What are Bonds and How Do They Work?
Looking for a short answer? A bond is a loan. It comprises of fixed coupon payment along with interest on the principal amount that was paid to the Company or Government.
In the previous blog, we examined which can be the best suitable investible option for you when it comes to debentures Vs shares. In this post, we would try to explore more about bonds.
What is a Bond?
A bond is a fixed-income security that represents a loan given to a borrower by an investor. A bond is a kind of loan given by the investor to the company issuing the bond and the bond includes loan terms and conditions.
The bonds are generally issued to raise funds for an existing project or expansion. Once they start earning from the project they try to repay the bondholders and clear off the debt. Bonds are units of corporate debt issued by companies and securitized as tradeable assets. In doing so the company doesn't give away its equity ownership like in the case of shares.
Now obviously as an investor why would you purchase a bond, the answer is simple. Risk-averse individuals can choose to invest in bonds. As they pay higher interest than CD (certificate of deposit) and also are not as risky as investing in the stock market.
Bond Issuer Vs Bond Holder
The issuer of the bond can be either corporate or government. On the other hand, the investor can either be an individual, HNI (High Networth Individual), corporate or government. These investors are called bondholders and the company issuing them is called a bond issuer. The bondholder is promised a fixed periodic coupon payment along with the repayment of the borrowed principal amount on maturity.
How do Bonds Work?
Bonds are issued at an issue price which can be high or low. Bonds have a face value which is the amount to be paid on the end date. It consists of coupon rates (interest rates) and coupon dates (dates on which the investor will receive interest). The end date on which the principal of the loan must be paid to the bond owner, as well as the terms for the borrower’s variable or fixed interest payments, are normally included in the bond specifics. However, it is not necessary to keep the bond till the date of maturity (one can sell it in the market when they want). This is especially done when the price of a bond increases to get immediate profit.
Bond prices fluctuate depending on the interest rate in the market and hence it can sometimes pay good money and sometimes not. Also, interest rates of bonds depending upon the credit score and reputation of the company. The more the risk involved in a bond’s price, the higher the interest investors will get and vice versa. These Bonds with higher interest rates with low credit score also come with the highest probabililty to default and are called as junk bonds.
Kinds of Bonds
Bonds come with options. There are convertible bonds. With these bonds the bondholder gets the option of converting the bonds into shares on maturity. This gives the opportunity to the bondholder to participate in the success of the company enjoy the price appreciation if the share prices increase. The investor or bondholder has the choice here.
Then there are callable bonds which can be called back by the company before maturity. This is done by the company if they are earning great profits and don’t want to pay interest anymore. Company calling the bonds depends upon the interest rate and the price predetermined. For eg. at 103 price, company will call the bond back. This is done by the company to avoid the steep fall in interest rate. But they ensure the investor gets the Principal amount properly hence it's amazing for mid-term investments. Unlike convertible bonds the issuer is in charge when it comes to callable bonds.
Just like callable bonds, there are also puttable bonds. These are generally the same as callable bonds. The only difference is here the bond owner can sell the bond back to the company before maturity if they don’t want to wait longer. Again the bondholder has the option here
There are also zero-coupon bonds. These bonds don’t pay back any interest. However, people here earn from the rise and decline in the prices of bonds. Then there are premium bonds and discount bonds depending upon their issue price.The above bond’s features, terms, and conditions may change depending on the company to company.
Diversification of Your Portfolio
Diversification is not putting all the eggs in one basket is always. having invested in bonds candiversify your portfolio and give you a steady income over the period of time which is more stable and guramnteed in nature. Thougth there is a possibility of default but its not as high as incurring a loss in the stock market. Hence it's essential to have complete knowledge before buying any bond.
We will soon come up with another blog with the motive to simplify your financial life! Till then happy learning.