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What are Bonds – Meaning, Types, Key Terms & How to Invest Through Secondary Markets

Author Clarice Mendonsa | Posted May 30, 2021

Did you know that bonds were discovered approximately 4,420 years ago in Iraq?!

What are Bonds

During those days this beautifully carved stone was used as a guarantee against payments. Over the years, this practice has grown to become one of the most popular methods of raising funds. Today most companies and government bodies issue bonds to raise funds from the general public.

This article will help you understand everything about bonds such as:

  1. What are bonds?
  2. Types of bonds
  3. Key terms for understanding bonds
  4. What is yield to maturity (YTM)?
  5. How price fluctuations affect the purchase price of bond in the secondary markets?
  6. What is accrued interest?
  7. Advantages of bonds
  8. Disadvantages of bonds
  9. Tax implications on bonds
  10. Two most popular bonds in India
  11. Alternatives to investing in bonds
  12. Who should invest in bonds?

What are Bonds?

A bond is a form of debt. Here, retail investors like you and me provide loan to the bond issuer. In return, the issuer agrees to pay fixed interest rate and return the borrowed capital on maturity.

In the world of investing, bonds are considered as a safe haven. It is securely backed by collateral. As a bondholder, you also get first right on a company’s assets and while distributing profits you are the first one to get paid.

Types of Bonds

What are Bonds

1. Central Government Bonds

Government bonds have been in trend since the early 1,100s. Back then Venice used to issue government bonds to fund its wars. Today this same practice of issuing bonds is followed by central banks across the globe. In India, these bonds are issued by the Reserve Bank of India (RBI) on behalf of the Indian government. They come with a maturity period of more than 10 years.

As they are issued by the government there are fewer possibilities of default. Hence, they are considered the safest investment option to earn regular interests. However, these bonds are exposed to inflation rate risk. It means there is a possibility that the inflation rate might outpace the returns delivered by your bond in the future.

You can easily apply for central government bonds using National Stock Exchange’s platform GoBid.

These bonds are further classified into four.

  1. Fixed rate bond: These bonds have a fixed interest rate throughout their tenure.
  2. Floating rate bond: As regular bonds pay fixed interest rates, floating rate bonds have variable interest rates. Hence, the interest amount you receive keep changing at regular intervals.
  3. Zero coupon bond: Zero coupon bonds have no coupon (interest) payments. They are issued at a discount to their face value and redeemed at par. The difference between the two prices is the investors profit. For example, a bond is issued at Rs 80 and redeemed at Rs 100. The difference Rs 20 is the investors profit.
  4. Inflation indexed bond: These bonds are the ones in which the principal amount and the interest payment is linked to an inflation
  • Consumer Price Index (CPI)
  • Wholesale Price Index (WPI)

Investment in these bonds ensures that your real return beats inflation.

2. State Government Bonds

State Government bonds carry very low default risk. An example of such bonds is 7.48KerelaSDL2032 Bond.

Here, annualised interest is 7.48%

State: Kerala

Type: State Development Loans (SDL)

Maturity year: 2032

3. Corporate Bonds

Corporate bonds are issued by private companies. It represents a large portion of the bond market. By issuing corporate bonds, companies raise capital at a low cost. These bonds pay higher interest than government bonds. However, they are exposed to inflation risk and credit risk.

Corporate bonds are further divided into two.

  • Convertible bonds: These bonds can be converted into equity shares in a certain ratio. If a bond has a conversion ratio of 2:1, then you will get two equity shares in exchange for one bond.
  • Non-convertible bonds: These bonds cannot be converted into equity shares.

4. Public Sector bonds

These bonds are issued by highly rated public sector companies for meeting their growth and expansion needs. They are relatively less risky than corporate bonds.

5. Tax-free bonds

Tax free bonds are issued by a government enterprise to raise funds for an upcoming project. Examples of such companies are:

The interest earned on these bonds is exempt per section 10 of the Income Tax Act of India, 1961.

Key Terms for Understanding Bonds

What are Bonds

1. Face value: This is the price of a bond at the time of issue on which interest is calculated.

2. Coupon rate: It is the rate of interest paid on the bond’s face value. It can be paid annually or semi-annually.

3. Coupon date: This is the date on which the investors receive interest payment.

4. Redemption year: It is the maturity year of the bond. Redemption can be done on par or premium.

  • Redemption at par: When the redemption price is equal to the face value, it is said to be redeemed at par.
  • Redemption at premium: When the redemption price is more than its face value, it is said to be redeemed at a premium. For example, if a Rs 100 debenture is redeemed for Rs 115, then Rs 15 is the premium.

5. Yield to maturity (YTM): It is the total expected return for an investor if the bond is held till maturity. This amount keeps changing as per your purchase price in the secondary markets.

How?

Let’s understand this with an example.

Formula to calculate yield:

YTM = Coupon rate / Bond price

Suppose there is a bond with a face value of Rs 1,000 and the coupon rate is 10%. How much yield will it provide? The answer is Rs 100.

Scenario 1: The bond is trading at a discount in the secondary market. 

Assume that the price of the bond today is Rs 800 in the secondary market. We can say that the bond is trading at a discount of Rs 200 to the face value.

