Government needs money for funding social programs and development of infrastructure, companies also need money for business expansion. In many cases money required is more than the loans offered by the banks. Hence these entities issue Bonds or Debentures to raise the funds.

In simple terms Bonds are loan taken by the Government or company for which the investors who buy bonds are lenders. In exchange the entities who issue bonds pays an interest called “coupon” at a predetermine intervals (usually annually or semi-annually) and return the principal called “face value or par value” on the maturity. Some bonds have a call provision i.e., it can be paid off (matured) at an earlier date at a slight premium to par value as per the discretion of the issuer.

Bonds are secured by the collaterals or physical assets of the issuing entity. Bonds are issued by central and state governments, PSUs and other government agencies, financial institutions and large corporations. The tenure of bonds is usually longer.

Debentures are basically unsecured bonds. Debentures are issued by private companies but no collaterals or physical assets back them up. Thus, investors have to purchase based on credit ratings of these companies. Debentures are generally issued for short to medium term and offer higher interest rates than bonds as they are unsecured. The debentures can be classified as convertible and non-convertible debentures. Convertible debentures can be converted into equity shares of the company. 

Different types of Bonds

• Fixed Rate Bonds – Fixed rate bonds pays the bondholders the fixed amount of interest until the maturity of the bond. Most Government bonds in India are issued as Fixed Rate Bonds.
• Floating Rate Bonds – Floating rate bonds do not have fixed coupon rate. Instead, it has a variable coupon rate which is re-set at pre-announced intervals (every six months or one year) depending on the bench mark set. It is majorly issued by the Government.
• Perpetual Bonds – Perpetual bonds have no maturity. The issuer in perpetual bonds continues paying steady interest till perpetuity and is not required to repay the principal amount to the bondholders.
• Inflation Indexed Bonds – Inflation indexed bonds as a concept was released by the RBI in June 2013 to reduce the impact of inflation on coupon payments and face value. Principal amount is adjusted as per the inflation rate every year and coupons are paid based on adjusted principal.
• Infrastructure Bonds – These bonds are usually offered by the Government and PSUs to fund the long-term infrastructure projects. They offer a decent rate of interest along with Tax benefits. They have a longish maturity period, between 10 to 15 years. They have specified lock in period.
• Zero coupon bonds & Deep discount Bonds – These bonds do not carry any interest (coupons) but are sold at a discount. The difference between discounted value and face value is the interest earned by the investor.
• Tax Free Bonds – Tax free bonds are issued by government enterprise to raise fund for particular purpose, example is municipal bonds. As the name suggests the main feature of these bonds are its absolute tax exemption as per section 10 of income tax act of India 1961.
• Masala Bonds & FCCBs – Masala Bonds are bonds issued outside India by an Indian entity but denominated in Indian Rupees. The major objective of Masala Bonds is to raise money in local currency by foreign investors to fund infrastructure projects and ignite internal growth.

Initially Bonds are being purchased through primary market i.e., directly from the issuer and then the issued bonds can be traded in the secondary market where investors deal with each other. Brokers and dealers are the main buyers and sellers in the secondary market of bonds and retail investors typically purchase bonds through them either directly as a client or indirectly through Mutual Funds and ETFs.

Even though bonds can be a great option to generate regular income and are widely considered to be a safe investment, especially compared with stocks. You should be aware of the potential Risk of holding bonds.

Below are the few risks associated with bonds.

• Default Risk – Corporate bond depends on issuers ability to repay the interest and principal, so there is always a possibility of default of payment.
• Prepayment Risk – The bonds issued can be paid off earlier than expected, normally through a call provision. This can be bad news for investors when interest rates have declined substantially. Instead of continuing to hold a high interest investment, investors are left to reinvest funds in a lower interest rate instrument.
• Interest Rate Risk – Interest rates can change significantly. If interest rates significantly declines, the investor faces the possibility of prepayment and if interest rate increase, the investor will be stuck with an instrument yielding below market rate returns. In secondary market when interest rate rises the bond prises fall and when interest rate decreases the bond prises increases.
• Inflation Risk – When inflation increases dramatically, bonds can have a negative rate of returns.
• Liquidity Risk – Low liquidity in some bonds can have prise volatility.
• Credit rating Risk – A change in credit rating of the company will have a significant impact on the prise of the bond.

Bond Ratings

A company’s ability to operate and repay its debt is frequently evaluated by major rating institutions such as Standard & Poor’s Ratings Services or Moody’s Investors Service. Rating ranges from ‘AAA’ to ‘Aaa’ for a high-grade issue to ‘D’ for issues that are currently in defaults. Bonds rated ‘BBB’ to ‘Baa’ or above are called “investment grade”, this means they are unlikely to default and tend to remain stable investments. Bonds rated “BB” to “Ba” or below are called “junk bonds” which means that default is more likely hence they are subject to price volatility.

If you depend on your investments for income, you should invest in bonds, by investing in bonds, one can expect a steady stream of income till maturity in the form of interests and If the bondholder holds the bond till maturity, the investor gets the entire principal amount and hence, these are considered as an ideal way to preserve one ‘s capital. Bonds can help you easily diversify your portfolio and sail through volatile times with ease. At the same time interest received from bond is fully taxable as per the slab rate and with the various risks associated with bonds one should be careful while investing in bonds.

The best way is to consult a qualified financial planner for guidance before investing in the Bonds.