Read this article to find out the basics of bonds and how they work.
Most investors know little about bonds and typically alternate between investing in equities and cash (savings or fixed deposits). Hence bonds often fall off the radar. Learn more about bonds and what they can do for your portfolio.
What are bonds?
Bonds are loans. The issuer of a bond (usually corporations and governments) is the debtor. The buyer of the bond is known as theholder. In India, most bonds are transacted by corporations and financial institutions. Bond fund managers are big buyers and sellers of bonds.
Like a loan, the bond holder earns interest. This interest is paid by the issuer to the holder and is known as coupon payments. The value and frequency of the coupon payment is pre-determined by the issuer when they issue the bonds for sale.
Like a loan, a bond also has loan tenure, known as its maturity. At the end of the tenure, the bond will be known to be matured and the bondholder will receive the principal investment, also known as the par value of the bond.
Let’s look at an example of a bond issued by the government of India: 8.20 per cent 2022 securities.
Holders of the bond are entitled to a coupon payment of 8.2% of the bond’s par value annually. The bond matures in 2022. Once that happens, the bondholder will receive the par value of the bond.
Types of bonds
There are many ways bonds can be structured. The three most common bonds are fixed rate bonds, floating rate bonds and zero coupon bonds.
A fixed rate bond is a long-term debt paper that carries a predetermined interest rate. These rates are fixed and will not change with the tenure or period of the bond. Such bonds provide stability in income.
A floating rate bond, in contrast to a fixed rate bonds, do not have a pre-determined interest rate. They come with variable coupons, usually a spread with respect to a reference rate. For example, in India, some floating bonds have a coupon rate of the Mumbai interbank offer rate (MIBOR) + 45 basis points. It means that the coupon amount will change according to the prevailing MIBOR at thetime of coupon payment.Buyers of such bonds buy in anticipation that the reference rate will rise in the near future, so that they receive a higher coupon rate in future.
A zero-coupon bond (also known as a discount bond) is a bond bought at a deep discount compared to its par value, where the face value of the bond will be repaid at the time of maturity. However, unlike fixed rate and floating rate bonds, it does not make periodicinterest payments. Investors earn returns from all the compounded interest paid along at maturity when the par value is returned. Buyers of zero coupon bonds usually do not need regular payouts and would rather have coupon payments compounded. An example of such buyers is financial institutions.
Why do governments and corporations sell bonds?
The main reason for selling bonds is to raise money. There are several avenues and ways for companies to raise money. They can raise money by selling equity (initial public offering if the first time or rights issue if the company is already listed), go to the bank for loans or raise money through the issue of bonds. The bond is a loan that the bondholder makes to the bond issuer. The bond issuer owes holders a debt and is obliged to repay the principal at a specific date and interest periodically. Because of this interest component that does not change throughout the bond's life (we refer to fixed-rate bonds); this is also why bonds are also known as fixed income securities.
Governments usually sell bonds to raise money for government spending. In India, part of the infrastructure projects and spending are financed by bonds issued to the public.
Why do Fund Managers buy bonds?
Fund managers purchase bonds to add stability to their portfolio. Bond fund managers invest mainly in bond assets. Bond assets are generally regarded to be of lower risk than equities and investors in bond funds will generally be less exposed to volatility.
Conclusion
Bonds are essential loans that corporations and governments issue to fund their projects or spending. Bonds are generally safer instruments compared to equities and have been commonly purchased by large corporation.
