What Are Bonds? Meaning, Working, Risks & How to Invest in India

Bonds are debt instruments issued by governments, companies and other eligible entities to raise funds. When you buy a bond, you lend money to the issuer, who pays interest as per the bond’s terms and repays the principal at maturity.

Bonds differ in tenure, interest payments, issuer, credit quality and risk. Understanding these features helps investors assess how a bond works and the risks involved.

Key Takeaways

• Bonds are debt instruments that governments, companies, and other entities use to raise funds from investors.
• Investors generally receive interest payments and repayment of the principal at maturity, subject to the bond’s terms.
• Bonds include government, corporate, and municipal bonds, each with different features and risk levels.
• Bond prices generally fall when market interest rates rise. Selling a bond before maturity may result in a profit or loss.
• Bond income and capital gains may be taxable, depending on the bond type, transaction, and applicable tax rules.

What is a Bond? 

A bond is a loan you provide to an issuer, such as a government or company, in return for regular interest payments and repayment of the principal on a specified date. You are the lender, while the issuer is the borrower. Unlike a traditional bank deposit, investors lend money directly to the issuer.

How Do Bonds Work? 

When you buy a bond, you lend money to the issuer for a fixed period. In return, the issuer pays you interest, called the coupon, and repays the principal when the bond matures.

For example, suppose a company issues a bond with a face value of ₹1,000, an 8% annual coupon and a 5-year tenure.

If you buy 10 bonds for ₹10,000:

• You receive ₹800 in interest each year.
• The interest may be paid annually, half-yearly, quarterly or at other intervals, depending on the bond.
• At the end of 5 years, the company repays your ₹10,000 principal, subject to the bond’s terms and assuming it does not default.

Over five years, you would receive ₹4,000 in interest, plus your ₹10,000 principal at maturity.

Key Bond Terms Every Investor Should Know

• Face Value (Par Value)

Face value, or par value, is the amount the issuer agrees to repay at maturity. For example, if a bond has a face value of ₹10,000, the issuer generally repays ₹10,000 at maturity, subject to the bond’s terms.

• Coupon Rate 

The coupon rate is the interest rate paid on a bond’s face value. It can be fixed or floating. For example, a bond with a face value of ₹10,000 and an 8% annual coupon pays ₹800 in interest each year if the coupon is paid annually.

• Maturity Date & Tenure

The maturity date is the date on which the issuer must repay the bond’s principal, as set out in its terms. Tenure is the period until the bond matures.

Bonds are generally classified by their tenure:

• • Short-term: Up to about 3 years
  • Medium-term: About 3 to 10 years
  • Long-term: More than 10 years
  • Perpetual Bonds: Have no fixed maturity date. They may continue to pay interest indefinitely, subject to the bond’s terms and the issuer meeting its payment obligations.

A bond can be sold before maturity if it is traded in the secondary market. Its selling price may be higher or lower than the purchase price, depending on market conditions and demand.

• Yield to Maturity (YTM)

Yield to Maturity (YTM) is the estimated annual return you may earn from a bond if you hold it until maturity, assuming all interest and principal payments are made as scheduled. 

It considers the bond’s current market price, coupon payments, face value and remaining maturity period.

Yield to maturity (YTM) = [C + (FV - PV) / t ] / [ (FV + PV) / 2]

Where:

• • C: Annual coupon payment
  • FV: Face value of the bond
  • PV: Current market price of the bond
  • t: Number of years remaining until maturity

• Accrued Interest 

When a bond is bought between two coupon payment dates, the buyer usually pays the seller for the interest accrued since the last coupon payment. This is known as accrued interest.

• • Clean price: The bond’s price excluding accrued interest.
  • Dirty price: The clean price plus accrued interest, or the total amount payable.

Suppose a ₹1,000 bond pays 8% annual interest. If you buy it three months after the last interest payment, around ₹20 of interest has accrued. If the clean price is ₹980, the total amount payable would be ₹1,000, including the ₹20 accrued interest.

• Credit Rating

A credit rating indicates an issuer’s ability to repay interest and principal on time. Credit rating agencies assign ratings, with higher ratings generally indicating lower credit risk. Lower-rated bonds carry greater risk and may offer higher yields to compensate investors for taking on that additional risk.

Types of Bonds in India

Bonds can be classified based on who issues them and the features they offer.

• By Issuer

  • Government Bonds: Debt securities issued by the Central Government and State Governments to raise funds.
  • Corporate Bonds: Issued by companies to fund business activities and expansion. They may offer higher yields but can carry higher credit risk.
  • Public Sector Undertaking (PSU) Bonds: Issued by government-owned entities such as NHAI, REC, PFC and IRFC to raise funds for projects and activities.
  • Municipal Bonds: Issued by local authorities to finance public infrastructure and other projects such as roads, water supply and sanitation.

• By Features

  • Zero-Coupon Bonds: Do not pay regular interest. They are issued below their face value and redeemed at face value on maturity.
  • Fixed- and Floating-Rate Bonds: Fixed-rate bonds pay a predetermined interest rate, while floating-rate bonds link interest rates to a benchmark.
  • Callable and Puttable Bonds: Callable bonds allow the issuer to repay the bond before maturity. Puttable bonds let investors sell the bond back to the issuer before maturity, subject to the terms.
  • Convertible Bonds: Allow investors to convert the bond into the issuer’s equity shares under specified conditions.
  • Tax-Free Bonds: Annual interest earned is exempt from income tax under applicable rules. 

