Bonds investment is not as simple as it appears. It is not as simple as buying any plain vanilla product and not worrying about it. Firstly, you have a wide choice. You can buy highly safe treasury bonds issued by the government. Alternatively, if you want a flavour of equity, you can buy convertible bonds. Above all, if you want yields that are higher than central government bonds, then you can buy municipal bonds and the bonds issued by government sponsored financial institutions.
Here we look at the basic concepts that you need to understand before buying bonds in the Indian market. For instance, we will look at the difference between shares and bonds as also the different types of bonds in India. Did you know that you can also buy bonds online and the latest features offered by the RBI also allows retail buying in government bonds directly.
A bond is a commitment or a promise to pay interest at regular intervals and principal on maturity. Bonds are unlike equities where there is no guarantee of returns and even capital depletion risk is quite high. In India you have a wide variety of bonds ranging from blue-chip bonds to gilt-edged bonds to convertibles and even junk bonds. Here is a primer.
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Understand what is a bond all about
As we stated earlier, the bond is a promise or an undertaking or commitment to pay interest at regular intervals and principal back on maturity. Unlike stocks, bonds don't give you ownership rights or voting rights. You are just a creditor to the company and the bond represents a loan from investor in the bond to the issuer of the bond.
In India, bonds are issued by central government, state governments, municipalities, government sponsored institutions, PSUs, private sector companies, NBFCs etc. Companies or governments generally pay a stated interest rate. If the bonds are listed, the market value of the bond changes over time. Bonds are credit rated by a professional agency, except the central government bonds. Normally, higher the rating, lower the yield and lower the rating, higher the yield. The yield curve is upward sloping, so short term bonds offer lower yields while longer term bonds offer higher yields to compensate for the higher risk of time.
Why should investors buy bonds?
Bonds offer some unique benefits like stability, steady income, diversification of risk etc. Buying a bond is like giving a loan to the issuer of the bond, which they agree to pay you back as face value on a specific date, and also commit to pay you periodic interest payments along the way. Interest is normally paid bi-annually.
It is true that bonds don’t give ownership rights or voting rights like equities. However, these bonds are also less vulnerable to the micro and the macro risks. To sum it up, bonds have two justifications for purchase. Firstly, when you hold these bonds as part of your portfolio; it gives you a steady stream of income. Secondly, these bonds will offset some of the volatility or risk that you might experience from owning stocks or other risky assets.
Bonds can be held or traded
In India it is the large institutions like banks, insurance companies, domestic financial institutions and mutual funds that actively trade in bonds. Most of the retail investors and HNIs are in the buy and hold category who prefer to hold the bonds till maturity. They just buy the bonds and wait for the bond to reach maturity, when the issuer has agreed to pay back the bond's face value. How can bonds be traded?
It is possible to buy and sell bonds on the secondary market, just like equities. The only condition is that there should be adequate liquidity and fine pricing of bonds. Normally, as the interest rates in the market change, the value of the bonds also fluctuate. If you want to trade bonds, the price of the bond, the liquidity, the impact cost will all matter a lot to you. Many investors tend to buy the bonds of companies that are in distress to make big profits when things normalize. That is a high risk bond trading game.
Bond concepts you must be familiar with
If you are a trader in bonds, there is a lot for you to know and learn. However, if you are a buy and hold type of investors in bonds, you can just know some of the basic things which would be sufficient for you.
• Coupon Rate: This is the interest rate paid by the bond on the face value. For example, 8% bond pays 8% of face value. In most cases, it won't change after the bond is issued.
• Bond Yield: The simplest is the current yield which is the coupon divided by the bond price. However, a more scientific approach is to look at the yield to maturity (YTM), which is the yield of the bond if held and reinvested till maturity.
Face Value of the Bond: This is the amount written on the Face of the bond, which will be redeemed. Interest is paid on this face value / par value. It is normally in multiples of Rs100.
Bond price: This is the amount the bond would currently cost on the secondary market. Several factors have an important role to play in determining a bond's current price. The most common factor is the coupon on comparable bonds.
Bond Maturity and Bond Duration
A bond's maturity is rather simple in the sense that it refers to the length of time until you will get the bond's face value back. It is also called the term or tenure of the bond. Normally, long the maturity higher the yield or returns on the bond. So a 20 year bond will always offer a yield that is higher than a 5 year bond. Of course, these are the normal assumptions and yield curve can also be inverted, but we will not get into that. The relationship between maturity and yields is called the yield curve. In a normal yield curve, shorter maturities = lower yields and longer maturities = higher yields.
Let us now step across to the concept of Bond duration. The duration is also like maturity in that it is also measured in years. It's the outcome of a complex calculation that includes the bond's present value, yield, coupon etc, but simply put it is the payback period of the bond including the periodic interest received. Duration offers the best gauge of the bond's sensitivity to interest rate changes. Normally, bonds with longer durations are more sensitive to rate changes compared to shorter duration bonds.
Credit rating and Bond Quality
Credit rating agencies (CRA) assign ratings to bonds based on their ability to service the interest on the bonds and the ability to pay back the principal on time. Higher the credit rating, higher the quality and hence lower the yields. It also works vice versa. Bonds with ratings below investment grade are called high yield bonds or junk bonds. They are high risk and high return bonds.