What are Bonds?

12 Dec 2020  Read 784 Views

Whenever someone talks about savings and earning additional money, FD (Fixed Deposit) is the term that generally first comes to mind as it is safe and offers a 6-7% interest rate on the amount after the maturity period. To make some additional money, people also lend money to others in exchange for interest rates on the lent amount. 

But, what if investors can get a higher interest rate which can be as high as a fixed income, and with the same level of risk as an FD? 

Well, investors can get these benefits by investing in the Bonds market which means by lending money to companies/government in exchange for predetermined interest, investors can earn higher interest rates than FD or other investments.

Stock markets tend to have more coverage and risk than bonds, but the global market of bonds is larger than the market capitalization of the equity market.

Let us get into the basics about bonds.

What is a Bond?

It is a fixed-income security that allows a lender to lend a predetermined amount of funds and be eligible for the interest rate of those funds after the tenure. 

Let's understand how bonds work with an example.

Suppose X is a company that needs funds. There are various ways from which a company can raise money like issuing equity shares, taking a loan from the bank, or borrowing money from the investors. And in return, the company is ready to pay 6% interest on the amount it borrowed from its investors. 

Whenever company X will need funds in the future, it will tell its investors in advance (Predetermined money) about how much money they will need and the amount of interest that the investors will be paid.

Key Features of Bonds

Let's now understand a few important features of bonds:

Face Value - The predetermined value of the fund mutually decided by the borrower and lender is known as the face value. One bond can have a face value of Rs. 1000, 10000, or more. 

Coupon Rate - The coupon rate is the interest rate on the bond until its maturity period.

Tenure/Maturity of Bonds - The date on which the borrower returns the lent money to the bond investor. The maturity of bonds can be short, medium, or long. 

Duration Risk - It tells us how the interest rate fluctuation in the market can affect the price of a bond. Experts suggest that bonds will decrease by 1% if the interest rate increases by 1%.

Tradable Bonds - Bonds can be traded in the secondary market within the tenure. Bonds can be transferred from one investor to another. Creditors sell their bonds when the market price is high, to earn profits.  

                                               

Benefits of Investing in Bonds

Following are some of the key benefits of investing in bonds:

Steady Income - Other investment instruments offer various forms of income, but bonds tend to offer a higher and more reliable source of income in the form of cash. 

When a company is not performing well and offers a lower interest rate, investors have plenty of other options such as high yield bonds or emerging market debt that can meet their income needs. 

Diversification - "Do not put all your eggs in one basket" is a phrase that every investor might have heard from market experts. 

It may be an overused phrase, but it is time-tested wisdom nonetheless. Over time, diversification offers a higher return and avoids any risk of the portfolio. More importantly, when the market is falling, bonds can help reduce volatility and preserve capital for equity investors. 

Bond Preserve - Fixed income investments are very useful for people who are nearing the point where they will need to use the cash they have invested – for instance, an investor within five years of retirement or a parent whose child is starting college. 

While stocks can experience huge volatility in a brief period, such as the crash of 2001-2002 or the financial crisis of 2008, a diversified bond portfolio is much less likely to suffer large losses in the short-term. 

As a result, investors often increase their allocation to fixed income, and decrease their allocation to equities, as they move closer to their goals.

Tax Advantage - Several types of bonds can help investors to reduce their tax burden. Income on bank instruments, money market funds, and equities are taxable. However, the interest on the municipal bond is tax-free for those who own the municipal bond issued by the state in which the investor resides.

Also, the income from U.S. Treasuries is tax-free on the state and local levels. While tax reasons shouldn't be the foremost reason to choose an investment, especially for investors in lower tax brackets, the fixed income universe offers several vehicles that the investors can use to minimize their tax burden.

Risk Involved in Bonds

Every investment comes with a risk, and hence, even investing in the bonds include the following risks:

Credit Risk - The borrower may not be able to make the payment on time and thus default on the bond.

Interest Rate Risk - Fluctuation in the interest rate may affect the bond value. If the bond is held to maturity, then the investor will receive the face value of the bond plus the interest rate. 

If the bond is sold before the maturity date, then the bond value may be lower or higher than the face value, depending on the market.  

Inflation Risk Inflation shows the price increase, and it is a risk for those investors who are getting fixed interest rates on the bond.

Call Risk - There is a possibility that the investor may retire the bond before its maturity date as the interest rate goes down, much like how a homeowner might refinance a mortgage to benefit from lower interest rates.

How Do Bonds Work?

To put it simply, bonds are the opposite of loans. When an individual takes a loan, they borrow money from someone and become a borrower. On the other hand, when an individual takes a bond, they lend money to someone and become a lender.

Bonds are issued with a 'face value'. This is what individuals receive when the bond matures. Along with this, the individual receives interest on the amount they have invested in the bond. This guaranteed interest payout is called the "coupon rate". 

The "yield to maturity", on the other hand, is the effective rate of interest an individual gets when they equate the bond's coupon payments, the amount received at maturity, and any accrued interest to the current price of the bond.

Bonds are usually long-term instruments. The period for which the bond is taken is called "term to maturity".

Final Thoughts

Whether an investor invests with his research or through finance management, bond investment should also be an important part of their diversified portfolio.

Investors who are risk-averse and long-term investors should consider investing in bonds as they can offer stability and predictable income to its investors.

So, before making an investment decision, it is advisable to look at your finances and invest in those that fulfil your individual financial goals.

About the Author: Divyanshu kumar | 49 Post(s)

Divyanshu is currently pursuing a Master's degree in Financial economics. Growing up, he has always been interested in codes and numbers which he has gradually learnt to express in words too.

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