What are Bonds and How They Work | Motilal Oswal
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.

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?

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.

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.

Different types of bonds

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.

Corporate bonds: Corporate bonds are issued by the private companies. These companies issue both secured and non-secured bonds.

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.

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.

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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