Note: The coupon rate remains constant and is always calculated on the face value of the bond. So, no matter at what price the bond is trading today, the coupon amount will still remain Rs 100. 

So now how much yield will the bond provide?

YTM = Coupon amount / Bond price

= 100/800*100

= 12.5%

Scenario 2: The bond is trading at a premium in the secondary market

Assume that the price of the bond went from Rs 800 to Rs 1,200. We can say that the bond is trading at a premium of Rs 200 to its face value.

Now, how much yield will the bond provide?

YTM = Coupon amount / Bond price

= 100/1200

=8.33%

So, YTM keeps fluctuating depending on what price you purchase the bond.

Let’s take a real life example. Here are the bond details of Hindustan Petroleum Corporation Limited (HPCL) Ltd. The bond was issued in February 2020 at a coupon rate of 9.18%.

What are Bonds

Today the same bond is trading at a premium and hence the yield is lower than the coupon rate.

What are Bonds

Source: thefixedincome.com 

So, your yield will vary according to the price you purchase the bond.

  • Premium = Low yield
  • Discount = High yield

6. Credit rating

What are Bonds

All bonds receive ratings from credit agencies based on factors like creditworthiness, business performance and past track record. Accordingly, they are rated from AAA to D.

Here is the Investment Information and Credit Rating Agency of India (ICRAs) long term rating scale.

Ratings Risk
AAA Low credit risk and highest degree of safety
AA Low credit risk and a high degree of safety
A Low credit risk and adequate degree of safety
BBB Moderate credit risk and a moderate degree of safety
BB Moderate risk of default
B High risk of default
Very high risk of default
D The security has already defaulted or is expected to be in default soon

Please note: Credit rating agencies use modifiers such as + (plus) or – (minus). It indicates their relative position within the rating categories. Thus, the rating of AA+ is one notch higher than AA, while AA- is one notch lower than AA.

The credit rating of a company largely affects the coupon rate.

  • If the issuer of the bond has a low credit rating, the default risk is higher. Hence these bonds pay more interest.
  •  If the issuer of the bond has a AAA credit rating, the default risk is low. Hence, these bonds pay lower interest.

Usually, bonds issued by the governments are very stable and are considered to be of the highest quality.

Now that you know the basic terminologies of bonds. Let us move ahead and understand the effect of price fluctuations and investing in bonds through the secondary market.

How Price Fluctuations Affect the Purchase Price of Bonds in The Secondary Markets?

Example of Primary Markets

Let’s say on 18th Feb 2021 Mr Roy invests Rs. 1,00,000 in a 10-year bond that pays him 12% fixed return annually. This means that he will be paid Rs 12,000 per year for 10 years until maturity.

Example of Secondary Market

On 24 Apr 2021, Mr Alan wants to invest in the same bond through the secondary market.

Here are the bond details:

Bond Issue Date: 18 Feb 2021

Bond Maturity Date: 18 Feb 2030

Bond Face Value (Value of one bond): Rs 1,00,000

Coupon Rate: 12.00% (Interest will be paid on 18th February annually till maturity)

Scenario 1:

If in the secondary market the price per bond is Rs 1,00,500. The YTM is 11.94% (12,000/1,00,500*100). Then Mr Alan has to pay the principal amount plus accrued interest of Rs 2,169 (calculation shown below). This accrued interest is the holding period interest payable to the seller of the bond.

So, the total amount payable to the seller is Rs 1,02,637.00 (Principal value plus accrued interest).

Scenario 2:

If the current price of the bond is Rs 99,500. The YTM is 12.06% (12,000/99,500*100). Here Mr Alan has to pay the principal amount plus accrued interest of Rs 2,169 to the seller. The total amount payable to the seller is Rs 1,01,637.00 (Principal value plus accrued interest).

Under both primary market and secondary markets scenarios, Mr Alan will get an annual interest payment of Rs. 12,000 every year on 18th February till the maturity of the bond. On maturity, he will get back his principal of Rs 1,00,000 along with that year’s interest.

The only difference in buying bonds from the secondary market is the addition of accrued interest.

What is Accrued Interest?

If a bondholder sells his bond in the secondary market before the next interest payment, then the buyer has to pay the estimated interest amount to the seller. This amount is called accrued interest. The bond issuer is not involved in this process.

The accrued interest is added to the market price of the bond. Hence, bonds will always cost more than the quoted price in secondary market.

Why Does the Buyer Pay Accrued Interest?

This is because only the bondholder on record will receive the next interest payment. But the former bondholder had held the bond for a certain period. Hence, he needs to be compensated for his original ownership.

The buyer of the bond will pay the accrued interest to the seller on top of the price of the bond during the sale. The bond buyer is then reimbursed at the next coupon date as he will receive a full interest payment even though he had only held the bond for a small period of time.

How is Accrued Interest Calculated?

