Bonds
A bond is a debt certificate issued by an institution- either governmental or non-governmental. It carries a fixed rate of interest and a fixed tenure. In India, there are many types of bonds issued by the public sector and private sector entities to raise funds for specific purposes. The primary buyer of the bond acts like a lender, who will be paid interest at regular intervals, and the principal amount at the time of maturity. Investment-grade bonds(BBB rated or higher) are popular instruments due to features such as guaranteed returns, capital protection and the probability of capital appreciation due to their marketability.
Bonds are essentially issued and purchased in the primary market, and then traded in the secondary market by way of institutional brokers. The market is highly liquid for government bonds and AAA rated bonds. Bonds are an excellent investment avenue to diversify one’s portfolio and balance the equity component.
Types of Bonds
Government Bonds
These are issued by the Government of India and hence carry a sovereign guarantee. They are issued to raise money from the general public and fetch risk -free, stable returns. Some of these bonds are tax-free, while some are taxable.
Municipal Bonds
These are issued by State and local governments to raise money for governmental activities. They have a three-year maturity period and are rated above investment grade. Hence, they are also considered a safe and stable investment. These could be taxable or tax-free as well.
RBI Bonds
These are issued by the Reserve Bank of India, in the capacity of being a banker to the government, to borrow money for financing the country’s debt. The interest on such bonds is taxable. The latest RBI Bonds issued in Jan 2018 carry an interest rate of 7.75% and a tenure of 7 years.
Company Bonds
These are issued by companies and financial institutions to raise money for company-specific purposes. They fetch higher returns, but also carry higher risk. They are rated by credit rating agencies to help the investor decide on the stability and credibility of the company and the bond.
High yield bonds
These are high-risk and high-return bonds issued by start-ups and growing companies, which may not have a track record. Hence one should be careful before investing in these bonds.
Tax-free bonds
These are typically ten-year-or-more bonds issued by the Central and municipal governments, the interest on which is tax-free. Resultantly, there is no TDS deduction. You can invest up to a maximum of ₹5 lakhs in these bonds. However, the initial investment amount in these bonds is not exempt from tax.
Tax-saving bonds
These are different from tax-free bonds, in that the initial investment amount in such bonds is exempt from tax under section 80CCF up to ₹20,000. This is over and above the ₹1.5 lakh limit under 80C. These bonds come
with a minimum lock-in of 5 years. Some examples include RBI Relief Bonds, NTPC Bonds, IRFC Bonds, etc. Certain bonds issued by REC and NHAI also provide Capital Gain Tax exemption from sale of assets.
PSU Bonds
These are issued by public sector companies which are implicitly government-backed, and hence are relatively safe.
Terms associated with Bonds
1. Principal: Principal is the face value of the bond, i.e. the amount of money invested by the investor, per bond. This amount must be repaid to the bondholder at the end of the term.
2. Coupon rate: This is the interest rate that a particular bond carries. It is different from the market interest rate. Market rates may periodically vary depending on the monetary policy, but the coupon rate on a particular bond remains fixed unless it is a floating rate bond. Coupon (interest) is generally paid out at periodic intervals, generally every 6 months, or annually.
3. Maturity: This is the term of the bond, after which the principal amount is repaid to the investor. There are generally short-term treasury bills (1-5 years), medium-term notes (6-10 years), and long term bonds (10 years+)
4. Yield: Yield is the total return on a bond, comprising of the interest rate it fetches and the capital appreciation on it. There are two kinds of yield:
a. Current yield: This is the percentage of annual coupon of the bond to the current market price of the bond. This is a lesser used measure as it does not take into account the tenure of the bond.
b. Yield to Maturity: YTM is calculated on the basis of the current market price of the bond, the coupon amount on the bond, the number of coupon pay-outs remaining, and the maturity repayment amount. It is the same as the Internal Rate of Return (IRR) of the bond.
5. Credit rating: This is the rating given to a bond by a credit rating agency on the basis of the repayment probability of the bond. This depends on the entity issuing the bond, the purpose for which bond is issued, and many other factors. High-yield bonds, or junk bonds, are those which are rated below investment grade, and hence are riskier. To compensate for this, they carry a higher coupon rate. Investment grade bonds have a rating of BBB and above, carrying lower risk and hence lower coupon rates.
6. Market price: The market price of a bond depends on the difference between the market interest rate and the coupon rate of the bond. Bonds with higher coupon rate than the market will sell at a higher market price, while the ones with lower coupon rate than the market will sell at a lower market price.