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How Does a Bond Work?
By Bajaj Broking Team
September 07, 2023
11 mins read
Bonds
The financial markets in India are not simply restricted to the stock market. Beyond stocks, there are many other financial instruments that you can choose from to diversify your portfolio. Bonds are among these options. They are debt securities that carry much lower risk than stocks, making them essential for portfolio risk reduction. However, before you invest in bonds, you need to know what they are, the types they come in and how bonds work in general. This, in turn, will make it easier for you to understand how bond trading works and make informed decisions about participating in the bond market.
In this article, we’ll take a closer look at how bonds work and the other key details you need to know about them.
How Do Bonds Work? A Comprehensive Guide
Bonds are fundamental to financial markets, providing a structured way for governments and corporations to raise capital while offering investors a steady income stream. Unlike stocks, bonds represent debt rather than ownership, making them a relatively stable investment. This guide explains how bonds work, their characteristics, different types, market dynamics, risks, and investment opportunities, helping investors make informed decisions.
What Is a Bond?
A bond is a fixed-income security representing a loan from an investor to an entity, usually a government or corporation. The issuer commits to paying interest at regular intervals and returning the principal at maturity. Bonds serve as a critical financial tool for funding projects, managing debts, and stabilizing investment portfolios by offering predictable returns with varying risk levels.
How Bonds Work?
- Issuance
Bonds are issued by governments, corporations, or municipalities when they need to raise funds for projects, infrastructure, or operational expenses. The issuer sets the terms, including the face value, interest rate, and maturity date, and sells them to investors. Once issued, bonds can be traded in secondary markets, where prices fluctuate based on demand and economic conditions. - Investment
Investors purchase bonds as a form of lending money to the issuer. This makes them creditors rather than owners, unlike stockholders. In return, bondholders receive fixed interest payments, making bonds a popular choice for conservative investors seeking stable returns. Investors can buy bonds directly from issuers or through secondary markets, mutual funds, or exchange-traded funds (ETFs). - Interest Payments
Bonds provide regular interest payments, known as coupon payments, based on a fixed or floating rate. These payments are typically made annually or semi-annually. The interest rate is determined at issuance and remains constant for fixed-rate bonds. Floating-rate bonds, however, adjust their interest rates periodically based on market conditions, providing protection against inflation and rate fluctuations. - Maturity
When a bond reaches maturity, the issuer repays the principal amount to the bondholder. Maturity periods vary from short-term (under 3 years) to long-term (over 10 years). Investors can hold bonds until maturity to receive the full principal amount or sell them in the secondary market, where prices may vary due to interest rate changes and economic conditions.
Characteristics of Bonds
Bonds have several defining characteristics that impact their investment value. Understanding these features helps investors evaluate risk, return, and market behaviour when choosing the right bonds for their portfolios.
1. Face Value (Par Value)
The face value, or par value, is the amount an investor will receive from the issuer when the bond matures. It is the initial amount loaned to the issuer, typically Rs.1,000 or Rs.10,000 per bond. Market prices fluctuate based on interest rates and demand, but the face value remains unchanged, ensuring a known payout at maturity.
2. Coupon Rate
The coupon rate is the fixed percentage of the bond’s face value paid as interest to investors. If a bond has a face value of Rs.10,000 and a 5% annual coupon rate, the investor will receive Rs.500 per year. Some bonds offer floating rates, where interest payments adjust periodically based on prevailing market rates to counter inflation.
3. Maturity Date
The maturity date is when the bondholder receives the principal amount from the issuer. Bonds are categorised as short-term (less than 3 years), medium-term (3–10 years), and long-term (over 10 years). Investors should consider their investment horizon and risk tolerance before selecting bonds based on their maturity periods and associated interest rate risks.
4. Yield
Yield represents the return an investor earns on a bond, considering its interest payments and market price. It is calculated as the annual coupon payment divided by the bond’s current price. When bond prices rise, yields decrease, and vice versa. Investors analyse yield to compare bonds, assess profitability, and determine investment attractiveness based on market fluctuations.
