Intermediate

Introduction To Bonds

A bond is a debt security or a form of a loan taken by corporations or the government (both central and state) from the public for a defined term. The borrower or bond issuer agrees to pay a fixed rate of interest and return the borrowed capital on maturity in return.

Bonds are considered a low-risk investment because the issuer is obligated to repay the principal on maturity. A bond issued by the corporation or government is usually backed by collateral.

The reason it is considered first by many investors as a low-risk investment is that the bondholder gets the first right on the company’s assets if the company goes bankrupt. Bondholders are given preference over equity shareholders during the distribution of profits by corporations.

To understand bonds better, following terms are required to be known beforehand:

  • Coupon Coupon is the interest that is paid to bondholder. The amount paid can be monthly, quarterly, bi-annually, or annually.
  • Coupon Date The date on which investors receive coupon payments.
  • Face Value Face value denotes the issue price of the bond on which interest is calculated. Face value of most Indian bonds is in multiples of Rs. 1000.
  • Market Value The selling price of a bond in the market is called market value. This value depends on various factors such as prevailing economic conditions, the business of the bond issuer, etc. Maturity There is the date on which the bondholder is paid back the principal amount. The bondholder stops receiving the interest once the amount is paid by the bond issuer. Yield to maturity Yield to maturity is the total rate of return you get from a bond if held till maturity. It is expressed in percentage. YTM = Coupon rate / Bond price
  • Rating Bonds receive a rating by Independent rating agencies depending on their creditworthiness. The ratings indicate the safety of a bond. AAA is the highest rating, and bonds with this rating are considered to be the safest while D is the lowest rating and such bonds are called junk bonds. The ratings are given based on the bond issuer’s creditworthiness, present cash flow, financial strength, borrowing and repayment history, and the ability to pay principal and interest on time. The table below highlights the ratings and their meaning: Rating Investment Grade Description Meaning AAA Investment Grade Prime Low credit risk with higest safety AA Investment Grade High Medium Grade Low credit risk with high safety A Investment Grade Upper Medium Grade Low credit risk with minimal safety BBB Investment Grade Lower Medium Grade Moderate credit risk with moderate safety BB Speculative Grade Speculative Grade Moderate credit risk B Speculative Grade Highly Speculative Grade High risk of default C Speculative Grade Substantial Risk Very high risk of default D Speculative Grade In Default Already defaulted or about to default The credit rating of a bond is inversely related to its coupon rate. If the issuer of the bond has a low credit rating, these bonds pay higher coupon rate.This is because issuer compensate investors for the high risk. If the issuer of the bond has a AAA credit rating,then these bonds pay lower coupons due to low default risk.

There are two types of taxes that are levied on certain types of bonds: STCG (Short Term Capital Gains): If the holding period is less than 12 months, the realized returns are termed STCG. They are taxed at the applicable individual tax slab rate. LTCG (Long Term Capital Gains): If the holding period is more than 12 months, the realized returns are termed LTCG. they are taxed at a flat 10% without indexation benefit. Let us see how gains are calculated in both the scenarios:

  • Investors receive regular fixed income upon buying bond.
  • Bonds give higher returns than fixed deposits.
  • Bonds are less volatile as compared to stocks.
  • Bond holders are creditors of the company and holds priority above above equity shareholders and debenture holders for payment.
  • Selected bonds provide tax-free returns.
  • Finding buyers for the bond in the secondary markets is difficult if the financial condition of the company is not good.
  • Bonds are less liquid compared to stocks.