The name’s Bond…
Imagine giving loans to the government or big companies. The borrowers would be paying you regular interest and would return your money after using it for some time. This can be done by the way of bonds.
Simply speaking bonds are a way by which entities can borrow money from the general public and for the general public it is a great way of diversifying their portfolio. Bonds are a safe haven for your money as the amount you invest as principal is returned back to you at the end of the tenure. You also earn a fixed interest on bonds which is known as coupon rate. This rate is predetermined and provides for a stable income.
Bonds are usually issued for a very long period of time which can be more than 20 years or they can be issued for even less than a year.
So why do entities like government or large companies issue bonds to the general public? Entities require money to operate and this money can be raised by equity or debt. If entities issue equity that means they are giving up control and if they do not want to do that they raise money through debt. Now, debt can be taken from financial institutions like banks but that loan comes with a lot of terms and conditions and is very expensive too. So entities borrow from the general public as it gives them more flexibility and is cheaper compared to other sources.
Types of bonds
Bonds can mainly be classified into following two categories based on who issues them:
- Government bonds: These bonds are issued by RBI on behalf of the government. They can be issued by central government, state governments or even local governments to finance their projects or meet any other monetary requirements. Government bonds are practically risk free as they are backed by the government and are quite liquid as they can be easily traded. They also have added perks of certain tax benefits.
- Corporate bonds: Bonds which are issued by public or private companies to finance their operations are classified as corporate bonds. They are not as safe as government bonds as there is risk involved as regards to payment of interest or payment of principal on maturity. But the rate of return is a bit higher than government bonds. To be sure about the risk you are going to take it is always good to check the financial position of the issuing company and also the ratings given by agencies, such as CRISIL, to the bonds.
There are various other types of bonds such as:
- Fixed-interest bonds: These bonds carry a fixed rate of interest with them throughout their tenure. This rate is predetermined and ensures fixed income for the investor.
- Floating-interest bonds: These bonds do not carry a fixed rate of interest rather the interest rate keeps on varying depending upon the rate decided by the RBI and other market factors.
- Inflation linked bonds: Inflation has an impact of reducing the purchasing power of consumers and reducing the actual returns. Inflation linked bonds help to curb the impact of inflation by adjusting the coupon rates and principal amount on maturity for inflation.
- Sovereign Gold bonds: These are government securities which eliminate the need of holding physical gold to invest in it. Generally gold prices are less susceptible to market volatility. The value of these bonds varies with the market value of gold.
- Zero Coupon Bonds: As the name suggests these bonds do not pay interest. So you must be wondering how these bonds will earn you any money. These bonds are issued to you at a price which is much less than the face value but they are redeemed at face value. The difference between the face value and the issue price is the money that you earn.
Advantages of Bonds
- Fixed Income: By investing in bonds you are able to earn a stable income by the way of interest. The interest is also earned on a predetermined rate.
- Low risk: Bonds are usually low risk investments because the principal amount is secure as it is a form of loan.The debtholders of a company have a priority over shareholders when it comes to repayment. Also the returns are free from the volatility of the market as the rate of interest is usually fixed. There might be some risk of default in case of corporate bonds but the government bonds are practically risk free.
Disadvantages of Bonds
- Low rate of return: Bonds have a lower rate of return as compared to stocks or mutual funds. This is because the risk involved is low too. Also sometimes the rate of return is too low to cover the dent that inflation leaves on your wallet.
- Limited liquidity: Bonds have lower liquidity as compared to other options such as equity. Although bonds are tradable in the stock market they are not very liquid.
So finally…Who should invest in bonds?
Till now we have understood that bonds are a low risk fixed income investment. So if you don’t wish to take the risks of the stock market and want to keep your money safe for a long term while obtaining a steady return then you should invest in bonds.