5. Credit Rating
Bonds are assigned credit ratings by agencies such as Moody’s, S&P, and CRISIL, reflecting the issuer’s ability to repay debt. Higher ratings (AAA, AA) indicate lower default risk, while lower ratings (BB and below) suggest higher risk but potentially greater returns. Investors use credit ratings to assess bond safety and balance their portfolios between low-risk and high-yield bonds.
Types of Bonds
Bonds come in various forms, each offering unique risk-return profiles. Investors should understand the differences to choose the most suitable bond type based on their financial goals and risk appetite.
1. Government Bonds
Government bonds, also known as sovereign bonds, are issued by national governments to fund infrastructure, defence, and welfare projects. They are considered the safest investments since they are backed by the government’s ability to tax and generate revenue. Examples include Treasury Bonds (T-Bonds) and Government Securities (G-Secs), offering fixed returns and minimal default risk.
2. Corporate Bonds
Corporate bonds are issued by companies to finance expansion, acquisitions, or operational needs. They offer higher interest rates than government bonds but carry varying risk levels depending on the issuer’s financial health. Investment-grade corporate bonds have lower risk, while high-yield (junk) bonds offer greater returns but come with a higher chance of default.
3. Municipal Bonds
Municipal bonds are issued by state and local governments to finance public projects like roads, schools, and hospitals. These bonds are often tax-exempt, making them attractive for investors seeking stable returns with tax benefits. However, they carry some default risk, depending on the financial stability of the issuing municipality and economic conditions.
4. Zero-Coupon Bonds
Zero-coupon bonds do not pay periodic interest. Instead, they are issued at a discount and redeemed at face value upon maturity. Investors earn returns through price appreciation rather than regular coupon payments. These bonds are ideal for long-term investors who do not require periodic income and prefer lump sum returns at maturity.
5. Inflation-Linked Bonds
Inflation-linked bonds adjust their principal and interest payments based on inflation rates, ensuring purchasing power protection. These bonds are particularly useful during periods of high inflation, as traditional fixed-income bonds lose value over time. Investors looking for security against rising costs prefer inflation-linked bonds to maintain real returns and safeguard long-term financial stability.
6. Convertible Bonds
Convertible bonds provide the option to convert the bond into company shares at a predetermined price. They offer a mix of fixed-income security and equity growth potential. If the company performs well, investors can benefit from capital appreciation. However, if stock prices decline, the investor still earns fixed interest, reducing the downside risk.
What is a Bond?
A bond is a debt instrument that is issued by an entity to an investor. The purchase value of the bond is essentially a loan that the investor offers the issuing entity. In other words, it signifies a debt taken on by the bond issuer. This is why bonds are categorised as debt instruments.
In return for this debt, the borrower (or the bond issuer) pays the lender (or the investor) interest at periodic intervals. The rate and frequency of interest payments are determined by the terms of the bond issue. Since these payments are assured and predefined, bonds are considered to be relatively safer than stocks.
Also Read: Different Types of Bonds Explained
How Do Bonds Work?
Although many interested investors find it easy to understand the meaning of bonds, they may not easily comprehend how bonds work. If you are also unfamiliar with the features of bonds and how they work, let’s break down the key components of these securities.
- Face Value
The face value of a bond, also known as its par value or principal, is the amount that the investor will receive at maturity. Typically, the par value is the purchase price that you have to pay. However, in some cases (as with zero coupon bonds), the purchase price and the par value are different, as you’ll see.
- Coupon Rate
The coupon rate is the rate at which the bond issuer pays interest to the investor. The coupon rate is calculated on the face value of the bond rather than its market price or current price. These rates can be fixed or floating.
- Maturity Date
The maturity date is the date on which the bond issuer will have to repay the par value of the security to the investor. In other words, this is simply a repayment of the principal. After a bond matures, investors will no longer receive interest or coupon payments.
This sums up the fundamentals of how bonds work. To give you more clarity on the subject, let’s discuss an example.
