Characteristics and Different Types of Bonds in India
Bonds in India are fixed-income generating instruments that usually carry a guaranteed rate of interest. Since corporations and governments (Issuers) are always in need of additional capital to fund operations, bonds are available at relatively high frequencies and you can earn a stable and guaranteed income by investing in them. So, if you are looking for fixed returns on your investments, you can invest in bonds.
Different types of bonds are available in the market to cater to the different needs of investors This empowers the investors by giving them both a vast variety of alternatives to pick from and scope to diversify.
But, to invest in the right bond, you first need to understand bonds and their types in detail with a special focus on their unique risks, returns, minimum investment amount, etc. So, let’s have a quick look at the concept of bonds and then check out their different types.
What is a Bond?
When the government or public/private sector organisation needs funds, it can issue bonds to raise the required funds from the general public. Investors putting their money into these bonds are lending funds to the bond-issuing entity, on which the latter promises to pay a predefined and guaranteed interest rate (also known as the coupon rate of the bond). Bonds, thus, are a form of loan given by investors to bond issuers.
Repetitive so let’s make it Bonds issued by governments/companies usually have fixed terms and prefixed interest rates
Read More: Bonds vs. FD: Which is Better?
For example, say a company XYZ needs Rs. 1 crore to fund a project. The company can issue 10,000 bonds with a term of 5 years and a face value of Rs. 1000 each. If the company offers an interest rate of 8% per annum, the investor will get an interest income of Rs. 80 per bond per year. In other words, when investors buy these bonds, they provide funds to the company. In exchange, the company pays the investor Rs. 80 per bond as interest.
Types of Bonds Based on the Issuer
Under this category, bonds are differentiated based on who is issuing them – Governments or corporations. The following types of bonds in India are available:
Also called G-Secs, these bonds are issued by the Central Government to borrow public funds for the country’s development. Government securities are said to be the safest as the Credit Risk is perceived to be relatively lower on account of the issuer being the government. These bonds’ interest rates are called risk-free rates of return. These interest rates often serve as benchmarks in the capital market when evaluating the performance of a variety of investment avenues including debt instruments.
As the name suggests, corporate bonds are those that are issued by private companies or corporates to raise funds through debt financing.
Corporate bonds usually have a higher interest rate compared to G-Secs. Like most debt instruments they too are prone to debt market risks like interest rate risk, credit risk, risk of rising inflation etc., which are related to interest rates, credit, and inflation.
Public Sector Bonds
Bonds that are issued by Public Sector Undertakings (PSUs) are called public sector bonds. PSUs are companies owned and managed by the government. The stake of the central/state government in PSUs is more than 50%. PSU bonds however do not come with a guarantee by the central government on the obligations promised to be met. PSUs issue such bonds to raise funds and come with credit ratings that reveal their default risks. A higher credit rating implies that the bond is relatively safer to invest in.
State Development Loans (SDLs)
Such bonds are issued by a state government to raise funds for the development of the state. They carry a credit rating determined majorly by the creditworthiness of the state considered. Since the issuer at hand is yet again a governing body, the credit risk is perceived to be relatively lower.
Sovereign Gold Bonds
Sovereign Gold Bonds (SGBs) are asset-backed bonds issued by the Central Government. These bonds are denominated in gold, with each bond being worth one gram of gold. You can buy SGBs instead of holding gold physically. The value of the bond depends on the value of gold, both at the time of issuance and also at redemption. You also get a fixed interest rate on your investment. In the case of SGBs, the investor benefits from the fixed return on investment and the appreciation in the value of gold (if any).
Types of Bonds Based on Nature and Frequency of Interest Payments
Fixed-rate bonds are the most commonly available bonds in the market and carry a fixed rate of interest, paid at regular predefined intervals, which can be annual, half-yearly, quarterly, or monthly. The interest remains fixed throughout the bond tenure.
Floating Rate Bonds
With these bonds, the interest rate does not remain fixed during their tenure – these bonds have a fixed component and a floating component. The interest keeps changing based on a pre-chosen benchmark interest rate. It usually augurs well for investors in floating-rate bonds if the interest rates keep rising.
Investing in these bonds may prove to be a good hedge against probable surges in interest rates hedge against rising interest rates. If the benchmark interest rate rises, the bond’s interest rate will also increase to give you better returns.
These bonds do not pay any interest explicitly. Instead, they are issued at a discount to their face value at maturity, these bonds are redeemed at their face value, thereby yielding significant returns to their investors. Zero coupon bonds give you returns in the form of the difference between the investment and redemption prices.
Say a zero coupon bond has a face value of Rs. 100. It might be issued at Rs. 90 and then redeemed at Rs. 100. Thus, one unit of the bond would give you a profit of Rs. 10.
Perpetual bonds usually take the form of subordinated debt and are so called because they do not have a maturity date. They do, however, pay the promised interest rate to the bond owner for as long as he holds the bond. These bonds usually specify different call dates on which the bond issuer can choose to redeem the bond and pay back the borrowed amount.
Bonds can give you a fixed income and are not exposed to market volatility. You can invest in them if you want a debt component in your portfolio. Bonds are increasingly becoming more marketable. This adds to the flexibility in making bond investments. As stated earlier, bonds with varying characteristics are available. Investor must always do their due diligence and pick the most suitable investments in accordance to their investment goals and risk profile
FAQs related to Bonds
What are the risks associated with bonds?
Some of the risks associated with bonds are:
Credit risk – the risk of repayment default by the issuer.
Inflation risk – the risk of inflation significantly reducing the returns on the bond.
Interest rate risk – the risk of rising interest rates after the bond is issued which leads to the devaluation of pre-issued bonds.
What is the coupon rate of a bond?
The coupon rate is the rate of interest paid by bond issuers on the bond’s face value. The coupon rate is calculated on the bond’s face value and not on the issue price.
Can investors hold more than one bond?
Yes, depending on your investment needs, you can buy as many bonds as you like.
Are bonds rated?
Yes, most bonds carry a credit rating. The rating is usually reflective of the creditworthiness of the borrower and also takes into account the risk-return dynamic of the issue.
What are tax-free bonds?
Bonds issued by government enterprises such as the Indian Railways Finance Corporation, the National Highways Association of India (NHAI), HUDCO, Rural Electrification Corporation (REC), etc are tax-free bonds. The interest earned on these bonds is completely tax-free under section 10 of ITA.
How do bonds work?
Bonds are much like loans, where the investor (in the bonds) lends a specified sum of money to the bond issuer, in return for a fixed interest after a predetermined tenure.
Are bonds safe?
Yes, bonds issued or backed by governments are considered some of the safest investment instruments. Corporate bonds that are backed by collateral (secured bonds) and/or issued by blue chip companies with a good history of profitability are also fairly safe (although there is always a risk of payment default). Unsecured corporate bonds, although offer a high coupon rate, are quite risky.