Understanding Bonds: A Complete Explainer For Beginners
KEY TAKEAWAYS
Bonds are essentially loans you give to companies or governments, where you earn interest (coupon) and get back the principal at maturity.
The yield of a bond is influenced by the price you pay for it, which can be at a discount or premium to its face value.
There are various types of bonds, including government, corporate, inflation-indexed, fixed-rate, floating-rate, zero-coupon, perpetual, convertible, callable, puttable, green, and municipal bonds.
Bonds are considered less complex once you understand key concepts like face value, coupon rate, credit rating, and yield.
You can invest in bonds through SEBI-registered online bond platform providers like Grip Invest, Wint Wealth, and Aspero.
Have you ever lost money because a friend or relative of yours never paid you back? In situations like these, it might have been better if you had lent your hard-earned money to a big and rather credible company like Tata or Adani? Or even to the government?
But how can you do this? Can you really loan your money to them? Well, you definitely can, by investing in their bonds!
So let us explain to you the concept of bonds, how they work, what their types/categories are, and the related terminologies you must understand.
What Is A Bond?
Bond is basically a loan that you give to a company or government.
When you buy a bond, you are basically lending your money to the issuer, who may be a company, government, municipality, or a corporation. In return for your invested money, the issuer promises to pay you a specified rate of interest (called as coupon) during the tenure of the bond, and repay the principal, also known as face value or par value of the bond, when it reaches maturity.
Let’s Understand How Bonds Work With An Example
Suppose Reliance Industries (the issuer company) needs Rs 5,000 crore to fund expansion of its business, and it decides to skip going to a bank for loan or raise an IPO, and instead, issues corporate bonds to raise funds.
The face value of each bond which Reliance issues is Rs 1,000. This is the principal amount which the issuer (Reliance) is expected to repay to you at maturity (i.e. the end of the tenure).
So, for example, if you invested in 100 such bonds at face value, you are basically lending Rs 1 lakh (Rs 1,000 face value x 100 bonds) to Reliance, who will repay this amount at maturity.
The credit rating assigned to this bond might be AA, which indicates that Reliance seems to have a strong capacity to meet its financial commitments, with very low default risk. The lower the rating, the higher the risk of default, and vice versa. Click here to understand more about credit rating mechanism and role of agencies like CRISIL, ICRA, etc.
Now coming to the vitamin M (money) question- what will you earn as an investor? Well, firstly, it's the coupon rate, i.e. the fixed annual interest rate which you will earn on a bond, expressed as a percentage of the bond’s face value.
Suppose the coupon rate is 8.5% p.a. here, that would imply that Reliance (the issuer) will pay you Rs 85 per bond every year (Rs 1,000 × 8.5% = ₹85). If you hold 100 bonds, you'll receive ₹8,500 annually as interest.
Now, at the time of maturity (which let’s assume as March 15, 2029), Reliance would repay the face value of Rs 1,000 per bond, i.e. a total of Rs 1,00,000.
But that’s not all. Besides the coupon payment, another concept you need to understand and factor in when investing in bonds, is the yield. After all, this is what you actually earn based on the price you paid for the bond.
Here’s how it’s different from the coupon.
See, it's not always that you buy a bond at exactly the face value. Sometimes it’s more , sometimes less.
So in the above example, you may buy the bond either at Rs 950 (discount) or at Rs 1050 (premium), with the price depending on the demand and supply.
When you buy the Rs 1,000 bond at Rs 950, that Rs 80 coupon suddenly means a higher return on your investment, which basically means a higher yield. Whereas if you buy that bond at Rs 1,050, your yield will be lower. So overall, in bonds, it’s not just about the interest rate, it’s about the price you paid for it too, which you need to factor in.
There are various other concepts in the calculation of Yield too, but let’s not get into the nitty gritties and confuse you. For now, understanding this concept should suffice :)
While everyone considers bonds to be complex, that perception is not really true. As an investor, once you understand the above concepts, it gives you a good place to begin.
