What are Bonds? how to invest in bonds

There are mainly two types of investors in the market. One who does not like the ups and downs of the stock market, due to which they do not even invest in the stock market. Others are investors who want to diversify their portfolio and invest their money in different places.



Bonds can be a great option for both these types of investors. Bonds have the ability to give you less returns than the stock market but higher than bank fixed deposits. The bond market in India has not yet developed that much. The main reason for this is that investors do not even know how to invest in bonds. But the bond market is likely to expand at a faster pace in India in the future.

As a smart investor, you should have proper knowledge about bonds. These articles are completely based on bonds, after reading this you will take your investing knowledge a step higher. Today we will talk about what are bonds, how to invest in bonds, types of bonds and every information related to it.

What are bonds?

Bond is a debt instrument which in Hindi means security or debenture. Through bonds, financial institutions and retail investors such as you and I provide loans to bond issuers. The bond issuer issues the bond to the person from whom the money is borrowed. In return, he promises to pay a fixed rate of interest. These issued bonds carry an interest rate, which is also called the coupon rate.

For example I need ₹1,000. You lend me this ₹1,000. Instead, I will issue you a ₹1,000 bond with 10% interest with maturity of one year. After one year you will give my bond back to me and I will pay you ₹1,000 plus 10% interest.
Bonds are mainly issued by the government and companies. Bonds are largely considered safe in the investment world which are secured by the collateral. The company has the first obligation to pay the bond holder.

How do bonds work?

Whenever the government needs money for government schemes, the government can raise money by issuing bonds. Similarly, if a company needs finance, it has mainly three options.

  1. The first is to issue equity shares in the stock market. In this the shares of the company are dilute.
  2. Another option is bank loan. But these are very costly to the company because the interest rate is very high.
  3. The third option is to raise money by issuing bonds. In this, the interest rate is lower than the bank loan and the company does not have to dilute its equity.
  4. In this way the company raises money from the market. Instead, they issue bonds with a fixed interest rate. Nowadays these bonds are held in digital form instead of certificate form. Their maturity period is fixed like 3 years, 5 years, 10 years etc.

Bond issuers pay interest to the bond holder at a fixed interval. At the end of the maturity period, the issuer of the bond pays the principal amount and interest to the bond holder.

How much return do bonds give?

At the time of issuance of bonds, a fixed rate of interest is fixed on them. Bond interest rate is also called coupon rate. Bonds typically have returns in the range of 5 to 14%. All bonds are also given different ratings. These ratings are issued based on the borrower's ability to repay the money.

Higher interest rates are offered to you in risky bond funds. Whereas low risk bonds have low interest rates such as government bonds. The actual return of bonds is YTM i.e. Yield to Maturity.

What is Yield to Maturity (What is Bond Yield)

While buying a bond, one should always look at the yield to maturity to know the actual return. Both the interest rate and YTM of the bond remain different. Let us understand it with the help of an example.

Case – 1
Buying Price (face value)₹1,00,000
Holding Period12 Months
Maturity Period12 Months
Coupon Rate10%
Selling value (face value)₹1,00,000
Capital Gains0
Interest Income₹10,000
Yield to Maturity (YTM)( 10,000 ÷ 1,00,000 ) × 100 = 10%
In this case you are holding the bond till the maturity period. Therefore, you will have to give the bond back to the bond issuer only at face value. Because of this, you will not get any capital gain in this case. Thus the Yield to Maturity will be worked out on the basis of interest received.

Case – 2
Buying Price(face value)₹1,00,000
Holding Period12 Months
Maturity Period60 Months
Coupon Rate10%
Selling value₹1,20,000
Capital Gains₹20,000 (₹1,20,000 – ₹1,00,000)
Interest Income₹10,000
Yield to Maturity (YTM)( 30,000 ÷ 1,00,000 ) × 100 = 30%
In the second case, you have already sold the bond before the holding period of 60 months. You have sold it with a capital gain of ₹20,000 on account of selling it in the market. Therefore, the Yield to Maturity of this bond will be calculated by adding the interest received and the capital gain.

