What are Bonds? Meaning, Types & Important Terms

In July 2023, the Uttar Pradesh government said the civic bodies of four smaller cities in the state – Agra, Kanpur, Prayagraj and Varanasi – planned to issue municipal bonds by the year-end to raise money from the market to finance sewerage and water supply projects. Bonds are issued by the central government and the states regularly to raise funds for infrastructure projects. But what makes this move stand out is that this will be the first time that tier-2 cities in North India will have taken the bond route for funds.If governments and state agencies are looking at bonds to raise finances for public projects, one may wonder: so exactly w hat are bonds? This is what we will explore in this blog, and also see how bonds function.

Bonds are fixed-income instruments that represent a loan made by an investor to a borrower. Usually, bonds are issued by are the government, government bodies, and corporates to finance their projects and operations. In other words, these entities are borrowers, and the investors who invest in these bonds are effectively lenders.As bonds are basically loans, the investors receive interest at specified rates and times till the time the principal becomes due which is then returned to the investor. The bonds are deemed fixed-income instruments as investors earn interest at a fixed rate on their investment.Bonds also have relatively lower risk and can be a good option to consider in India for those seeking investment avenues that spell steady income.But before we get into discussing bonds and types of bonds , let us understand some keywords that are frequently used in discussions related to this instrument.

Coupon Rate: Bondholders or investors receive interest against the money that they have lent to the borrower. The rate of interest on such bonds is called a coupon rate. For example, a bond with a coupon rate of 8% means the rate of interest offered is 8% annually. Face Value : Face value is the price of the bonds (and shares) as fixed by the issuing entity, and is not influenced by market fluctuations. This is what makes it different from market value, which is affected by market conditions.. Bond yield : This is the return on your investment in the bond. So after you buy a bond, you will earn a certain predetermined amount as interest over the bind’s entire lifespan. Additionally, when the bonds mature, the issuer will also pay you their total face value.Bond yield is inversely related to the bond price – when the price rises, the bond yield falls, and vice versa.There are some other terms that you should understand when discussing bond yields; some of these are coupon yield, current yield, and yield-to-maturity. Let us understand those. Coupon yield : Also known as the coupon rate, this is the annual interest rate that was stated at the time of issuing the bond; as mentioned earlier, this rate does not change during the bond’s lifespan. Current yield : This is the bond's coupon yield divided by its current market price meaning it will change if there is any change in the current market price. It is expressed as a percentage of its market price.Say you buy a Rs 1,000 bond in the primary market (i.e. at the time it was issued) and receive Rs 45 as annual interest payments, your coupon yield is 4.5%, which is also the current yield as long as the price remains constant at Rs 1,000. Now let us assume the price has gone up by Rs 103 and is being at traded at Rs 1,030 in the open market, then the current yield drops to 4.37%.Current yield becomes important for you if your aim is to sell the bond before it matures. But if it is a new bond that you have bought at par and held it till it matures, your current yield and the coupon yield will be the same at the tie of maturity. Yield to maturity : This is the overall interest rate you would have earned had bought at the market price (as opposed to buying on par) and held it till maturity. Credit Rating : Just like you have a credit score that represents your credit history and helps you borrow money from financial institutions easily, companies too have credit ratings which represent their creditworthiness and the default risk that they carry. Such credit rating is given by recognised rating agencies after investigating factors like a company’s financial performance, outlook, and past credit history.The higher the credit rating of a company, the easier it is for them to obtain money from investors. The lower coupon rates they offer also falls. Likewise, companies with lower credit ratings find it difficult to find investors and are likely to offer higher coupon rates to compensate for the increased risk.

There are various types of investment bonds that an investor can invest in depending on their goals and their risk appetite. Let us look at some of these.

Government Bonds

Government bonds, as the name suggests, arebonds issued by the government (central or state). Such bonds have the highest credit rating as they carry a sovereign guarantee and are therefore considered low risk instruments. The return they offer is also lower.

PSU Bonds

Bonds that are issued bypublic sector companies in India are called PSU bonds. Such bonds just like government bonds are safer than corporate bonds and offer investors stability in their portfolios.

Corporate Bonds

Companies that borrow capital from the credit market issue corporate bonds. They are also called debentures. As these bonds are issued byprivate companies, they carry a higher risk than government bonds or PSU bonds. As a result, the returns on such bonds are a little higher than the government bonds.How much risk such bonds carry depends on the issuing company and the industry it is present in. Hence, while investing in corporate bonds, an investor needs to do due diligence about the company’s fundamentals.

Municipal Bonds

The local bodies of governments issue municipal bonds to fund development projects like building schools, hospitals, bridges, etc., in towns and cities. The Uttar Pradesh tier-2 cities mentioned earlier issued these bonds. Such bonds have a maturity period of three years, and they even carry tax benefits for the investor.