• • Sovereign Gold Bonds: Government securities denominated in grams of gold and linked to gold's market value. They let investors gain exposure to gold without holding or storing physical gold.]

Who Issues Bonds in India? 

Different types of organisations issue bonds and other debt securities to raise funds for operations, projects, or other financial needs.

• Central Government: Raises funds through government securities, including Treasury Bills for short-term borrowing and dated securities for longer periods.
• State Governments: Raise funds through State Development Loans (SDLs), issued through RBI-conducted auctions.
• Public Sector Undertaking (PSUs): Government-owned entities issue bonds to finance projects and meet long-term funding needs.
• Banks and Non-Banking Financial Companies (NBFCs): Issue bonds and other debt securities to raise funds for their lending and business activities.
• Private Companies: Raise money through bonds and Non-Convertible Debentures (NCDs), either through public issues or private placements.
• Municipalities and SPVs: Municipal bonds are primarily issued by urban local bodies and their authorised Special Purpose Vehicles (SPVs) to raise public capital for infrastructure and civic development projects.

How Are Bonds Rated?

In India, SEBI-registered credit rating agencies (CRAs) assess bonds based on the issuer’s ability to pay interest and repay principal. They consider factors such as financial strength, debt and cash flows.

Bond Credit Ratings range from AAA to D, with higher ratings generally indicating lower credit risk. Major SEBI-registered CRAs include CRISIL, ICRA, CARE Ratings, India Ratings, Acuité, Brickwork Ratings and Infomerics.

Investors should remember that a credit rating does not guarantee repayment. Ratings can also be revised when an issuer's credit profile changes. 

Bonds vs Fixed Deposits vs Stocks

Benefits of Investing in Bonds

• Regular income: Bonds can provide interest payments at fixed intervals, making them a potential source of regular income.
• Greater stability: High-quality bonds and government securities can offer more stability than other investments, although repayment is subject to the issuer meeting its obligations.
• Diversification: Adding bonds to a portfolio can help spread risk across different asset classes.
• Different choices: Investors can choose bonds based on their preferred maturity, return potential and level of risk.

Risks of Investing in Bonds

• Credit risk: The issuer may fail to pay interest or return the principal on time.
• Interest rate risk: Bond prices generally move inversely to market interest rates. When interest rates rise, bond prices tend to fall, and vice versa.
• Liquidity risk: Some bonds may have limited buyers, making them harder to sell at a favourable price before maturity.
• Inflation risk: Rising prices can reduce the purchasing power of the interest and principal you receive.
• Call risk: Some bonds can be repaid by the issuer before maturity, which may leave you with fewer opportunities to earn the same return.
• Reinvestment risk: If interest rates fall, you may have to invest the interest payments you receive at lower rates. This can reduce the income you earn from those payments over time.

How Bond Prices Move with Interest Rates 

Bond prices and market interest rates generally move in opposite directions or are said to have an inverse relationship. When interest rates rise, existing bonds with lower coupon rates become less attractive, so their market prices tend to fall. When interest rates fall, existing bonds with higher coupon rates become more attractive, so their market prices tend to rise.

For example, if an existing bond pays an 8% coupon and new bonds start offering 10%, investors may pay less for the older 8% bond. The reverse can happen when new bonds offer lower rates.

This inverse relationship matters when a bond is sold before maturity, as changes in its market price can result in a capital gain or loss.

How to Invest in Bonds in India

• RBI Retail Direct

The RBI Retail Direct platform allows individuals to invest directly in government securities such as G-Secs, Treasury Bills, SDLs and Sovereign Gold Bonds. Investors can open a Retail Direct Gilt Account online using their PAN and bank details.

• Online Bond Platforms

Online bond platforms allow investors to compare bonds based on factors such as credit rating, coupon and YTM. Investors can choose from different bonds based on their investment preferences and risk profile.

• Stock Brokers and Exchanges

Listed bonds can be bought and sold through a demat and trading account on exchanges such as NSE and BSE. Groww also allows investors to access listed bonds through its platform. The available options may include government securities, corporate bonds, tax-free bonds and SGBs. 

• Debt Mutual Funds and Bond ETFs

Debt mutual funds and bond ETFs provide exposure to a basket of debt securities instead of a single bond. They can be suitable for investors who prefer diversified exposure, but returns are not fixed and the investment does not have a maturity value like an individual bond.

• Corporate Bond Public Issues

Companies may raise funds through public issues of bonds or NCDs. Investors can apply during the issue period through available application channels, with the minimum investment varying by issue. Listed issues may also be traded on stock exchanges after listing.

Taxation of Bonds in India

Things to Check Before Investing in Bonds 

• Credit rating: Check the bond’s credit rating and review any recent upgrades, downgrades or changes in outlook.
• Issuer’s financial health: Look at the issuer’s debt, cash flows, profitability and ability to repay its obligations.
• Secured vs Unsecured bond: Find out whether the bond is secured against specific assets or unsecured.
• Interest payments: Check how often the coupon is paid and whether the payment schedule suits your financial needs.
• Yield To Maturity (YTM): Look at the YTM along with the coupon rate to get a better idea of the bond’s potential return.
• Liquidity: Check whether the bond is actively traded and how easily you may be able to sell it before maturity.

Conclusion 

Bonds can provide regular income and help diversify a portfolio, but they are not risk-free. Credit quality, interest rates and liquidity can affect your returns. Before investing, understand the bond’s terms, credit rating and YTM, and consider whether it fits your financial goals and risk appetite.