Case – 3
Buying Price (face value)₹1,00,000
Holding Period12 Months
Maturity Period60 Months
Maturity Period10%
Selling value₹95,000
Capital Gains– ₹5,000 (₹95,000 – ₹1,00,000)
Interest Income₹10,000
Yield to Maturity (YTM)( 5,000 ÷ 1,00,000 ) × 100 = 5%
In this case also the bonds have been sold before the maturity period. But due to sluggish demand, these bonds have been sold below their face value. So here the YTM has been worked out on a net profit of only ₹5,000. It is worth noting that if you returned this bond to the bond issuer after 60 months, you would have got the entire Rs 1 lakh and not Rs 95,000.

Thus, the actual return of bonds is the yield to maturity and not the coupon rate. YTM is calculated on the basis of returns for the entire bond tenure.

What is Accrued Interest in Bonds?

If the bond holder sells his bond before the next interest payment date, then the new buyer has to pay the estimated interest to the seller. In simple words, for the time for which the bond holder has held the bond, he collects the interest from the new buyer. This is called accrued interest.

Let us understand it with an example –

Suppose you have a bond on which you will get interest after next 12 months. If you are selling this bond only after holding for 8 months, then the buyer will also give you interest for these 8 months. Because after 4 months full interest will be given to the buyer. Out of 12 months, 8 months interest will be paid to the old bond holder at the same time as buying the buyer bond. This 8 months interest will be Accrued Interest.

Advantages and Disadvantages of Bonds

Along with some advantages of investing in bonds, there are also some disadvantages that you need to keep in mind.


Benefits of Bonds

(i) Good Returns – Bonds are such a long term investment that offer you a fixed and good interest rate as compared to other investment options. Their returns are higher than bank fixed deposits and savings accounts. Bond returns also help you beat inflation.

(ii) Low Risk – Companies that raise money through bonds have the first obligation to return the money to the bond holders. Whereas in the case of government bonds, the risk is negligible. A bond is a financial contract between the two parties under which the borrower has a legal obligation to return the money in due time.

(iii) Portfolio Diversification – Bonds provide stability to your portfolio with a fixed interest rate and security. If you invest in stock market, mutual fund, public provident fund etc., then you can diversify your portfolio by investing some part of investment in bonds.

Investing in different investment options reduces the risk.

(iv) Pledging – Many financial institutions also allow you to pledge bonds.

Disadvantages of Bonds

  1. Due to rising inflation rate and slowdown in the economy, high rated bonds start offering investors lower interest rates than inflation.
  2. Bonds have a fixed maturity period. So you may have to wait till maturity to sell the bond. However, you can sell the bonds through an intermediary.
  3. Bonds have lower returns than stocks and mutual funds.
  4. In the event of the company going bankrupt, there is a risk of losing money.

Types of Bonds

(1) Government Bonds - Whenever the government needs money to fulfill its schemes, it collects money by issuing government bonds. These bonds are guaranteed by the government, so the chances of them defaulting are negligible. Because of this, the interest rate offered in these is also low.

(2) Municipal Bonds – These types of bonds are issued by the local government or municipal corporation to meet their financial needs.

(3) Corporate Bonds – These bonds are issued by a private company. These types of bonds carry a slightly higher risk but also higher interest rates.

(4) Secured Bonds – These bonds are secured. The company which has borrowed money from you has to repay your money back. Even if the company is running in loss. You can also sue the company if the money is not paid back. Secured bonds have lower interest rates.

(4) Unsecured Bonds – These types of bonds are considered quite risky. If the company refuses to return your money, then you cannot even sue the company. These bonds offer you high interest rate.

(5) Fixed Interest Bonds – In the case of these types of bonds, the bond holder gets the same interest rate throughout the life of the bond. There is no change in their interest rate.

