Bonds refer to high-security debt instruments that enable an entity to raise funds and fulfil capital requirements. It is a category of debt that borrowers avail from individual investors for a specified tenure. When the bond reaches maturity, the issuer returns the money, principal, and interest. The bond issuer uses the money raised from bonds to undertake various activities such as funding expansion projects, refinancing existing debt, undertaking welfare activities, etc. Bonds are less risky compared to market-linked instruments like equities.
TERMINOLOGIES USED IN RELATION WITH BONDS:
Coupon Coupon is the interest that you get as a bondholder. The amount is paid on a specific schedule which could be monthly, quarterly, bi-annually, or annually.
Face Value Face value implies the price of a single unit of a bond issued by an enterprise. Principal, nominal, or par value is used alternatively to refer to the price of bonds. Issuers are under a legal obligation to return this value to the investor after a stipulated period.
Market Value The cost at which the bond is sold in the market is called market value. This value depends on the prevailing economic conditions and the business of the bond issuer among other things.
Maturity There is a pre-defined date on which the bondholder is paid back the principal amount. This is known as the bond maturity date. Once the amount is paid, the bondholder stops receiving the interest.
Yield to Maturity Yield to maturity is the total rate of return you get from a bond after payment of all interest and principal. It is expressed in percentage.
Rating Independent rating agencies rate bonds depending on their creditworthiness. The ratings indicate the safety of a bond. The ratings are given based on the bond issuer’s financial strength and the ability to pay principal and interest on time.
ADVANTAGES AND LIMITATIONS:
TYPES OF BONDS: Fixed-interest bonds: Fixed-interest bonds are debt instruments that accrue consistent coupon rates throughout their tenure. These predetermined interest rates benefit investors with predictable returns on investment irrespective of alterations in market conditions.
Floating interest bonds: These bonds incur coupon rates which are subject to market fluctuations and elastic within their tenures. The return on investment through interest income is thus inconsistent as it is determined by market factors such as inflation, the condition of the economy, and the confidence of investors in an entity’s bonds.
Inflation-linked bonds: Inflation-linked bonds are special debt instruments designed to curb the impact of economic inflation on the face value and interest return. The coupon rates offered on inflation-linked bonds are usually lower than fixed-interest bonds. ILBs thus aim to reduce the negative consequences of inflation by adjusting coupons concerning prevailing rates in the debt market.
Government Securities Bond: Government securities bonds are issued by the central and respective state governments. Acknowledging the government’s debt obligations, government bonds can be for the short-term or long-term. Short-term G-Sec has a maturity of less than one year, while that of long-term bonds is more than one year.
Corporate Bonds: Corporate bonds are bonds issued by companies to investors. When a company wants to fund its existing operations or undertake expansion projects, instead of approaching banks for money, it raises funds from the public by issuing bonds for a fixed tenure. After the end of the tenure, investors will receive the bond’s face value along with interest.
Zero Coupon Bonds: These bonds don’t pay any interest but trade at a major discount. When the bond matures, it gives investors a lump sum amount that includes its face value. Convertible Bonds: The issuing company can convert these bonds into shares of the issuing company’s stock at a pre-determined conversion ratio. They offer the investor the potential for capital appreciation and fixed income.
TAXATION OF BONDS: Bond taxation depends on the type of bond you are investing in. In the case of regular taxable bonds, the earnings are of two types – interest and capital gains. While interest is added to your income and taxed as per the tax slab, capital gains are both long-term capital gains (LTCG) and short-term capital gains (STCG). While STCG tax is applicable at the applicable tax slab, LTCG is taxed at 10% without the benefit of indexation. You need not pay any tax on interest earned from tax-free bonds. However, returns from such bonds on maturity or upon sale are categorized under LTCG and STCG according to the holding period.
CONCLUSION: Bonds are a crucial part of the global financial system, providing a means for governments, corporations, and other entities to raise capital. The benefits and dangers of each bond type should be carefully considered by investors and issuers before choosing which bonds to buy or issue. Bonds are a crucial asset class in any well-diversified portfolio because, despite their hazards, they are a well-liked investment option for individuals looking for stable income, diversification, and lower risk.