What are bonds? How do they work? Important bond terms to know and different types of bonds


What are bonds? How do they work? Important bond terms to know and different types of bonds | Vrid
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Bonds are considered one of the safest investment options. Bonds offer security similar to a Fixed Deposit and offer better interest rates than FD.

But when was the last time you discussed bonds or the debt market with your friends?

In India, most people are more focused on the stock market than the bond/debt market because they are unaware of bonds. They don’t understand how they work? How to invest in them? And how important they are?

So, we thought we will start a Bond Series (Not the James Bond one) – where we discuss everything about bonds. How they work, different types of bonds, their use cases and how you can invest in them.

And in this post, we start by exploring the basics of bonds.

Estimated read time: 4 minutes and 19 seconds

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Buckle up. Here we go!

What are bonds?

By definition, “A Bond is a fixed income instrument that represents a loan made by an investor to a borrower.” 

In simple terms, bonds are like IOUs (I owe you). When you buy a bond, you are lending money to an entity—a government or a corporation—that promises to repay the amount with interest over a specified period. 

What do you do when you want to buy a car or house but don’t have enough money? You take a loan from banks and promise to pay them back with interest.

Similarly, when governments and corporates want to buy or invest in something, they don’t have enough money. They borrow money from banks, or they can borrow money from us directly.

Government and Corporate issues a bond agreement where you become the lender, and they become the borrower. They promise to repay the loan to you with fixed interest within a specified period.

Bonds are a great way for governments and companies to raise funds for various projects and for us, the investor, to earn a fixed income.

Types of Bonds in India

In India, several types of bonds cater to different needs and preferences. We can categorise bonds based on the issuer, tenure, credit rating, secure or unsecured, tax status, etc. Here are some common ones:

1. Government Bonds

Issued by the Central or State Government, these are considered the safest and most secure. Government Bonds in India fall under the broad category of government securities (G-Sec) and usually offer lower interest rate than other bonds as it offers the highest security.

2. Corporate Bonds

Companies issue these bonds to raise funds. They offer higher interest rates but come with varying levels of risk. Popular corporate bonds include those issued by the State Bank of India (SBI), Reliance Industries, and Tata Group.

3. PSU Bonds

PSU bonds are issued by public-sector companies, such as PSU banks, power sector companies, railways, etc., with a government stake of over 51%. As the government backs these bonds, they carry less risk and offer lower interest than corporate bonds. Some PSU bonds offer tax advantages.

4. Infrastructure Bonds

These bonds focus on funding infrastructure development projects such as roads, bridges, and power plants. They often come with tax benefits and longer tenures. Popular infrastructure bond is NHAI bonds.

Important bond terms to know

To understand the world of bonds effectively, familiarise yourself with these key terms: 

1. Face Value

The initial value of the bond, which is repaid at maturity, is face value. Face value is determined at the time of issuance of the bond. Unlike the market price, face value remains fixed throughout the bond tenure. The most frequent par value for bonds is ₹1,000. 

2. Coupon Rate

In the world of bonds, the fixed rate of interest paid by the bond issuers on the face value of the bond is known as the coupon rate. 

3. Market Price

Like equity stocks after the primary issue, bonds are also traded in the secondary market. The price quoted in the secondary market is known as the market or current price.

4. Yield

The yield on the bond is the effective rate of return an investor gets for holding the bond. While the coupon rate is fixed, the yield is variable if we brought the bond from a secondary market. Yield is determined by the secondary market price of the bond and the remaining coupon payments.

5. Maturity Date

Maturity date refers to the date on which the bond issuer should repay the bond’s face value and the remaining coupon payments to the bondholder.

6. Secure or Unsecured

Similar to loans, we can also categorise bonds into secure and unsecured. A secured bond is backed by some specific assets that provide protection to the bondholders in case the issuer defaults. An unsecured bond is not backed by any asset and is riskier when compared with secure bonds.

7. Credit Rating

Credit rating agencies like CRISIL, ICRA, and CARE provide ratings based on the issuer’s ability to repay the bond. The lower the credit rating, the riskier the bond, and the higher the interest rates.

How do bonds work?

When you purchase a bond, you are essentially investing in debt. Here’s a step-by-step breakdown of how bonds work:

1. The Issuance

The issuer (government or corporation) announces the bond issuance with specific details, such as the coupon rate, maturity date, and face value.

2. The Purchase

Investors like us can buy these bonds through various channels, including banks, brokers, or the primary market.

3. Coupon Payments

Bonds often pay periodic interest, known as coupon payments, typically annually or semi-annually. These payments represent a percentage of the bond’s face value.

4. Maturity

Bonds have a predetermined maturity date when the issuer repays the face value to the bondholder. This period can range from a few months to several years.

5. Secondary Market

If you wish to sell your bond before its maturity, you can do so on the secondary market, subject to prevailing market conditions.

6. Redemption

If you hold the bond till maturity, on the maturity date, the bond issuer will repay you the principal amount – the face value of the bond and the last coupon payment. 

Bonds are an essential component of any well-diversified investment portfolio, offering stability, income, and risk management. While planning your portfolio, consider bonds as an option to meet your financial goals. 

Remember to share these insights with your buddies.

Still Curious?

If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.

5paisa – Bond basics: How to invest in bonds and how are they different from stocks?

Bonds India – Bonds: Definition, Types and Benefits of Bonds

Yadnya Investment Academy – What is a Bond? Introduction to Bonds

Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.

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DISCLAIMER: This newsletter is strictly educational and is not an investment advice or a proposal to buy or sell any assets. Please be careful and do your own research.

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