(6) Floating Interest Bonds – The coupon rate in such bonds varies regularly during the bond tenure. Interest rates depend on factors like market conditions, inflation.

(7) Inflation Linked Bonds – The returns of these bonds are according to the rate of inflation.

(8) Perpetual Bonds – There is no fixed maturity period in these types of bonds. There is no obligation on the issuer of the bond to repay the principal amount. These bonds are bought to earn interest as regular income over a long period of time.

How to invest in Bonds

Most of the people in India do not know how to invest in bonds. For this reason, the bond market in India has not developed so much.

Ways to invest in bonds

(i) Debt Funds – Debt funds are the first way to invest in bonds. Debt fund is a type of mutual fund. Debt funds are an indirect way to invest in bonds. For investing through debt funds, you have to pay an expense ratio of 1 to 2% which reduces your returns. For this reason, this method is not considered a good way to invest in bonds.

To invest in Government Bonds, you can invest in Gilt Funds.

(ii) Online Platform – You can buy bonds online directly. This method is the best way to buy bonds. You can buy bonds online through the following websites –

(iii) Through stock broker – Many corporate bonds are also traded on the exchange. You can buy and sell bonds through your stockbroker. Nowadays government bonds can also be bought through bids with the help of a stockbroker.

(iv) Commercial Bank – You can also buy bonds directly through the bank.

Tax on Bonds

There are also some tax-free bonds available in bond investing. Tax free bonds are mostly issued by PSU companies like HUDCO, NHAI, REC etc.

The tax treatment of both listed bonds and unlisted bonds is different. Listed bonds are those that are listed on a stock exchange. Their tax treatment is same as that of stocks.

If you sell listed bonds with a tenure of less than 12 months, you will incur short term capital gain (STCG). Its profit will be added to your regular income and taxable as per your current tax slab.

Long Term Capital Gain (LTCG) occurs when a listed bond is sold by holding it for 12 months or more. This profit is subject to LTCG tax which is taxable at 10%.

The same is the case of unlisted bonds with STCG for less than 36 months. These benefits get added to your income, which is taxed as per your tax slab.

LTCG tax is levied on the gain on sale of unlisted bonds by holding 36 or more. Currently its rate is 10%.

Who should invest in Bonds?

The purpose of investing in bonds can be different for each investor. If you want to get a regular return which is higher than bank FDs, then you can invest in bonds. Bonds can give you less returns than stock market but higher than FDs.

Bonds can be a good option for investors who want to put their money in a very low-risk place.

Bonds have a slightly longer maturity period. So always invest only that money in it which you do not need in the near future. If you want to diversify your portfolio i.e. you want to invest your money in different places, you can still invest in bonds.

Conclusion

Bonds can be a good option to get a stable income for a long period of time. But you should avoid buying risky bonds. In my opinion, you should buy AAA rated bonds only. Also, while buying bonds, always buy bonds by looking at the Yield to Maturity (YTM).

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FAQ on What are Bonds

  1. What are the types of bonds?
  2. There are many types of bonds such as corporate bonds, government bonds, secured bonds, unsecured bonds, perpetual bonds, inflation linked bonds, etc.

  3. What are the differences between shares and bonds?
  4. When an investor buys shares, he buys some part of the company. When someone buys a bond, it means that he is lending money to the company or to the issuer of the bond.

  5. How to buy government bonds?
  6. You can buy gilt mutual funds in the form of government bonds. Additionally, retail investors can buy government bonds by registering themselves for non-competitive bids on the stock exchange. You can also invest in government bonds directly through a stockbroker.

  7. Is a demat account necessary to buy bonds?
  8. Demat account is not necessary for buying bonds. But to buy bonds through online platforms and stockbrokers, a demat account is necessary.

  9. Can an NRI buy Indian bonds?
  10. Yes, an NRI can also buy Indian bonds.

  11. What is the Yield to Maturity in Bonds?
  12. Yield to maturity is the total return received in a bond over the entire bond tenure. This includes interest and capital gains.