Zero-Coupon Bonds

Zero-coupon bonds are those that do not offer the investors any earnings in the form of interest. As the name suggests, the coupon rate is zero.What makes them lucrative for investment is this: when zero-coupon bonds are issued, they are issued at a discount to the face value of the bond. Investors earn returns in the form of the difference between the issue price and the maturity price. It is similar to bonds that pay accrued interest at the maturity date rather than paying it regularly.

Floating Rate Bonds

Some bonds offer a fixed rate of interest over and above a benchmark that is variable. An example would be the RBI Floating Rate Savings bonds, popularly known as RBI bonds, which are linked to the National Savings Certificate (NSC) scheme.This bond offers the investors an interest rate of 0.35% over and above the prevailing interest rate in NSC. In the April-June 2023 quarter, the interest rate in NSC was 7.7%. This meant investors in the RBI bonds were offered 8.05% (7.7% + 0.35%).Investors invest in floating rate bonds to take benefit of changing interest rates.

Inflation Linked Bonds

Inflation-linked bonds are a variant of floating rate bonds designed to help investors protect themselves from the effect of inflation. These bonds are linked to the country’s inflation index i.e. the Consumer Price Index (CPI), to adjust itself according to the inflation rate in the economy. Such bonds not only adjust the coupon rates with changes in inflation, these also adjust their face value accordingly.

Perpetual Bonds

Bonds that are issued by an entity with no maturity date are called perpetual bonds. These do not come with a maturity date but instead offer the investors perpetual interest, thus offering them a stable interest income for their lifetime.Most perpetual bonds come with a call option. This enables the borrower to call back the bonds by redeeming them at a predetermined price.

Callable and Puttable Bonds

Some bonds come with put options; they are called callable bonds and puttable bonds.The callable bonds have an in-built call option wherein the issuing company can call the bonds back from the investors and redeem them at a pre-determined price. This way, companies can redeem when the interest rates drop which allows them to get funds at cheaper rates.Similarly, puttable bonds have an in-built put option wherein the investors can execute the put option and redeem their bonds before their maturity date. They do so when the interest rates are high and they can invest their money at a higher interest rate. However, puttable bonds are not so common these days.

Bond prices and interest rates have an inverse relationship; when rates go up, bond prices fall, and when rates go down, bond prices rise.To understand why this happens, let us assume you hold a bond with a face value of Rs 1,000 offering a coupon rate of 5% annually. Guess what happens when a year down the line, interest rates rise?This is what will likely happen: any fresh bond with a matching face value of Rs 1,000 will likely offer coupon rates higher than yours – say at 6%. Why? Because companies that now want to borrow funds from the market will be forced to match the higher interest rates that banks are offering.This will have an immediate impact on your bond: its value will start dropping; you will realise this if you try to offload your bond in the secondary market – chances are that you will have to sell it at a discount, i.e. under Rs 1,000.

Like any financial instrument, bonds carry certain risks as well. Let us explore these:

Default Risk

Bonds represent loans given by the investor to the issuing company. Hence, they carry a default risk wherein the borrower could default on the payments of interest and even principal due to liquidity issues.Almost all bonds issued by entities other than the government (central or state) carry default risk. This brings the creditworthiness of the borrower under question, and also explains why credit ratings is an important factor while determining the default risk in a bond.

Interest Rate Risk

One important risk with bonds that investors should be aware of is interest rate risk. As already explained, interest rates and bond prices are inversely related; if interest rates go up, bond prices go down. Of course, you won’t face actual loss if you plan to hold the bonds till maturity. But it will be a loss of opportunity as you could have earned a higher interest if you had invested in bonds that offer a higher interest rate.

Liquidity Risk

It may so happen that when you try to sell your bonds, you are not able to find a buyer. In other words, there is a risk that you won’t be able to get your money when you require it.

Consider the following when evaluating bonds:

1. Security: Check if the bond is secured or unsecured (secured bonds are backed by company assets and offer slightly lower rates but greater safety).
2. Liquidity: Assess the bond’s liquidity; traders are limited so check for sufficient exit options if you don't intend to hold the bond until maturity.
3. Coupon Rate: Verify if the bond's interest rate is competitive, as bonds with coupon rates significantly lower than market rates tend to trade at a discount.
4. Credit Rating : Evaluate the bond's credit rating, with AAA bonds being the safest but potentially offering lower yields. Lower rated bonds may provide higher yields but come with increased risk.
5. Callability Clause: Check if the bond has a callability clause, where the issuer can redeem the bond if market interest rates decline sharply. This may impact long-term financial planning relying on high yields.
6. Post-Tax Yields: Remember that bond interest is taxable. Explore tax-free infrastructure bonds like those issued by REC and PFC, which offer entirely tax-free interest.

Investors who don’t want to take up higher risks by investing in equity or investors who wish to reduce their portfolio risk by diversifying can choose to invest in bonds. But it is advisable to consulting a qualified financial advisor before investing.