Bonds refer to high-security debt instruments that enable an entity to raise funds and fulfil capital requirements. It is a category of debt that borrowers avail from individual investors for a specified tenure.
Organisations, including companies, governments, municipalities and other entities, issue bonds for investors in primary markets. The corpus thus collected is used to fund business operations and infrastructural development by companies and governments alike.
Investors purchase bonds at face value or principal, which is returned at the end of a fixed tenure. Issuers extend a percentage of the principal amount as periodical interest at fixed or adjustable rates.
Individual investors acquiring bonds have legal and financial claims to an organisation’s debt fund. Borrowers are therefore liable to pay the entire face value of bonds to these individuals after the term expires. As a result, bondholders receive debt recovery payments before stakeholders in case a company faces bankruptcy.
With this understanding of what bonds are, take a look at the features of this debt category.
Bonds are classified into different categories as per the model of return and validities of legal obligations. The prevailing types of bonds in the public debt market are –
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Other types of objective-specific bonds offered by corporations and governments include war and climate bonds.
Bonds have several features that investors should take into account. The popularity of this debt instrument can be assigned to some intrinsic factors as mentioned below.
Face value implies the price of a single unit of a bond issued by an enterprise. Principal, nominal, or par value is used alternatively to refer to the price of bonds. Issuers are under a legal obligation to return this value to the investor after a stipulated period.
For instance, an investor chooses to purchase a corporate bond at face value of Rs. 6,500. The company issuing the bond is thus obliged to return Rs. 6,500 plus interest to the investor after maturity of the tenor. Note that the face value of a bond is different from its market value as market operations influence the latter.
Bonds accrue fixed or floating rates of interest across their tenure, payable periodically to creditors. Bond interest rates are also called coupon rates as per the tradition of claiming interests on paper bonds in the form of coupons.
Interest earned on a bond depends on various aspects such as tenure, the issuer’s repute in the public debt market.
Tenure or term refers to the period after which bonds mature. These are financial debt contracts between issuers and investors. Financial and legal obligations of an issuer to the investor or creditor are valid only until the tenure’s end.
They can thus be segregated as per the tenure applicable for them. Bonds with maturity periods below 5 years are called short-term bonds, whereas a tenure of 5-12 years is attributed to intermediate-term bonds. Long-term bonds refer to the ones with terms higher than 12 years. Also, longer tenures suggest the participation of issuing companies in prevailing businesses in the trade market in the long-term.
The credit quality of a bond refers to the creditors’ consensus on the performance of a company’s assets in the long-term. It is determined by the degree of confidence that investors have in an organisation’s bonds. Credit rating agencies classify bonds based on the risk of a company defaulting on debt repayment.
These agencies assign risk grading to private players in the market and categorise bonds into investment grade and non-investment grade debt instruments. Investment grade securities are susceptible to lower yields due to a steady market risk factor, whereas non-investment grade securities offer high returns at considerable risks.
Bonds are tradable in the secondary market. The ownership can thus shift among various investors within a given tenure. These creditors often sell their bonds to other entities when market prices exceed the nominal values as they have an option to secure bonds with high yield and appropriate credit ratings.
Investment in bonds is advantageous to customers in extensive ways. Due to the dependability of interest and principal returns, bonds have proved to be a stable investment option for customers averse to excessive risk in the market. The advantages thus include-
Even though bonds are a low-risk investment option, they come with specific limitations that investors should be acquainted with. The disadvantages include –
Investors have to consider the following factors before investing in secure and fixed-investment options such as bonds.
Investors have to take into account their return expectations on investment according to the nominal value, coupon rates and tenure of an entity’s bonds. They can further achieve stability of their investment portfolio by parking their funds in bonds.
Consideration of the tenure is essential when it comes to investment in these debt instruments. Bond interest rates are usually higher for the ones invested for a long term and can benefit investors with a steady interest income. Customers purchasing long-term bonds imply long term capital commitment through this debt instrument.
Contrarily, bonds of medium or short term offer better liquidity to investors and are thus suitable for meeting immediate as well as extended financial requirements.
Investors should analyse the credit rating of a company to acquire the best bonds in the market. High-yielding bonds are often offered by companies with high-risk factors as graded by credit rating agencies and vice versa. Choice of a bond should thus also depend on an investor’s risk-taking capacity.
Investors should also measure the possibility of companies retracting their bonds before the maturity period due to increasing market prices and faltering interest rates. They should thus examine annual reports and market trends to predict call risks by enterprises.
Individuals can invest in bonds for financial security and corpus growth in the long-term. As issuers return the principal amount invested in their bonds after a specific tenure, investors have the option to earn periodic interests on the nominal value of bonds, making them viable investment options in corporate and government debt instruments.
YTM is a way through which we can price bonds. It is that sum of expected return for an investor if the bond is held to the end of its lifetime i.e its maturity. Though yield to maturity is a long-term bond yield but is represented as an annual rate.
YTM can be a little difficult to understand sometimes but is immensely useful for evaluating, calculating, and comparing the benefit of one bond to the other.
YTM = [(face value/present value)1/Time period]-1
YTM is compared with the coupon rate(Interest rate of the bond) for investors to determine whether or not to go ahead with the investment.
Although there is no particular time to invest in bonds due to predominantly consistent interest cycles, investors who are risk-averse should consider bonds. Individuals are met with several options while investing in bonds as per their financial inclination. Investors inclined towards safe debt instruments should accumulate bonds from high-rated companies.
Additionally, investors who are willing to take market risks can find it financially beneficial to accumulate bonds from low-safety rated companies for a higher rate of return on these fixed-income securities.