Say you purchase a bond with a face value of Rs. 1,00,000 with a 5-year maturity date and a 6% coupon rate per annum. This means the bond will pay you Rs. 6,000 per year for 5 years. At the end of the 5-year period, you will receive the face value of Rs. 1,00,000. This is how most bonds work — by distributing the coupon payments throughout the lifetime of the bond and repaying the principal at maturity.
Different Types of Bonds
To get more insights into the bond market and how bond trading works, you need to be aware of the different types of bonds. These debt securities can be classified based on different criteria as outlined below.
Types of Bonds Based on the Issuing Entity
Depending on the nature of the entity that issues a bond, you can find two types of securities — government bonds and corporate bonds.
- Government Bonds
Government bonds are debt securities issued by the central and state governments to raise funds for different kinds of public expenditure. They are considered to be extremely low-risk securities because they are backed by the sovereign guarantee. The interest rates on these bonds are generally lower than those of corporate bonds.
Additional Read: Sovereign Gold Bond
- Corporate Bonds
Corporate bonds are debt instruments that are issued by corporate entities. These corporate entities could be banks, financial institutions or other publicly listed companies. The level of risk varies from one corporate bond to another depending on the creditworthiness of the issuing entity. Broadly, however, corporate bonds carry higher coupon rates and more risk than government bonds.
Types of Bonds Based on the Interest Rate
The manner in which the interest rate is levied also varies among bonds. Based on this, we have fixed and floating rate bonds.
- Fixed Rate Bonds
As the name indicates, the coupon rate in fixed rate bonds is fixed beforehand. When you invest in these bonds, you know exactly how much interest you will earn until bond maturity. On the flip side, the interest rates remain the same even in a booming economy, so you cannot benefit from the economic growth.
- Floating Rate Bonds
Floating rate bonds have variable coupon rates that are linked to economic benchmarks like the repo rate. The coupon payments also vary depending on the changing market rates. Due to the uncertainty involved, floating rate bonds are riskier than fixed rate bonds. This is why they are only suitable for investors with a slightly higher appetite for risk.
Types of Bonds Based on the Structure
Bonds can also be structured in different ways. Based on this parameter, we can identify two types of bonds that deviate from the typical structure of how bonds work.
- Zero Coupon Bonds
As is evident from the name, zero coupon bonds do not offer any coupon or interest payments during the bond’s lifetime. Instead, these bonds are issued at a discount to the face value. Thereafter, at maturity, these bonds are redeemed at their face value. The difference between the issue price and the face value is the benefit the investor earns.
- Convertible Bonds
Convertible bonds are debt securities that can be converted into the stocks of the issuing company after a given period of time. The terms and conditions of the conversion may vary from one entity to another. However, the essence remains that these securities combine the features of bonds and stocks.
Advantages and Limitations of Bonds
While you may now be clear about the different types of bonds and how they work, you can broaden your understanding of the subject by learning about the key advantages and downsides of these instruments. They include the following.
Advantages of Bonds
- They offer a stable income
- The income is known beforehand (except in the case of floating rate bonds)
- They help reduce the overall portfolio risk
- They are easy to purchase and sell
Limitations of Bonds
- They are vulnerable to inflation risks
- They may not be ideal for short-term investment
- They offer lower returns than potential stock market returns
Conclusion
Bonds are a crucial investment tool, offering stability, income, and risk diversification. Whether investing in government bonds for security or corporate bonds for higher returns, understanding their characteristics, risks, and market dynamics is essential. Investors should assess their financial goals, risk tolerance, and market conditions before selecting bonds. With the right strategy, bonds can enhance a well-balanced portfolio and provide steady financial growth.
The bottom line is that bonds have many beneficial features for different kinds of investors. Once you understand how bonds work and what their key features are, you can create a plan to include these debt securities in your portfolio.
If you are a conservative investor, the stable returns on these instruments align with your risk tolerance levels. On the other hand, if you are an aggressive investor who is willing to take on more risk, you can make use of bonds to bring some stability to your overall portfolio.
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