Different Types of Bonds
Remember the old saying; “Gentlemen Prefer Bonds”! That was the belief that for people of culture government bonds were the ultimate investment since they were safe and secure. Thinking has changed substantially in the last 100 years as people realized that just as bonds have their role in protection, equities also had their role in wealth creation. Anyways, getting back to the subject of bonds, let us look at some of the different types of bonds. You have surely heard of terms like bond markets and government bonds. Let us look at these concepts in greater detail.
Bonds can be categorized based on coupon rates, maturity, convertibility, and so on. Now bonds investment is not just for safety and security but it can also give high returns on occasions. Bonds come in a wide maturity. They range from very short term treasury bonds to very long term bonds going as long as 30 years. Let us look at the different types of bonds in India. There are also advanced types of bonds like STRIPS, which are not available in India but only in other developed Western bond markets.
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Categories of Bonds available in Indian bond markets
Here is a quick take on some of the most popular bond categories in India. Bonds are debt market investments that pay a fixed assured return. Their returns are lower than equity but their risk is also lower than equity. Here are some important types of bonds.
These are the most common types of bonds in India. These Fixed-rate bonds carry a fixed coupon or interest rate. For example, a 9% bond would pay 9% coupon interest each year on the face value of the bond. For example, if the face value of the fixed rate bond is Rs1,000 and the coupon rate is 9%, then you earn Rs90 as interest each year. Such interest can be paid year, half year or quarterly, depending on the terms of the bond issued. Fixed rate bonds have a fixed coupon and also a fixed maturity date.
Variable rate bonds or floaters
These variable rate bonds or floaters have become quite popular in recent times. In the case of floaters, the coupon rate is not fixed, but it is variable and benchmarked to a certain base like the repo rate or the 10-year G-Sec rate. When interest rates go up in the economy and the benchmark yield goes up, then the interest rate on the floating rate bonds also goes up simultaneously. When interest rates are rising, fixed rate bonds see depreciation in value but floating rate bonds are not impacted so much since the rate of interest on these bonds also rise in tandem.
Deep discount or zero coupon bonds
These bonds are known by either name. As the name suggests, there is no regular interest payments on these bonds. Instead, such bonds are issued at a discount and redeemed at face value. For example, if a 2 year bond is issued at a price of Rs82.645 and redeemed at Rs100 after 2 years, then the implied annualized interest on this bond is 10%. As the name implies, these bonds do not pay periodic coupons during their tenure. In the past, zero coupon bonds were popular as the difference between the issue price and the redemption price was treated as capital gains. However, later it started being treated as interested taxed annually, after which the attraction of these deep discount zero coupon bonds reduced.
As the name suggests, the perpetual bonds are those debt securities that do not have a maturity. They will be paid a fixed coupon rate perpetually, but the principal is not repaid. However, in reality, most of the perpetual bonds tend to offer an exit route to the investors at the end of 7-10 years. In the absence of that, investors may not find the issue of perpetual bonds too attractive. One of the best examples of perpetual bonds is the AT-2 (additional tier 2 bonds) issued by the banks to prop up their capital base. Even in this case, despite being perpetual, the issuing banks do provide an exit route at the end of 8-10 years.
Inflation indexed bonds
These are quite popular as inflation protection bonds and give the investor protection against rising inflation. These bonds can be quite popular, especially in times like the current one where inflation has been going up across the board. Like in other indexed bonds, these inflation indexed bonds are benchmarked to either the CPI inflation or the WPI inflation and the coupons are reset accordingly. Due to the protection in the bonds, the coupon tends to be much lower so in normal times they are not too attractive.
As the name suggests, these bonds can be converted into equity at a future date. Bonds are either non-convertible (NCD), partially convertible or fully convertible. When the convertible bond is issued, the swap ratio for converting the bond into equity is also determined in advance. Most of the convertible bonds are mandatorily convertible. However, there are options like the Optionally Fully Convertible Bonds (OFCDs) wherein the holder of the bond has the option to covert the bonds into equity or choose to retail them as bonds.
Bonds with call and put options
These are often referred to as callable and puttable bonds. The callable bonds are high coupon paying securities that give the issuer the right to call back the bonds at a pre-agreed price and date. Bonds are normally called back if the rate of interest falls too sharply. For instance, the millionaire bonds issued by IFCI and IDBI were called back when the interest rates fell sharply in 2001-20002.
Puttable Bonds give the redemption option to the investor rather than the issuer. The bond holder, in this case, gets the right to return the bond and ask for repayment of principal at a pre-agreed date before maturity. Due to the call option available to the investors, the coupons tend to be much lower.
Sovereign Gold Bonds
The last category of bond we will see are unique in the sense that the bonds are nothing but proxy for gold purchased in cash at the extant price of gold. The gold bonds are held in terms of number of grams of gold in demat form. They can be redeemed fully at the end of 8 years but the RBI offers a sale window after 5 years. Sovereign gold bonds are free from capital gains if they are held for the full 8 years only. They also carry 2.5% coupon, so the SGB is a hybrid product between a coupon bond and a commodity price backed bond.
The bottom line is that bonds provide safety and stability to your portfolio by offsetting the risk of equities and other higher risk assets.
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