When people cannot afford to purchase things like a car, a house, or an education, they generally approach the banks for loans. Similarly, when businesses aim at expansion, they too need to borrow funds for operations, expansion into new markets, innovation, and general growth. Their needs, however, often exceed the bank’s provision ability. Hence, companies raise funds by issuing bonds to the public.
By investing in a bond, you lend money to the issuer. Bonds can diversify your portfolio and reduce volatility, thereby balancing it. However, even experienced investors may find the bond market unfamiliar. Since bonds appear to be so complex and confusing, many investors make only passing forays into them. However, a bond is a very simple debt instrument. Learn more about what is a bond, its types, and more, in this blog.
What Is a Bond?
Investment bonds are securities in which investors lend money to a company or a government for a set period and receive interest payments in return. Bonds are regarded as I.O.U.s between lenders and borrowers containing details of the loan and the repayment schedule. Since bonds earn fixed payments over their lifetime, they're often referred to as fixed-income investments.
Organizations, such as municipalities, governments, and companies, issue bonds to investors. It is common for companies to sell bonds to finance the ongoing operations, new projects, or acquisitions of their businesses. Governments sell bonds to raise funds and supplement their tax revenues.
The investor purchases bonds at face value or with the principal, which issuers refund at the end of a specified period. The issuers pay fixed or adjustable interest based on the principal amount.
An organization's debt fund is legally and financially accessible to investors who purchase bonds. If a company faces bankruptcy, creditors will pay bondholders before stakeholders.
Additionally, every bond has some risk of default by the issuer. Although, multiple independent credit rating agencies evaluate bond issuers' credit risk. They provide investors with credit ratings, which assist them in evaluating risk and determining interest rates.
Low-credit-rated issuers will pay a higher interest rate for their debt. It's important to note that investors purchasing bonds with low credit ratings may earn higher returns, but they must also prepare for the possibility of the bond issuer defaulting.
Who Issues Bonds? Now that you’ve learned the bonds definition, let’s take a look at institutions that issue bonds.
● Government: To improve infrastructure, governments issue bonds to invest in roads, schools, dams, and public places. The sudden costs of war may also require funds.
Ratings for government bonds are typically very high, although this can vary depending on the government that issues the bond. Bonds issued by governments of developing countries are usually riskier and have lower ratings than bonds issued by governments of developed countries.
● Corporations: Corporations may borrow to expand their business, purchase property and equipment, undertake profitable projects, invest in research and development, or hire employees. Typically, large organizations require more money than their banks can provide. Hence, they turn to bonds.
● Supranational and Multilateral Entities: A supranational entity is based in more than one nation. The World Bank and the European Investment Bank are two examples of supranational entities that issue bonds. The rating of these bonds is usually quite high, just like that of government bonds. Supranational entities may issue bonds to fund their operations, and receive coupon payments from their operating revenues.
● Regions and Municipalities: A smaller municipality may also issue bonds in the same way as a government. Even though the government does not issue the bonds, they are typically backed by their full faith and credit.
Individual investors can assume the role of lenders by investing in bonds. Thousands of investors can lend a part of the capital needed through the public debt markets. Additionally, markets make it possible for lenders to sell their bonds to other investors or buy bonds from individuals.
Types of bonds
Now that you understand the bond meaning in finance and the concept of bond issuers, let’s get into the details of the types of bonds.
They are debt securities issued by firms and sold to investors. Investors receive fixed or variable interest payments at either a fixed or variable interest rate as a return for their capital investment. Upon maturity, the bond's payments cease and the original investment is repaid.
Corporate bonds are generally considered to be a safe and conservative investment in the investment hierarchy. To balance out riskier investments such as growth stocks, investors often add corporate bonds to their portfolios.
These are debt instruments issued by governments to finance their needs and regulate the money supply. These bonds are often used by the government to finance infrastructure development and government spending. As a result, the government will issue bonds and invite investors to invest. When the bond reaches maturity, the government will repay the principal and interest as specified in the contract.
