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Types of Bonds

What are Bonds?

For an individual, a Bank loan maybe sufficient to finance his needs like a car or a home but for Government or corporate entities, only loans may not suffice. This is where financial Bonds come into play. Instead of taking a loan from a Bank, the Government or the companies take loans from investors. In turn, legal certificates are issued which entitles an investor to fixed interest payments till maturity after which the loan amount is paid off. This is essentially what a Bond is all about.

In other words, it is a debt instrument which allows the Government or companies to undertake development or fund businesses and the investors, to get interest on their investment. These interests are generally paid to investors on an annual and semi-annual basis.

Types of Bonds

  1. Government Bonds

– These Bonds are issued and backed by the Government and are considered relatively low risk for a medium to long term investment.

  1. Corporate Bonds

– Issued by corporate entities to fund new ventures,expansion plans or other initiatives and capable of providing better interest. Here, the risk involved is also higher as these bonds generally have a lower bond-rating  as compared to government Bonds by the rating agencies.

As a thumb rule, higher bond rating is considered to be a safer investment.

  1. Tax Saving Bonds

– These Bonds are issued by RBI since 2003 and are available at many public and private banks. The interest rate offered is currently 8% with a minimum deposit of Rs. 1000/- with a 6-year maturity period. The bonds are non-transferrable and the interest earned on these bonds is taxable.However, these bonds are exempted from Wealth Tax.

Factors to Consider while buying Bonds

While looking to invest in a bond, it is better to select Secured Bonds over Unsecured Bonds. Secured Bonds come with collateral (backed by a specific asset) to ensure that your investment can be repaid by the issuer. On the other hand, unsecured bonds are backed only by the credit worthiness of the issuer and there is no collateral asset involved.

Secured Bonds are a safer option as the bond issuers can ask for selling the collateral assets in case of a payment default and even during liquidation (bankruptcy), bond holders need to get paid first. In unsecured Bonds, there is no such security and investment might have to be recovered using legal course in case a company goes bankrupt.So when going for unsecured Bonds, it is important to be well aware of the issuer’s credibility and repayment capacity.

Secondly, you should also evaluate your risk taking capacity before deciding on what bond to buy. Investment grade bonds get a credit rating between AAA and BBB and come with a low risk of default.On the other hand, Bonds with credit rating lower than that have higher risks but also carry the possibility of higher returns. These are known as Junk bonds.

Here’s a Bond Rating table to understand the investment grade in different Bonds as rated by different credit rating agencies: –

Rating Table for Bonds

Risks associated with Bond Investments

Although Bonds are considered to be “fixed-income” instruments, market fluctuations can affect the returns from bond investments. The most common risks associated with Bonds are –

Interest Rate Risk

– The Price of a Bond and interest rate work in an inverse manner i.e. if the interest rate reduces, then the price of the Bonds rise and if there is a rise in the interest rate, then the Bond prices go down.

To help you understand how it works, consider this: The coupon rate on your Bonds is 6%. Now, the interest rate rises to 7.5% and as investor, you would prefer to have a higher coupon rate at which you will be willing to trade your current Bonds. And like you, there are many other investors who would do the same and this trading on a mass level will result in the price level of the Bonds (that were initially purchased at a 6% coupon rate) to go down.

Reinvestment Risk

– When bond interest rates fall, the bond issuer can call your Bonds and repay the amount which affects the maturity amount you were supposed to get for the initial lock-in period. Now since the bonds are being redeemed at a lower rate, the amount that you get might be slightly higher than the original amount. But the investment that would be made with the funds form this redemptionwill be at a lower coupon rate, leading to lower returns.

Inflation Risk

– A risk that is subject to the change in the cost of living. There is always a possibility that your bond investments might not be able to provide returns which are in sync with the rising rate of inflation  i.e. the Bonds might give you returns lesser than the inflation rate.

Revaluation of Credit Ratings

– Depending on the company’s growth, increase in operations and cash flow, agencies can upgrade or downgrade the credit ratings of your Bonds. While an upgrade in rating can be looked at in good light, a downgrade only makes your Bonds more reactive to market changes.

Liquidity Risk

– This risk is more likely to be there for corporate bonds than Government bonds. If the interest rates drop, you might have to sell your bonds at a lower interest rate as the number of interested buyers might be low or if liquidation is an absolute must at the time.

Risks due to Natural Causes

– In case of natural calamities like earthquakes or floods, industries might be affected which result in market fluctuations that in turn affect your Bond prices.

 

Benefits of Bond Investments

When it comes to Bond investments, a little risk is often present. But considering the fact that the possibilities of potential returns are very appealing, investing a small portion of your investment budget on Bonds makes for a pretty wise option.

Learn more about other tax saving investments like ELSS, RGESS etc. here.

Some Terms Used with respect to Bonds

Indenture

– A legal contract that states the obligations, terms and conditions of a Bond.

Coupon

– Interest rate on a Bond

Accrued Interest

– The interest accumulated since the last interest payment

Yield at Maturity

– This is the final return that you will receive from your investment in a Bond

Credit Rating

– To determine credit worthiness of companies, agencies like CRISIL assign a credit rating to each company which can help investors make a more informed decision before investing in a company’s Bond.

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