Bonds: Meaning, Types, Characteristics, Advantages and Disadvantages

Meaning Of Bonds

A Bond is a fixed-income instrument representing the loan provided by investor to borrower who can be either governmental or corporate institutions. It is defined as medium of loan used by businesses and government for raising funds from public. In simple terms, the bonds serve as contract in between the lender and borrower and contains all details regarding loan such as amount of borrowed loan, due date of principal payment, rate of interest and terms of interest payments. Bonds are mostly issued by state and sovereign government, municipalities, companies and several other entities for financing projects and operations. These are purchased by investors as savings and security option.

Bondholders or investor receive income in the form of fixed interest on regular basis, in return for the money they lent. Also, bonds are backed by collateral that acts as an security for investors. If in case, the borrower defaults in doing loan repayment then investor can sell off that collateral security in secondary market at a higher price and make a profit. The bond issuers carry an obligation to pack back the principal amount on maturity date along with all due interest. Nowadays, bonds are getting much popularity as an investment option due to their nature of being safer. The bondholders are first who get right on company’s asset if in case, the company goes bankrupt. 

Types of Bonds

There are different types of bonds that are segregated on distinct basis such as: Type of issuer, Type of options, Type of tax benefits and Type of coupon rates. 

Types of bonds on the basis of borrower (Issuer)

Central Government Bonds: These bonds date back to early 1,100s when Venice used to issue the government bonds for funding its wars. This practice is now followed by central banks all across the globe. The central government bonds hold a sovereign guarantee as being issued by government, thereby making them one of the safest types of bonds. However, due to their long maturity period, such bonds are exposed to the risk of inflation. There may be a possibility that the returns delivered by these bonds in future get depreciated by inflation rate.

State Government Bonds: State government bonds are also known as state development loans (SDLs). These bonds are issued by state government for funding the infrastructural developments in state or at the time of liquidity crunch. 

Public Sector Bonds: Public sector units (PSUs) also like the central and state government, can raise funds from general public via issuing bonds known as public sector bonds. Such types of bonds are issued by top-level public-sector enterprises or institutions for funding their expansion and growth needs. Public sector bonds are less risky in comparison to corporate bonds issued by private sector companies. 

Corporate Bonds: The bonds issued by private companies for raising funds is termed as corporate bonds. These bonds represent a large share in India’s bond market. Companies are able to raise funds at low cost via issuing corporate bonds. Issuance of corporate bonds is considered much better than issuing fresh shares as there is no dilution of equity capital in case of corporate bonds. However, corporate bonds carry high risk of default and this is why these bonds pay higher amount of coupon in comparison to the government bonds. In addition to having a higher amount of credit risk, corporate bonds too carry inflation and reinvestment risk.

Types of Bonds on the basis of coupon or interest

Fixed rate bond: Fixed rate bonds are the bonds that carries consistent coupon rates throughout their tenures. These predetermined rates of interest provide benefits to investors with predictable returns on their investment irrespective of the alterations in market conditions. Creditors have benefit of being aware of the receivable amount of interest on periodic basis within the schedule of long-term investment.

Flexible rate bond: Flexible bonds have interest rate that is fluctuating in nature as per current market rate of reference. The coupon rates of these bonds are elastic during their entire tenure and are subject to market fluctuations. Return on investment via interest income is thereby inconsistent as determined by market forces such as inflation, economy condition and investors’ confidence in entity bonds.

Zero coupon bond: Zero coupon bonds are bond having zero rate of coupon. They do not pay any amount of interest but instead are issued at discount on their face value and redeemed at par. The issuer of bond pays back the principal amount on maturity to investor. Bondholder is able to generate returns once the amount is paid back at face value by issuer.

Inflation indexed bond: The inflation-indexed bonds are special type of debt instruments that are designed to curb economic inflation’s impact on the face value and interest return. These types of bonds offer low coupon rates as compared to fixed-interest bonds. Inflation linked bonds aims at reducing the negative consequences of inflation via adjustments of coupons concerning the prevailing rate in debt market.

Types of Bonds on the basis of Call and Puts Options 

Callable Bonds: A callable options mean an option that is exercised by the issuer of bond. When bond issuer calls out his right to redeem bond prior to its date of maturity then it is termed as callable bond. The callable bonds contain a clause wherein issuer carries right of repurchasing bond from investor even before the maturity date. This is usually done by borrower in order to refinance the high debt. These types of bonds are used by issuer in converting high debt bond into low debt bond. 

Puttable Bonds: Puttable bonds are one where investor decides to sell off their bond and get back their money prior to the date of maturity. It is beneficial for investors who believes that the bond value may fall and this way, they will be able to get back their principal amount before the fall in bond value. 

Types of Bonds on the basis of Taxation

Tax free bond: Tax free bond are bonds issued by governmental entities to raise the funds for upcoming projects. Some of the prominent tax-free bonds in India are one issued by National Highways Association of India (NHAI), Rural Electrification Corporation (REC) and Indian Railways Finance Corporation (IRFC). In India, the interest earned on these categories of bonds is exempt under the Section 10 of Income Tax act., 1961. 

