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 periodic interest 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.