Okay, Now Let’s Look At The Types Of Bonds
Bonds as investment instruments have multiple categories into which they can be divided, with the major ones being the following:
Government Bonds
The central and state governments in India issue government bonds to fund public projects. These bonds are highly regarded for their safety, as the government backs them. Additionally, they provide moderate returns of around 5.5%-6.5% p.a. and are generally long-term investment options.
Corporate Bonds
Simply put, a corporate bond is a loan that you give to a company, who in return gives you periodic interest payments and eventually your principal (the money you invested) back, when the bond matures at the end of the tenure. Interest rates on corporate bonds generally range around 9%-14%.
Inflation-Indexed Bonds (IIBs)
As their name suggests, IIBs are a type of government bonds that help protect your money from losing value due to the ‘money eater’ inflation. Unlike regular bonds with fixed returns, both the interest and the principal of IIBs go up with inflation, usually based on the Consumer Price Index (CPI). This means your investment keeps pace with the rising prices!
Fixed-Rate Bonds
Fixed-rate bonds offer investors a consistent and guaranteed interest rate throughout the entire investment period, providing predictable and stable returns. This makes them ideal for those who prioritize financial stability and long-term income.
Floating-Rate Bonds
Floating rate bonds have variable interest rates that are linked to a reference benchmark (this rate is usually a widely recognized, market-driven interest rate such as repo rate or NSC rate, that reflects current economic conditions.)
The rates are adjusted periodically, thus offering investors protection against fluctuations in interest rates.
Zero-Coupon Bonds
As their name suggests, zero-coupon bonds do not pay any interest to the investor. ZCBs are issued at a discount on the bond’s face value and upon maturity, investors receive the face value of their investment. So, you, as an investor, profits from the difference between the discounted buying price and the face value of the zero coupon bond.
Perpetual Bonds
Perpetual means everlasting, or forever, right? Perpetual bonds work in a similar manner. These are bonds that can keep paying interest to the investor for an infinite period, until the issuer itself redeems back the bonds at a particular date.
Convertible Bonds
A convertible bond pays regular interest like a normal bond but also gives you, i.e. the bondholder, the option to convert it into a fixed number of shares of the issuing company’s stock.
Callable Bonds
Callable bonds give the issuer the right to redeem the bonds before their maturity date at a predetermined price and time. To compensate investors for the increased risk of early redemption—where they might receive their principal back sooner than expected and potentially miss out on future interest payments—these bonds typically offer higher coupon rates.
Puttable Bonds
Puttable bonds provide bondholders with the right to sell their bonds back to the issuer before the maturity date, usually at a predetermined price. These bonds typically offer lower coupon rates compared to regular bonds, reflecting the added flexibility and early redemption option they provide to investors.
Green Bonds
Green bonds work just like regular bonds, but with one key difference. The money raised from investors in case of green bonds gets used exclusively towards financing projects that have a positive environmental impact, such as renewable energy and green buildings.
Municipal Bonds
Municipal bonds are issued by local governments and urban development authorities in order to raise funds for infrastructure projects and public services. The government has actively encouraged and recommended local entities to utilize bonds as a means to meet their funding needs.
Okay, So How Can You Invest In Bonds?
Well, there are a bunch of SEBI-registered OBPPs (online bond platform providers) who enable you to invest in bonds. Some of the prominent OBPPs include Grip Invest, Wint Wealth, and Aspero. We have done a detailed analysis on these companies – feel free to click on the links to see the details of these platforms.
Please note that this is an opinion blog and not an official research or investment advice. This blog aims to help retail investors make an informed decision when stepping into the bond market, and it neither encourages nor discourages you from investing in any particular asset class or platform.
If you would like to learn more about bonds and various other alternative investment options, you can join the ALT Investor community here. We have various industry experts and fellow investors as part of our community who can help you with your queries and provide useful insights!