RBI bonds (Floating rate savings bonds): RBI bonds are issued by Reserve Bank of India and are also known as RBI taxable bonds. This type of bonds comes with maturity period of 7 years and rate of interest is fluctuating in nature that keeps on changing every six months. The minimum amount of investment in these types of bonds is Rs.1,000 and there is no maximum limit on doing investment. Amount of interest received from RBI bonds is taxable as per the income slab of bond holder.

Characteristics of Bonds

The characteristics of bonds are well-discussed in points given below: – 

Face Value: Face value of bonds denotes the worth of a bond at the time of its maturity. It is also termed as reference amount, as bond issuers uses it while calculating the interest payments. The face value of bond can vary in between Rs.1000 and Rs.1 crore. 

Coupon rate: Coupon rate refers to rate of interest that bond issuer pays on face value of bond and is expressed in % terms. Like for example, a 5% coupon rate means that investors will receive 5% x $500 face value = $25 each year

Coupon Date: Coupon dates are the dates on which the issuer of bond makes interest payments. The payments of interest can be made in any interval but the standard generally followed is of semi-annual payments.

Time to Maturity: Time to maturity refers to the time period left in maturity date, i.e., when the bond will become mature for repayment of principal amount. Certain bonds carry longer date of maturity and thereby pay the higher rates of interest. Bondholders get exposed to inflation and interest rate risk for an extended time period under the bonds having long maturity date, and therefore high-interest rate is paid to them.  

Credit quality: Credit quality represents one of the principal determinants of coupon rate. If bond issuer carries a low credit rating, then the risk of default is higher and as a result then bonds pay more interest amount. The agencies engaged in credit ratings keep on updating the ratings of a bond frequently. Bonds issued by government are very stable and are considered of highest quality. These are referred to as investment grade bonds. Whereas, bonds that are not investment grade but not in default are referred to as junk or high yield bonds.

Maturity date: Maturity date means the date on which bond issuer will pay back the face value of bond to investor. This date indicates the date of loan repayment by borrower.

Duration of Bond: Bond duration measures the sensitivity of a bond’s price to the variations in rate of interest. This does not represent the time length till the date of maturity.

Advantages of Bond

The primary advantages of bonds include fixed returns and regular interest. Few of the common benefits of bonds are as discussed in points given below: – 

Fixed returns on investment: A fixed amount of investment provides investor with regular interest amount at timely intervals. The biggest benefit of holding investments in bonds is that investors are totally aware on how much their returns will be. 

Less Risky: Bonds are considered as less risky for investors in comparison to other stocks and securities available in market. Although both bonds and stocks are two types of securities, but the clear difference among these two is that the bond gets matured within specific time period whereas stocks remain outstanding for indefinite period of time. In addition to this, bondholders are paid first over the stockholders in case of liquidity. 

Less Volatile: Doing investment in bonds is much safer than stock market that contains several types of risks. Although the value of bond gets fluctuate as per the current rate of interest or inflation, but then also they are considered more stable in comparison to stocks. 

Clear Ratings: The bonds get universal ratings by credit rating agencies but stock does not get such ratings. This further provide assurance to investors regarding the right time for doing investment in bonds. On the basis of clear ratings, an investor can choose to buy bonds of any issuer with better face value of bonds. 

Protection of investor: The bondholders get security against many types of failures. Legal protection is one where investor can benefit from doing investments in bank. In case of bankruptcy with company, the bondholders will still receive some amount of money back in the form of recovery amount.

Disadvantages of Bond

There are certain disadvantages too involved in doing investments in bonds. 

Bankruptcy: Bonds carries the biggest disadvantage of bankruptcy where the investor incurs huge amount of losses. In case, if the company goes bankrupt then the bondholders are going to lose majority of their investment value. In countries such as USA, much leverage and protection laws are given to investors in bankruptcy cases. This means that the investors are expected to receive some amount or full of their invested money. But in many nations, there is no such type of protection provided.

Less liquid compared to stocks: Majority of the companies may have high degree of liquidity but bonds issued by small or less financially stable corporations may be less liquid as there are very few investors who are willing to buy them. Also, the bonds having high face value will be less liquid but at same time, companies with lower face value won’t be able to find out the investors easily.    

Needs larger investment: Cost of buying bonds always remain the major disadvantage of bonds. The cost is directly in proportion to the company’s reputation. Although some of the bonds can be purchased at relatively lower sums, but most of the bonds require larger investment value. This means that investors will not be able to access some of the bonds. 

Involvement of numerous types of risk: The fixed-rate bonds are subject to risk of interest rate that denotes their market prices will fall in value when the generally prevailing rate of interest will rise. There are several other types of risks involved with bonds such as credit risk, call risk, liquidity risk and inflation risk.