Bond Investing Basics: What are Bonds, Their Main Types and Key Terms to Know?

Bonds are among the many financial securities that you can invest in. Most new investors often tend to overlook this particular investment in favour of stocks. However, including them in your portfolio can bring about a host of benefits, ranging from portfolio diversification to passive income in the form of interest payments. 

If you are planning to build a well-rounded investment portfolio capable of creating wealth in the long run, you must consider investing in these financial securities. Here is a comprehensive guide on bond investing that explores the basics of these securities, how they work and the various terms and terminologies that are commonly associated  with them.   

What are Bonds? 

Bonds are debt instruments that companies, governments and municipalities issue to raise capital from the public. When you purchase a bond from an issuing entity, you basically lend money to it. In exchange, the issuing entity pays you interest periodically on the borrowed amount at a predetermined rate until the bond matures. The issuing entity will return the principal amount to you upon bond maturity. 

Bonds are also referred to as fixed-income securities because they provide regular interest payments, which are typically fixed, throughout the bond's tenure. Bond issues are one of the most preferred ways through which companies and governments often raise funds.  

How Do Bonds Work? 

Now that you know what bonds are, let us try to understand how they work with the help of a hypothetical example. 

Assume ABC Limited, a company involved in manufacturing Fast Moving Consumer Goods (FMCG), is looking to raise capital to expand its business to other regions of the country. The company requires Rs. 10 crore for the expansion and has decided to issue bonds to raise funds. 

ABC Limited issues 1,00,000 bonds with a face value of Rs. 1,000 each, offering interest at a rate of 9% per annum. The tenure of the bonds is 10 years, and the interest on the invested amount is credited each month. Let us assume that you purchase 500 bonds of ABC Limited by investing Rs. 5,00,000. 

Now, ABC Limited is obligated to pay an interest of Rs. 3,750 [(Rs. 5,00,000 x 9%) ÷ 12 months] each month until the bonds mature, which will happen 10 years from the date of issue. Once the bonds mature, ABC Limited will repay the principal amount of investment, which is Rs. 5,00,000, that you invested.

As you can see from this example, by investing in the bonds of ABC Limited, you were able to generate a passive income of Rs. 3,750 each month for 10 years. Additionally, the initial amount of investment that you made will also be returned to you upon maturity.  

What are the Different Types of Bonds?

There are many different types of bonds, each with its own distinct characteristics and risk profiles. Here are some of the most commonly issued bonds in India. 

• Government Bonds

Government bonds are debt securities issued by the union government or state governments. The capital raised through the issue of these bonds is used to meet government spending and obligations. Government bonds carry almost no risk of default since they are backed by a sovereign guarantee.

• Municipal Bonds

Municipal bonds are debt securities issued by local government entities like municipalities and city corporations. The money from the issue of these bonds is generally used to fund public projects such as roads and infrastructure.   

• Corporate Bonds

Corporate bonds are issued by companies to raise capital for business operations, expansion or other needs. These bonds typically offer higher interest rates than government bonds but also come with higher risk. Corporate bonds are usually rated by credit agencies. Bonds with high credit ratings are safer and carry lower risks compared to those with low ratings. 

• Inflation-Indexed Bonds

Inflation-indexed bonds are debt securities whose principal and interest payments are adjusted based on the prevailing inflation rates. For instance, if the inflation rate increases, interest payments will also increase. The primary objective of these bonds is to protect investors from the negative effects of inflation.

• High-Yield Bonds

High-yield bonds are bonds with low credit ratings and a higher risk of default. To compensate for the increased risk, these bonds offer higher interest rates to attract investors. High-yield bonds are also termed junk bonds due to their low credit ratings. 

• Secured Bonds 

Secured bonds are debt securities backed by collateral. Since these bonds are secured by assets, they carry much lower risk and offer added security to investors in the event of default by the issuer. 

• Unsecured Bonds 

Unsecured bonds are not backed by any collateral. Investors interested in these bonds must rely solely on the issuer's creditworthiness and promise to repay. Due to the increased risk associated with unsecured bonds, the issuers typically offer higher yields to compensate. 

• Fixed-Rate Bonds 

As the name implies, fixed-rate bonds are debt securities that offer a fixed rate of interest throughout their tenure. These bonds provide predictable income to investors.  

• Floating Rate Bonds 

Floating-rate bonds are debt securities with adjustable interest rates. The interest rates are adjusted periodically based on a benchmark rate. These bonds protect investors against interest rate fluctuations. 

• Sovereign Gold Bonds  

Sovereign Gold Bonds (SGBs) are issued by the Government of India and are denominated in grams of gold. The bond is redeemed at the end of eight years at the price of gold prevailing at that time. In addition to capital appreciation, SGBs also offer a nominal interest rate of 2.5% per annum on the amount of investment, which is paid semi-annually. 

• Convertible Bonds 

Convertible bonds are debt securities that can be converted into equity shares of the issuing company after the expiration of a predetermined period. The conversion rate and the date of the conversion are usually intimated at the time of the issue itself.    

What are the Key Terms Associated with Bonds? 

As a potential bond investor, understanding the key terms associated with bonds is essential for making informed investment decisions. Here are a few of the key terminologies associated with these financial securities. 

• Face Value 

The face value, also known as the par value, is the value at which a bond is initially issued by the issuing entity. It is the value at which the bond is eventually redeemed by the issuing entity on maturity. 

• Coupon Rate 

The coupon rate is the annual interest rate that the issuing entity pays to the bondholder. It is expressed as a percentage of the bond’s face value.

• Maturity 

The maturity date is the date on which the issuing entity redeems the bonds by repaying the face value to the bondholders. 

• Yield to Maturity (YTM)

The Yield to Maturity (YTM) is the total return you receive from a bond if you hold it until its maturity date. The YTM is an important metric that takes into account the interest payments and the capital gain or loss from buying the bond at a price different from its face value.

• Credit Rating 

A credit rating is an assessment of the creditworthiness of a bond issuer. It indicates the issuing entity’s ability to repay the debt. The higher a bond is rated, the safer it is deemed to be. That said, it is important to note that different credit rating agencies have different rating mechanisms.  

• Market Price

The market price is the current price at which a bond is being traded in the secondary market. The market price can be higher or lower than the face value of the bond. Some of the factors that influence a bond’s market price include interest rates and the creditworthiness of the issuer.

• Call Provision 

A call provision, in the context of bond investing, is a feature that allows the issuing entity to redeem the bond before the maturity date. Usually, issuing entities exercise this option if interest rates fall since they can issue new bonds at a lower coupon rate.  

• Put Provision 

A put provision, in the context of bond investing, is a feature that allows the bondholder to return the bond before the maturity date. However, to exercise this option, certain conditions must be met. 

Conclusion

With this, you must now be aware of the basics of investing in bonds. Including bonds in your investment portfolio is a good way to bring stability, reduce overall risk and generate steady income. Furthermore, if you are a conservative investor with a low tolerance for risk, you could consider investing in bonds to create wealth over the long term.