Number of days = 24 April 2021 – 18 February 2021

= 66 days

Now, calculate interest on principal value:

= Face value* coupon rate/100 *No. of days/365

= 1,00,000*12.00/100*66/365

= Rs 2,169

Advantages of Investing in Bonds

Advantages of Bonds to Investors

  • Bond issuer provides regular and fixed income to bondholders.
  • The interest provided on bonds is higher than fixed deposits.
  • Bonds are less volatile compared to stocks.
  • As bonds are liquid, you can easily sell them in the secondary markets.
  • Bond holders are creditors of the company. Hence, they will be paid before shareholders and debenture holders.
  • Few bonds provide tax free returns to their bondholders.

Advantages of Bonds to the Issuing Company

  • In the case of a bank loan, the company has to pay regular interest of 12% to 14%. But by issuing bonds, the company has to pay 8% to 9% interest. So, bonds are a cheaper source of finance.
  • Bondholders do not get voting rights. Hence it does not dilute the control of the management.

Disadvantages of Investing in Bonds

Disadvantages of Bonds to Investors

  • If you buy a bond from the secondary market at a premium, the returns you earn will be much lesser.
  • If the financial condition of the company is not good, then finding buyers for the bond in the secondary markets is difficult.
  • Bonds are less liquid as compared to stocks.

Disadvantages of Bonds to the Issuing Company

  • Repayment of principal amount and interest rate are legal obligations of the company. Hence it is a financial burden on the company.
  • The credit rating of the company is highly affected if the company defaults on its payments.
  • Bonds are issued against collateral such as factory building or any other asset. So the asset is mortgaged till the bondholder’s capital is repaid. Hence, it restricts the company from selling the mortgaged asset.

Tax Implications on Bonds

The interest you earn is credited to your bank account and is considered as income from other sources. So, tax is applicable as per your income tax slab. If there is appreciation in the bond price, it is considered as capital gains.

  • If you sell the bond after a year but before maturity, then you are eligible to pay long term capital gains (LTCG) at 20% with indexation.
  • If you sell the bond before a year in the secondary market, then you have to pay short term capital gains (STCG) is as per your tax slab.
  • Tax free bonds are exempt from tax.

Two most popular bonds in India

1. Sovereign Gold Bond (SGBs)

This bond is issued by the central government of India for those who wish to invest in digital gold. The interest earned from this bond is tax free. It is also considered a highly secured bond as it is offered by the Government of India.

They come with a maturity period of eight years and pay 2.5% interest rate.

2. RBI Bonds (Floating Rate Saving Bonds)

Floating rate saving bonds 2020 is issued by the Reserve Bank of India (RBI). It is also known as RBI taxable bonds. It comes with a maturity of seven years and interest rate keeps fluctuating every six months.

You can invest in these bonds with as low as Rs 1,000 and there is no maximum limit on investments. Interest received from these bonds will be taxed as per your income slab.

Alternatives to Investing in Bonds – Debt Mutual Funds

A debt mutual fund is a mutual fund scheme that invests 65% of its corpus in fixed income instruments such as corporate and government bonds, corporate securities, money market instruments etc. These funds provide steady income with diversification. You can invest in debt funds with as low as Rs 500.

List of Best Debt Funds for 2021

Fund Star rating 1-Year Return 3-Year Return 5-Year Return NAV Expense Ratio
Kotak Bond Short Term Fund – Growth 5 Star 6.48% 8.40% 7.65% Rs 41.30 1.16%
IDFC Government Securities Fund – Constant Maturity Plan -regular Plan-growth 5 Star 4.28% 12.33% 10.29% Rs 36.05 0.61%
Tata Money Market Fund Regular Plan Growth 5 Star 4.71% 4.34% 5.35% Rs 3663.18 0.43%
Nippon India Banking And PSU Debt Fund – Growth Plan-growth Option 5 Star 6.56% 9.32% 8.31% Rs 16.30 0.79%
HDFC Medium Term Debt Fund – Regular Plan-Growth 5 Star 9.74% 8.50% 7.97% Rs 44.09 1.32%
Aditya Birla Sun Life Income Fund – Growth-regular Plan 5 Star 7.04% 9.72% 8.18% Rs 99.23 1%
ICICI Prudential Long Term Bond Fund – Growth  5 Star 3.14% 9.94% 8.82% Rs 71.92 2.01%

*This is simply the list of best debt funds. This is not an investment advice.

Who Should Invest in Bonds?

Risk averse investors and retired individuals should invest in bonds.

In the long term, bonds can become an attractive investment option as it offers regular income with low to no volatility. If you opt for a 10 year bond which provides 7.5% to 8% returns and the inflation rates stay at 6% then you can easily earn 1.5% to 2% real return on your investment.

So, bonds are a great investment option as it adds safety and diversification to your entire investment portfolio. But while investing in bonds, you should invest in only AAA+ or AAA rated bonds.

Click here to know more about credit ratings.

To diversify your investment further, invest in debt mutual funds. Indeed, finding the best debt fund is a daunting task. Luckily, Samco’s RankMF rates and ranks all mutual funds in India and gives the most honest answer to kaunsa mutual fund sahi hai…!

So open a RankMF account today!

Happy Investing

By Clarice Mendonsa

The author has done a Bachelors in Banking and Insurance (BBI). She is a budding financial content writer. Her strength lies in simplifying financial jargons. Her goal is to help readers make better investment decisions.

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