Investment in Bonds and its types

Bonds are one of the most likely debt instrument that is in demand amongst the investors majorly government bonds and corporate bonds. As they are risky and have their own benefits. Let’s understand more about the bonds and explore its types accordingly.

Bonds are issued by borrowers to raise capital from investors or public at large. The issuer company borrows money from bondholders and pays interest in return for the principal amount. The interest paid is also known as the coupon rate. The bond contract is for a fixed interval, i.e. monthly, semi-annually or annually basis.

Corporate and government issues bonds to raise funds that will finance them for their current expenses or long term investment. Investors usually go for Bonds as they have low risk and receive a steady income.

The bond market is of two types; Primary market where the borrower approaches the investor to raise capital. At the time of raising capital, the coupon rate and the issue price of the bond remains fixed. And secondary market, that is traded on exchange or OTC. The bonds can be sold when the investor wishes to exit from that bond depending upon the liquidity in the secondary market.

In the secondary market, price of the bond and the coupon rate has an inverse movement. That means when interest rate goes up, the price of the bond goes down. Taking an example, a bond issued at Rs. 1,000 coupon rate is 8%, thus the interest received on that bond would be Rs. 80. While, if the price of the bond goes up to Rs. 1,050, the new holder will get same coupon but he has paid more than the issue price, so his effective return drops and will be lesser than 8%. Hence, the yield will fall as the price increases.

Bonds can be invested in 3 ways:

Government bonds

Bonds backed up by the Government of India is said to be government bonds. It carries minimal credit risk as it is issued by the Central Govt. These bonds are commonly known as G-Secs or T-Bills (less than 1 yr papers).

Benefits of government bonds –

Fixed rate interest bonds – These bonds provide fixed coupon irrespective of the market fluctuations throughout its tenure.

Floating rate bonds – These bonds have an interest rate fluctuating every interval of their tenure that is already mentioned before issuing the bond. After each interval, let say 6 months the interest rate would change.

Treasury bills – they are short term bonds that have a short duration until a year such as 91 days, 182 days and 364 days. The profits that an investor gets from these bonds is the difference between the face value and the discounted price that the bond is purchased at. Cash management bills – these short term securities are flexible in nature and have less than 91 days’ duration.

State development loans - are securities issued by the state to meet their market borrowing requirements. The purpose of an SDL is to meet state government budgetary requirements. States can borrow certain limit from SDL. They are traded on the RBI managed NDS-OM (Negotiated Dealing System-Order Matching) and traded in the voice market (NDS).

Floating rate savings bonds, 2020 - These bonds are issued by RBI for resident individual, joint holders and HUFs (Hindu undivided families), but not for an NRI. The bond interest would differ every 6 months i.e. on 1 st January and 1 st of July every year. Current interest offered form 1 st January 2021 is 7.15%. They are repayable on the expiry of 7 years from the date of issue and premature redemption is availed to specific category of senior citizen. Subscription towards this bond could be in any mode but via cash only upto Rs. 20,000, there is no maximum limited for investing in this bond. Interest earned on this investment would be taxable under the Income Tax Act, 1961. For more details, you can visit the RBI website.

Sovereign gold bonds - The sovereign gold bonds are also issued by the RBI in multiples of grams from time to time with the basic unit of 1 gram. Gold bonds provide fixed interest rate of 2.5% per annum that is payable semi-annually on the nominal value. These bonds are purchased with cash at the issue price and can be redeemed in cash on the maturity date. For individual the maximum limit to subscribe the bond is 4KG, HUF is also 4KG while for trust and a few entities it is 20KG. For a Joint holder, the first applicant has the 4KG limit to subscribe. Nearly 40 tranches have been issued since the date of launch, sourced from the Reserve bank of India. 8 years is the tenor of the bond, while the exit is possible after 5 th year exercised on the interest payment dates.

Inflation-linked bonds- these bonds both principal amount and the interest earned are indexed to inflation, thus it is an effective way to handle inflation risk. Whole Sale price index and Consumer price index are the two indices linked by this bond.

Corporate bonds

These bonds are backed by the corporate houses. They are accessible to every individual, but they are less safe as compared to a government bonds. The issuing company for corporate bonds are subject to industries ups and downs, market volatility and uncertainty, and many more. These bonds are backed by the credit rating and repayment ability of the company. At times, the assets of the firm could be used as a collateral for the bonds.

Benefits of corporate bonds –

There are two types of corporate bonds – convertible and non-convertible bonds. Convertible bonds can be exchanged for common stock in the issuing company based on pre-specified terms. Non-convertible are just plain vanilla bonds.

There are various other bonds such as:

Zero coupon bonds – these bonds are offered at a discount on face value and on maturity the investors get the face value back, the difference is the profit.

Junk bonds – these bonds are financially not stable and they are risky as there are higher chances of default and has low rating set by the rating agencies. These bonds are created from existing securities and are not issued through auction.

Tax saving bonds – the interest earned in these bonds is tax free, so no taxes to be paid until you hold these bonds or wait for its maturity.

Perpetual bonds – these bonds do not have a fixed maturity date and are riskier quasi-debt instruments, issued by the banks or companies. Banks provide the perpetual bonds under Additional Tier 1 (AT1) bonds. As per Basel III norms, the AT1 bonds are issued to raise capital that ensures the capital requirements of financial institutions.

Capital gain bonds – An investor gets tax exemption on long term capital gains on the sale of the assets, under section 54EC of Income tax 1961. The interest rate is taxable, even if no TDS is deducted. Within 6 months of its transfer in eligible bonds, investment needs to be made. These bonds are safe and secure as they are AAA rated bonds. The lock-in period, interest rate, minimum amount entry differs from company to company. This bond can be availed in physical form or can be held in demat. The maximum amount cap limit of this bond is Rs. 50 lakhs in a financial year.

Summing up:

In times of volatility and high uncertainty, it is better to move to safer assets where there is higher return predictability as well as capital safety. In the bond market, the Government bonds are well known for their highly secure and safe investment avenue. In a portfolio towards debt allocation, the investor needs to have the right combination of government and corporate bonds to balance out the risk and returns. Retail investors have a limited opportunity in government bonds due to the long exit options.