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Bonds Basics: Types, Features & Markets

basics of bonds

When companies need funds to expand their projects, they have two choices either to go for the equity or borrow money from banks or investors. Bonds issued by companies when they decided to borrow money from investors.

bonds are a debt instrument that pays fixed or floating interest and have a fixed maturity and it is a borrower’s obligation.

It is a lending investment so it carries low risk relative to the stock of the companies.

A Bond has maturities of short term(less than a year), long term(more than 5 years), and medium-term(between 1 to 5 years). Bond names vary based on their maturity. e.g. bills for the short term notes for the medium term, and bonds for the long term.

You need a bunch of money to buy a bond, the minimum amount in India is 10,000- 10,00,000 and goes up to more than that depending on the type of the bond.

Benefits of buying a bonds

Provide higher interest than bank saving accounts and fixed deposits-

Investing in a saving account doesn’t seem risky but it is–concerning your money value. Inflation reduces your purchasing power of a currency. In India, the inflation rate of averaged 5.92 percent from the last ten years is increased. So it is your responsibility to invest in securities that grow more than the inflation rate.

Make your portfolio diversified-

Diversifying an investment portfolio is a wise decision that often investors make. Most stocks and real estate are high/medium risk investment and bond carries low risk, so adding a bond to your portfolio is a wise decision to manage your risk.

Provide steady income by paying interest periodically-

The bond pays interest payment over the life of the bond either monthly, semi-annually, or annually.

7 features to know before buying a bonds

These are the key determinates of investors because they determine bond schedule payments.

Issuer: Government, such as India or China; municipals, such as Maharashtra or Punjab and companies, such as Nestle or Britannia are the main issuer of the bonds.

Maturity: Maturity is a specific date on which the issuer is obligated to repay your investment amount.

Coupon rate: The coupon rate is the annual interest of a bond you will get each year until the bond maturity date.

Frequency: It’s important to know at what frequency you will get your interest payment. Annually, semi-annually, quarterly, and monthly are these four types of frequency used by entities. Mostly government, municipals, and corporates pay interest semi-annually.

Principal value: Principal value is the amount that the borrower agrees to repay at the maturity date. This is your bought bond price, also called par value, face value, principal value.

Currency denomination: if you are buying a foreign bond consider checking in which currency you will get interest payment and repay of your investment.

Yield to maturity: altogether interest you will get until maturity of the bond.

The details about each feature are contained in an indenture. An indenture is a legal contract that states bondholder rights, issuer obligations, the form of a bond, and other factors.

Types of Bonds

Different types of bonds are traded in the market or issued by issuers. Let’s look at some of these.

Bond

This is a simple type of bond that is traded on the capital market issue by issuers. To illustrate, a bond with a par value of 10,000 with a coupon rate of 7% and maturity is 10 years might be sold to the buyer for 10,000.

The bondholder is entitled to payment of 7% of the face value or 700 annually over the life of the bond. If an issuer makes interest payments semi-annually so they will pay 350 two times a year.

At maturity, the issuer will repay a bondholder principal and make payments of its last interest.

Zero-coupon bond: As the name suggests, this bond doesn’t make coupon payments rather they issue at discount to their par value and redeem at their original face value.

e.g. a bond of 10,000 face value issue at a discount of 6500, maturity of 5 years, and sold to the investors. Throughout the life of the bond–bondholders don’t get any payment of interest rate however, at maturity bond is redeemed at face value.

The difference between the face value and discount value of the bond is the bondholder’s profit or return on investment.

Convertible bond

Convertible bonds consist of both debt and equity features. It gives rights to the bondholder to convert bonds to the specified number of shares in the issuing company.

It has a low yield relative to a common bond because the conversion of the bond is valuable to investors.

Putable bond

The bondholder has the right to sell the bond before maturity. It has a high price relative to the simple bond and low yield because it is valuable to the investors.

Some bonds may offer sellback of bonds only once or multiple times throughout the bond life.

Callable bond

A callable bond gives the issuer the right to buy back all or part of the bond before the maturity date. The reason to issue a callable bond is to decline interest rates after issuing the bond.

In simple words, the issuer will benefit from refinancing its debt at a low-interest rate. It provides a high yield because the issuer has more benefit in it.

How to invest in bonds?

There are two ways to buy bonds—directly and indirectly.

Ove-the-counter market

Bonds do not trade on exchange rather, it sold by advisory brokerage firms or in the over-the-counter market. Bonds include fees of your advisory to buy or sell on your behalf.

Newly issue bond advisory purchases on your behalf in the primary market.

Afterward its trades on the secondary market among investors. All details of bond contained in the bond prospectus, provided by an investment advisor.

Mutual funds & exchange-traded funds

Mutual funds and ETFs are indirect methods to invest in bonds. They are somewhat the same but with some minor differences.

The major difference is that ETF trade on the stock exchange and mutual funds sell bought and redeemed by the mutual fund company.

Final words

Now you have a basic understanding of bonds– bonds features, benefits, characteristics, types, and how you can invest in bonds. It’s all up to you now which type of bond to choose. I hardly recommend choosing a bond based on your risk tolerance and time horizon is the best decision you can make.

If you still want to know more about bonds and other types of investments you should follow this blog to learn about them.

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