Government bonds in India are generally long-term investments. Typically, these bonds last between 5 and 40 years. Further, government bonds fall into the category of government securities (G-secs). Both state and federal governments can issue government bonds.
The state, city, county, and other non-federal government entities issue municipal bonds. As with corporate bonds, municipal bonds fund projects or ventures within a state or city, such as highways and schools.
A municipal bond's interest is tax-free at both the federal and state levels. Thus, high-net-worth investors and retirees seeking tax-free income can invest in them.
There are different types of municipal bonds based on their maturity terms. A short-term bond usually matures within one to three years, while a long-term bond can take up to ten years to mature.
Sovereign Gold Bonds
Central governments issue these bonds to investors who want to invest in gold but do not want to store the gold physically. This bond's interest is tax-exempt. Due to its government backing, it is also regarded as a highly secured bond.
If an investor wishes to redeem their investment, they can do so after the first five years. The redemption date will only affect the date of interest payments following the redemption.
There are many types of bonds to invest in, but RBI Bonds are one of the most profound. RBI Bonds are issued by the Indian government and can be held by Indian citizens. 12 nationalized banks sell RBI bonds, including the Bank of Baroda, Bank of Maharashtra, State Bank of India, Central Bank of India, and Indian Bank.
The maturity term of an RBI bond is 7 years, but one can demand a return at any time. This, however, carries a penalty.
Unlike tax-free bonds and fixed deposit accounts, these bonds provide higher returns, a safer source of funds, and relatively short lock-in periods.
With inflation-linked bonds, coupon payments and face value are less affected by inflation. The principal amount is adjusted according to the inflation rate, and interest payments are calculated accordingly.
As the name implies, this financial instrument pays no interest. Until the bond matures, the money invested doesn't earn a regular interest rate on the investment. The bond is also called the pure discount bond.
An investor receives the face value when the bond matures, along with the annual returns on the principal amount.
Unlike other bonds, this type of bond pays interest and has a face value at maturity but can be converted into stock of the issuing company at a certain point. It combines the features of debt and equity.
How do bonds work?
Besides stocks (equities) and cash equivalents, bonds are usually considered to be fixed-income debt securities and are one of the most familiar asset classes for individuals.
Whenever a company or other entity needs to raise money to finance a new project, maintain a running operation, or restructure debt, they may issue bonds to investors. To borrow funds (bond principal), the borrower issues a bond that defines the terms of the loan, interest payments, and when the loan must be repaid (maturity date). Bondholders receive interest payments (the coupon) in return for lending their funds to issuers.
Bond prices vary depending on a number of factors, including the credit quality of the issuer, the term of the bond, and the interest rate environment at the time. When the bond matures, the debtor repays the face value, which is the principal.
It is generally possible for the original bondholder to sell the bond to another investor after it has been issued. Therefore, bond investors do not have to hold bonds until they mature.
Investors should familiarize themselves with several aspects of bonds, including
● Issuer: A legal entity that sells securities, such as bonds, to raise money to fund new projects or investments.
● Face value: Also called "par value," this is a price assigned to a stock or bond when it is brought to market by the company. In contrast to market value, face value does not fluctuate. Bonds and stock certificates have a par value printed on them.
● Coupon rate: This is the interest rate on fixed-income security, such as a bond. Bond issuers pay a fixed interest rate based on the face value of their bonds. In most cases, interest is paid semi-annually.
● Issue date: The issue date is when the bond is issued and interest begins to accrue.
● Maturity date: It is the date when your bond's principal will be repaid. Purchasing and selling bonds on the open market is possible before their maturity date. Be aware that the maturity date change will affect the amount of money you receive from the issuer.
● Credit quality: It is the ability and willingness of an issuer to make timely interest and principal payments. A bond's credit rating indicates its quality.
