What are bonds?
Bonds are a type of investment that typically offers a fixed return and serves as a source of regular income. Bonds are a popular investment option among investors who prefer to invest in low-risk instruments. Different types of bonds are available in the market, each with different features and characteristics that cater to the needs of diverse investor groups. In this article, we will discuss the different types of bonds that are commonly available in the market.
What are the types of bonds?
The following are the different types of bonds:
1. Fixed-rate bonds
Fixed-rate bonds are the most common type of bonds. These bonds pay a fixed interest rate over the life of the bond. This ensures that the bondholder receives a fixed amount of income for the period of the investment.
2. Floating-rate bonds
Floating-rate bonds are bonds whose interest rate is adjusted periodically according to the market conditions. The interest rate on these bonds fluctuates with changes in the market rate.
3. Zero-coupon bonds
Zero-coupon bonds are bonds that do not pay interest. Instead, these bonds are offered at a discount to their face value, and the investors receive the full-face value of the bonds at maturity. These bonds are also called deep discounted bonds.
4. Puttable Bonds
These bonds grant the bondholder the right to compel the bond issuers to repurchase the debt securities prior to their predetermined maturity date. However, whether to avail this right is entirely at the discretion of the bondholder. They are not obligated to exercise this option.
5. Convertible Bonds
Convertible bonds are a type of hybrid security that offer both fixed interest payments and a pre-determined option to convert to a specific number of equity shares within a specific timeframe at a set price. The investor has a voluntary option to convert, which creates an opportunity for them to become a shareholder of the company. Additionally, convertible bonds offer investment flexibility for companies as they provide a lower interest rate than traditional corporate bonds and the potential for future equity.
6. Callable Bonds
These bonds offer greater flexibility to corporations or governments to redeem the bond issue before their scheduled maturity date. Callable bonds typically offer higher interest rates to compensate investors for the additional risk, but the bond price may rise less if interest rates fall. Investors must review the bond prospectus carefully before investing to understand the terms, conditions, and early redemption clause associated with the callable bond.
7. Perpetual bonds
Perpetual bonds are bonds that do not have a maturity date. They provide a fixed interest payment to bondholders indefinitely. Perpetual bonds are popular for their steady and reliable income stream.
8. Inflation-linked bonds
Inflation-linked bonds are bonds that offer a return that is indexed to the inflation rate. As inflation rises, so does the interest rate on these bonds. This ensures that the return on the investment keeps pace with inflation.
Features of bonds
Bonds exhibit distinct features that set them apart from other investment vehicles. Here is an elaboration on these features:
Interest rate: The interest rate on a bond represents the coupon payments made by the bond issuer to the bondholder. This rate is generally a fixed percentage of the bond's face value and is disbursed at regular intervals over the bond's lifespan.
Maturity date: The maturity date signifies the redemption date when the bond issuer is obligated to repay the bond's principal amount to the bondholder. It is the point at which the bond reaches its full term, commonly known as "maturity."
Face value: The face value denotes the sum that the bond issuer commits to pay the bondholder upon maturity. It is also referred to as the par value of the bond.
Yield: Yield represents the rate of return on a bond, expressed as a percentage of the bond's current market price. It takes into account both the coupon rate and the prevailing market value of the bond.
Credit rating: Credit rating agencies evaluate and assign a bond rating based on the creditworthiness of the issuer. This rating serves as an indication of the likelihood of the issuer defaulting on its bond payments.
Liquidity: Bonds are tradable in the secondary market, allowing investors to buy or sell them before reaching maturity. The liquidity of a bond refers to the ease with which it can be transacted in the secondary market, providing investors with flexibility.
Things to consider before investing in bonds
Before investing in bonds, it is important to consider the following factors:
- Credit Rating: The credit rating of the bond issuer is an important factor to consider while investing in bonds. It indicates the issuer's creditworthiness and the risk associated with the investment.
- Interest Rate: The interest rate offered by the bond matters as it affects the returns on investment. Bonds with higher interest rates provide a higher return on investment, but they also have a higher risk.
- Maturity: The maturity period of the bond reflects the time until the principal amount is repaid. Longer maturity bonds offer higher interest rates but carry a higher risk.
- Inflation: Inflation affects the value of the bond. Investing in bonds that provide inflation protection can help investors maintain the purchasing power of their investment.
- Tax implications: The income earned from bonds is taxable as per the income tax rates. Investors must consider the tax implications before investing in bonds.
- Liquidity: Liquidity is essential while investing in bonds. Investors must consider whether the bond can be sold readily in the secondary market.
- Diversification: Diversifying the investment portfolio is crucial while investing in bonds. Investing in bonds across sectors and different types of bonds can help investors spread the risk.
Careful consideration of these factors can help investors make intelligent investment decisions in bonds in India.
Conclusion
Bonds are a popular investment option among investors looking for a fixed and reliable income stream. Different types of bonds are available in the market, each with different features and characteristics. Investors should consider various factors such as credit risk, interest rate risk, yield, and tax implications before investing in bonds. By understanding the different types of bonds and considering the risks and benefits associated with each, investors can make informed decisions and diversify their portfolio.
