on such bonds are in accordance with the inflation. Ordinarily, these bonds are issued for retail investors and are indexed in accordance with the consumer price index (or CPI) or wholesale price index (or WPI).
7.75% GOI Savings Bond – This government security was launched in 2018 in order to replace the 8% savings bond. The interest rate applicable here is 7.75%. The RBI stipulates that these bonds can be in the possession of individual(s) who aren’t NRIs, minors, or are a Hindu undivided family. Interest earned via these bonds is taxable as per the Income Tax Act of 1961 keeping in mind an investor’s income tax slab. Bonds are issued for a minimum amount of INR 1000 and in multiples of INR 1000 as well.
Bonds with Call or Put Option – Issuers are entitled to buy back such bonds via a call option or the investor has the right to sell the same with the put option to the issuer.
Zero-Coupon Bonds – These bonds don’t earn interest. Instead, investors accrue returns via the difference that exists between the issuance price and the redemption value. They aren’t issued via auction but are created via existing securities.
Pros and Cons of Investing in Government Bonds
- sovereign guarantee
- inflation-adjusted tools
- regular stream of income.
- Barring the 7.75% GOI Savings Bond, interest-earning on other G-Sec bonds is lower.
3. Municipal Bonds
Municipal bonds (or muni) are debt instruments that are issued on behalf of municipal corporations or bodies associated with them across the country aimed at socio-economic development. Municipal bonds can be purchased with a maturity period that amounts to three years.
Types of Municipal Bonds in India
General Obligation Bonds – These bonds generate finance for various projects in general and therefore their repayments are made from the general revenues of the municipality.
Revenue Bonds – These bonds are focused on generating funds for specified projects and the repayment and interest issued to bondholders are processed via revenue explicitly generated via the projects declared in the bonds. They have extended maturity periods of upto 30 years and higher returns than GO bonds.
Advantages of Municipal Bonds
- Transparency – Municipal bonds that have a credit rating amounting to BBB or higher as set forth by the country’s leading credit rating agencies (such as CRISIL) are entitled to be issued to the public.
- No taxes – interest rates developed via municipal bonds are also free of taxation.
- Minimal risk
Disadvantages of Municipal Bonds
- Lock-in period is 3 years – affects liquidity
- Hard to sell bonds of unpopular municipalities
- Low interest rates
4. Retail bonds
A retail bond offering allows a company to raise additional capital by borrowing at a fixed rate from an investor for a specific length of time. Companies typically issue retail bonds to expand their business, pay off debt, or fund a specific project, as with any capital raising. Retail bonds are typically listed and can thus be bought and sold during regular market hours, allowing investors more flexibility.
5. Junk Bonds
Also known as high-yield bonds, junk bonds those bonds that fall below investment grade made clear by the three large bond rating agencies i.e., Moody’s Standard & Poor’s, and Fitch. Junk bonds are characteristic of having a higher risk of default in comparison to other bonds as well as higher returns.
Should more investors be amenable to buying junk bonds, their willingness to incur risk highlights an optimistic outlook towards the economy and vice versa.
Understanding how Junk Bonds are Rated
Keeping in mind the ratings of the aforementioned large rating agencies, junk bonds are given a “Baa” rating or lower from Moody’s and a “BBB” rating or lower from Standard & Poor’s. A “C” rating indicates a higher rate of default by the bond issuer in question whereas a rating of “D” is indicative of the bond being in default. Ordinarily, investors buy junk bonds alongside other bonds or investments that are less risky.
Pros of Junk Bonds
- Potentially higher rates of return.
- During liquidation, holders of junk bonds are given precedence over stockholders .
- They can serve as risk indicators
Cons of Junk Bonds
- Comparatively high likelihood of defaulting.
- Further, if a company’s credit rating sinks below where it presently stands, the value that their bonds hold falls.
- The prices of junk bonds are volatile owing to the uncertainty
6. What are Electoral Bonds?
General public can issue these bonds to fund eligible political parties. A political party that classifies as eligible to run campaigns must be registered in the Representation of the People Act, 1951, under Section 29A. Additionally, to classify as a registered political party, the party should secure not less than 1% of votes polled from the prior general election to the legislative assembly. There are tax benefits to issuing electoral bonds.
Advantages of Electoral Bond Scheme
- Makes election funding more secure and digitized. Any donation above ₹2000 is now legally required to be in the form of cheques of electoral bonds.
- All bonds issued are to be redeemed by bank accounts that have been disclosed by the Election Commission of India, hence, visibility of any potential malpractice is strengthened.
Disadvantages of Electoral Bond Scheme
- Electoral bonds do not threaten the formation of shell companies in any way.
- Unchecked foreign funding
What Is Risk Tolerance?
If you take on more risk than you are comfortable with, it’s possible you may panic and sell your investments at the wrong time. Generally, people that are just starting out their investment journey and are younger are encouraged to take on more risk than older individuals who are restricted to a shorter investment horizon.
Levels of Risk Tolerance
In a general sense, risk tolerance can be divided into three levels: aggressive, moderate, and conservative. The investment portfolios of each of these three levels of risk tolerance would look like this:
Aggressive Risk Tolerance: Usually found among market savvy investors with a deep understanding of securities. The goal is to reach maximum returns through maximum risk taken. They tend to go for highly volatile instruments like options contracts which may worthlessly expire or small-cap stocks that can skyrocket or flop.
Moderate Risk Tolerance: Approach to investments is balanced with some risk being taken. The investment horizon is estimated to be about 5–10 years. Investors may combine bonds with large-scale mutual funds and pursue a 50–50 portfolio structure in equity vs debt investments.
Conservative Risk Tolerance: Often, these are retirees who have used their formative years to create a portfolio that requires as little risk as possible to preserve now. They target instruments such as secured bonds. They also go for bank deposits, treasury investments, and more such savings-oriented investments that will aid in the preservation of capital.
Secured and unsecured bonds
Broadly, there are two types of bond instruments: secured bonds and unsecured bonds. The fundamental difference between these two types of bonds is that secured bonds offer collateral to bondholders while unsecured bonds do not. Due to this security, investors consider secured bonds good investments even at low rates of interest. Hence, these types of bonds are suited to people with lower appetites for risk in their investments. Investors choose unsecured bonds based on the credit-worthiness of the issuer.
Consider the following parameters before following through with a bond investment.
- How risky is bond investment?
- How tolerant are you of risk?
- Does my bond investment align with my investment horizon?
- Will I be keeping my bond until maturity?
- How is interest paid out (e.g. floating vs fixed interest)?
- What happens in case of a default (e.g. secured vs unsecured)?