When it comes to investing, most people immediately think of the stock market. But there’s another side to investing that’s often more stable and less risky, i.e., bonds. A bond is like a loan you give to a government or company, and in return, they pay you interest and return your money after a set time.
In this article, we’ll explain what is a bond, how it works, who issues it, and why it’s a smart choice for steady, low-risk returns.
What Is a Bond?
A bond is a high-security debt instrument through which governments, companies, municipalities, and other entities raise funds from investors. When you invest in a bond, you’re lending your money to the issuer for a specified tenure, known as the maturity period. In return, the issuer agrees to pay you regular interest and repay the principal amount upon maturity.
Bonds are typically considered safer than stocks as they offer fixed returns, making them a popular choice for those seeking stable income and lower-risk investment options.
How Bonds Work?
When you buy a bond, you’re lending money to a government, company, or other entity in need of funds. In return, the issuer agrees to pay you interest at periodic intervals (known as the coupon rate) and repay the principal amount on a specified date, called the maturity date. This system allows organisations to raise capital for new projects, operations, or infrastructure development, while offering investors a predictable income stream.
Bonds are initially issued at their face value (or “par value”), but their price in the secondary market can vary based on various factors like time to maturity, credit quality, and interest rate changes. You don’t always have to keep the bond until maturity. You can sell their bonds in the secondary market, where they can be purchased by others. So, bonds work by offering stable returns in exchange for lending money. They are useful for investors who want a steady income with lower risk as compared to stocks.
Who Are the Issuers of a Bond?
A bond is issued by an organisation that needs to borrow money. There are three main types of bond issuers:
- Government: Governments often issue bonds to fund public projects like roads, schools, or hospitals. Bonds issued by the government are considered very safe. Examples include Treasury Bills, Government Securities (G-Secs), and Capital-Indexed Bonds.
- Companies (Corporate Bonds): Businesses issue corporate bonds when they need money for growth, expansion, or to manage daily expenses. These offer higher interest than government bonds but come with some credit risk. The safety of the bond depends on the company’s financial health.
- Municipal or State Authorities: Local governments or public sector bodies also issue bonds to fund development in cities or states. These are usually used for infrastructure projects like bridges, water supply, or public transport.
Each bond issuer has a credit rating that shows how safe or risky the bond is. This rating is given by the credit rating agencies. Bonds with high ratings are called investment-grade bonds and are considered safer.
Types of Bonds
There are many types of bonds available in the secondary market, where previously issued bonds are bought and sold. Each type of bond offers different features and benefits to suit different investor needs. Here are some popular ones:
- Fixed-Rate Bonds: Fixed-rate bonds are among the most common types of bonds. They offer a fixed coupon rate, which means you will receive the same amount of interest until the bond matures. This makes fixed-rate bonds a predictable and stable investment option, especially for those looking for regular income.
- Floating-Rate Bonds: Unlike fixed-rate bonds, floating-rate bonds have an interest rate that changes over time. The interest rate is typically linked to a market benchmark, such as the RBI’s repo rate or MIBOR (Mumbai Interbank Offer Rate), which fluctuates based on market conditions. These bonds are particularly beneficial in times of rising interest rates, as they help protect your income from the effects of inflation or changes in the market.
- Zero-Coupon Bonds: Zero-coupon bonds are quite different from regular bonds. They do not pay any interest during the life of the bond. Instead, they are sold at a discount to their face value. The difference between the purchase price and the face value is your profit. This profit acts as the interest on the bond, but it’s all paid at the end when the bond matures.
- Convertible Bonds: These are bonds that can be converted into equity shares of the company issuing them after a specified period, typically at a predetermined conversion price. This gives you the flexibility to take advantage of the company’s growth. If the company’s stock price rises, you can convert your bond into shares and potentially make a profit. However, until you convert them, these bonds work like regular bonds with fixed interest payments.
- Inflation-Indexed Bonds: Inflation-indexed bonds are devised to protect your investment from the effects of inflation. The returns on these bonds adjust with inflation, so as prices rise, both the interest payments and the principal value of the bond increase.
Characteristics of Bonds
To make informed decisions, it’s important to know the key features of a bond:
- Face Value: The principal amount the investor gets back at maturity.
- Coupon Rate: The fixed interest rate paid by the issuer.
- Maturity Date: The date when the face value is repaid.
- Issuer: The entity borrowing the funds.
- Yield: The return you get based on purchase price and coupon payments.
Advantages of a Bond in the Capital Market
Bonds play an important role in both an individual’s portfolio and the capital market. Here’s why:
- Stable Income: Bonds offer regular coupon payments, making them attractive for retirees or those seeking predictable returns.
- Lower Risk: Compared to stocks, bonds usually have lower volatility, especially government bonds and investment-grade bonds.
- Capital Preservation: With bonds, you get back the amount you invested (the face value) when the bond matures, as long as the issuer doesn’t fail to repay you.
- Diversification: Bonds reduce overall credit risk in your portfolio and balance out high-risk investments.
- Tax Benefits: Certain bonds, like municipal or government bonds, may offer tax exemptions on interest income.
Conclusion
Now that you understand what is the meaning of bonds, it’s clear they are a valuable investment option, especially if you’re looking for stable income and lower risk. They help diversify your portfolio and preserve capital. However, it’s important to consider factors like credit risk, interest rates, and inflation before investing.
Looking to balance your portfolio with safer investments? Open a 3-in-1 account with Torus Digital and explore low-risk options like government securities.