● Market value: A bondholder pays this price when they purchase a bond. What is the difference between this and the face value of your bond? The bond's market value fluctuates, unlike face value. Interest rates and other factors will affect its rise and fall.
● Yield to maturity: A bond's yield to maturity represents the total return you will receive from the date you purchase the bond until it matures.
Example of How Bonds Work
Consider XYZ wants to acquire a large tea company in Asia and wants to borrow INR 100 crore from investors. Based on its market assessment, it believes it can set a coupon rate of 2.5% for its 10-year maturity date. It promises to pay pro-rata interest semi-annually and issues bonds at a par value of INR 1,000. It approaches investors through an investment bank. To raise INR 100 crore, XYZ must sell 10 lakh bonds at INR 1,000 each before paying the fees it would incur.
The interest rate on each INR 1,000 bond is INR 25 per year. Due to the semiannual nature of the interest payment, INR 12.50 will be paid every six months. The INR 1,000 will be returned at the end of 10 years, and the bond will cease to exist if everything goes according to plan.
How Do Bond Ratings Work?
Bonds are all subject to default risk. Investors will have difficulty recovering their principal if a corporation or government issuer declares bankruptcy. A bond credit rating helps you gauge the default risk of a bond investment. Also, they indicate how likely the bond issuer will be able to pay its investors the coupon rate on time. Rating agencie evaluate bond issuers' financial health in the same way that credit bureaus assign you a credit score.
Financial institutions develop ratings based on intrinsic and external factors. Among the internal factors are the bank's overall financial strength rating, a risk measure indicating its likelihood of requiring external monetary support. Financial statements and financial ratios of the firm under analysis determine the rating.
Other external influences include networks with other interested parties, such as local government agencies, parent corporations, and systemic federal support commitments. It is also necessary to research the credit quality of these parties. After analyzing these external factors, a comprehensive external score is calculated. BBB, for example, is the overall grade obtained after adding this grade to the "intrinsic score."
A bond rating is more than a quick analysis of a firm's ratios and balance sheet. Various measures are used for different industries, and external influences affect the complex process in a variety of ways.
How Bonds Are Priced?
Bonds are priced based on their specific characteristics. Like any publicly traded security, the bond’s price changes daily depending on supply and demand.
However, bond values follow a logic. Keeping a bond to maturity ensures you'll get your principal plus interest; however, you don't have to hold it to maturity. Bondholders are free to sell their bonds on the open market at any time, where prices may fluctuate, sometimes dramatically.
In the secondary market, bonds are priced based on their face value or par value. Bonds trading above their face value—above par—are said to trade at a premium, while bonds trading below their face value—below par—trade at a discount. Market interest rates and credit ratings play a major role in pricing.
Consider credit ratings: High-rated bonds pay lower coupons (lower fixed interest rates) than low-rated bonds. As a result of the smaller coupon, the bond has a lower yield, which means you get a lower return on investment. Nevertheless, if market demand for your highly rated bond suddenly declines, it will start trading at a discount to par. As a result, its yield would rise, and buyers would earn more over the bond's life because the fixed coupon rate represents a more significant portion of the purchase price.
Market interest rate changes complicate the situation. Bond yields rise along with market interest rates, depressing bond prices as a result. An Indian company, for example, issues bonds for INR 1,000 that carry a 5% coupon. In the following year, interest rates rise, and to keep up with market rates, the same company issues a new bond with a coupon of 5.5%. The new bond would have less demand than the bond with a 5% coupon.
The old 5% bond would trade at a discount, say INR 900, to keep the first bond attractive to investors using the INR 1,000 par example. Investors would receive a discount on the purchase price to make the old bond's yield equivalent to the new 5.5% bond.
It is important to keep fixed-income investments at the forefront of your investing strategy, regardless of whether you work with a financial professional or manage them yourself. Bonds can provide income and stability as part of a well-diversified investment portfolio.