What is a Bond?
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.
Types of Bonds
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.
Features of 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
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.
- Interest or coupon rate
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 of bonds
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.
- Credit quality
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.
- Tradable bonds
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.
Advantages of Bonds
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-
- Stability – Bonds are long-term investment tools that accrue assured returns in comparison to other investment options. They provide a low-risk avenue to investors apprehensive of the volatility of returns from equity. Even though dividend incomes from equities are traditionally higher than coupon returns, bonds are comparatively inelastic as compared to cyclical market fluctuations.
- Indentures – Bonds grant a legal guarantee that binds borrowers to return the principal amount to the creditors in due time. They serve as financial contracts which contain details such as the par value, coupon rates, tenure, and credit ratings. Companies that attract massive investments in their bonds are highly unlikely to default on interest payments due to their reputation in the securities market. Besides, bondholders precede shareholders in receiving debt repayment in the event of an entity’s bankruptcy.
- Portfolio diversification – Investors massively rely on investment in fixed-income debt instruments such as bonds to diversify their investment portfolio as they offer superior risk-adjusted returns on investment. Consequently, portfolio diversification reduces the possibility of short-term losses due to increased allocation of investment funds to fixed-income resources instead of solely depending on equities.
Limitations of Bonds
Even though bonds are a low-risk investment option, they come with specific limitations that investors should be acquainted with. The disadvantages include –
- Inflation’s influence – Bonds are susceptible to inflation risks when the prevailing rate of inflation exceeds the coupon rate offered by issuers. Debt instruments which accrue fixed interests face risks of devaluation too due to the impact of inflation on the principal value invested.
- Limited liquidity- Bonds, although tradable, are mostly long-term investments with withdrawal restrictions on the investment amount. Shares precede bonds in terms of liquidity, as in bonds are liable to several fees and penalties if creditors decide to withdraw their debt amount.
- Lower returns – Issuers offer coupon rates on bonds which are usually lower than returns on stocks. Investors receive a consistent amount as interest over the tenure in a low-risk investment environment. However, returns are much lower than on other debt instruments.
Things to Consider Before Investing in Bonds
Investors have to consider the following factors before investing in secure and fixed-investment options such as bonds.
- Investment objectives
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.
- Tenure of the bond
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.
- Analyse risk factor
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.
- Call risk
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.
Who Should Invest in bonds?
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.