What are Bonds and How They Work | Motilal Oswal

The Benefits of Investing in Bonds

The very first thing that comes to the minds of people when we talk about investments is investing in stock markets. It is true that share markets are exciting and the news about people gaining wealth and becoming rich overnight are quite common. Bonds, though are considered by many as a good investment option, do not carry the same appeal. The lingo itself sounds arcane to a normal person and many consider these boring; that holds true during the days of exciting bull markets.

But, bonds are known for their security and safety and many investors make sure to have bonds in their portfolio. So, what are bonds, and how to invest in them and what the risks involved when you invest in bonds? Let 's get an answer to all the above questions.

What is an investment bond?

Did you ever borrow money? Yes, most of us have borrowed money at some stage in our lives. Similarly, companies need money for expansion and government too needs funds for social programs and infrastructure. In many cases, the money required is more than that can be issued by the banks as a loan. Hence, these entities issue bonds to the public markets. A number of investors thus helps raise the money by lending a portion of the funds that are needed. In simpler terms, bonds are similar to loans for which the investor is a lender. The company or the entity that sells the bonds is known as the issuer. Bonds can be treated as IOUs that are given by the issuer to the lender, who in this case is the investor.

No one would lend money for nothing and hence the issuer of the bonds pays that extra for using the funds in the form of interest. The interest on the bonds is paid at a fixed rate and predetermined schedule. The interest rate when it comes to bonds is often called as 'Coupon '. The amount that is being borrowed is called as the face value, and the day the amount has to be repaid is known as the maturity date. Bonds are the fixed income securities as the investor knows the amount of cash he/she would get back when they hold it until maturity. Bonds are less risky when compared to stocks, but they also come with low returns.

Why investing in bonds is important?

While you are trying to understand the nature of an investment bond, you may want to also know why investment in bonds makes up an important part of your overall financial portfolio. The first rule for any prudent investment strategy is to diversify a portfolio. Since, more often than not, with the vast majority of investors, hard-earned money is being allocated to different instruments, investors must be careful not to lose it. Safeguarding wealth is not the only thing that is crucial, but growing it is vital as well. Bonds give you security, and if you are just entering the world of investment, bonds can be a good place to begin. 

Bonds investment provides an income stream that is easily predictable and in many cases, bonds pay the interest twice in a year. If the bondholder holds the bond till the day of maturity, the investor gets the entire principal amount and hence, these are considered as an ideal way to preserve one 's capital.Bonds can also provide the offset exposure to the extreme volatile shareholdings one might have. By investing in bonds, one can expect a steady stream of income even before the maturity in the form of interests.

In practical and simple terms, bonds are usually backed by the government and provide you with security in your portfolio. If you have a portfolio of direct equity, and you want some mitigation of risk, then bonds serve that purpose. 

Calculating the yield and the bond prices

A number of investors find it confusing when it comes to the bond prices and the return one can get via bond investments. A number of novice investors will be surprised to learn that the bond prices change day to day, similar to any other security that is traded publicly.

The yield is the returns one can expect from their investment made in bonds. The simplest way to calculate this is by using the formula; yield is equal to the coupon amount divided by the price. When the bond is bought at par, the yield can be equal to the rate of interest. Thus, the yield changes with the bond price.

Another yield that is often calculated by investors is the returns that they get upon the maturity of the bond. This is a more advanced calculation which will provide the total yield one can expect if the bond is held until the date of maturity.

What are bonds in the market? Different types of bonds

If you wish to know the bonds available in the market in terms of the types you can invest in, you will find a range. The bonds you ultimately invest in will depend on your ability to handle risk, as much as the wealth you have to make investments with. Just as in other investment routes, bonds are of certain types, and you should do your research into each, although these are safer than stocks, before you plunge in and invest. 

Bonds can be mainly classified into,

Government bonds: These are the bonds that are issued by the government directly. These are secured as they are back by the Government of India. These bonds generally have a low rate of interest. Within the area of “government bonds” offered by the Reserve Bank of India, there are further classifications of fixed versus floating bonds. You should have a basic idea about these sub-categories as they can influence your investment decisions. 

  • Fixed-rate bonds - If you invest in a fixed-rate bond, you get a fixed rate of interest. This rate remains the same right through the term of the bond. Market rates may fluctuate, but this predetermined rate will still apply. You may stand to get low returns when markets are positive, but you get safety too. 
  • Floating-rate bonds - The very name of these suggests that your interest rates on the bond will change according to market highs and lows. You stand to gain when market fluctuations veer towards the positive side, but you may lose out on your returns if markets are negative. 

Corporate bonds: Corporate bonds are issued by the private companies. These companies issue both secured and non-secured bonds. When you choose among corporate bonds in the market, you should know about sub-categories in this asset class too. Secured corporate bonds have a backing of collateral. This means that the issuer will pay an investor if there is any default related to the bond before or at maturity of the bond. Unsecured corporate bonds are basically called debentures, and these hold nothing but the promise of companies to hold good on the bond. That means, companies promise that interest payments will be paid, and paid in due time. Such bonds may be invested more in the value of “faith” than anything else. 

Tax saving bonds: The tax saving bonds or tax free bonds are issued in India by the government itself to provide tax savings to individuals. Along with the interest, the holder would also receive a tax benefit.These bonds are good for senior citizens and those individuals who wish to save on tax in the long run.

Bank and Financial institution bonds: These bonds are issued by various banks or financial institutions. A number of bonds that are available in this segment are from this sector. These bonds are secure as the financial companies that back them are officially rated and built on solid financial histories and reputations. 

Investors can buy these bonds by opening an account with a broker. It is also advisable to check with your financial advisor before making your investment in bonds and to know which one to choose from.

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