How Does a Bond Work?

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The financial markets in India are not simply restricted to the stock market. Beyond stocks, there are many other financial instruments that you can choose from to diversify your portfolio. Bonds are among these options. They are debt securities that carry much lower risk than stocks, making them essential for portfolio risk reduction.  However, before you invest in bonds, you need to know what they are, the types they come in and how bonds work in general. This, in turn, will make it easier for you to understand how bond trading works and make informed decisions about participating in the bond market.

In this article, we’ll take a closer look at how bonds work and the other key details you need to know about them.

What is a Bond?

A bond is a debt instrument that is issued by an entity to an investor. The purchase value of the bond is essentially a loan that the investor offers the issuing entity. In other words, it signifies a debt taken on by the bond issuer. This is why bonds are categorised as debt instruments. 

In return for this debt, the borrower (or the bond issuer) pays the lender (or the investor) interest at periodic intervals. The rate and frequency of interest payments are determined by the terms of the bond issue. Since these payments are guaranteed and predefined, bonds are considered to be relatively safer than stocks. 

Also Read: Different Types of Bonds Explained

How Do Bonds Work?

Although many interested investors find it easy to understand the meaning of bonds, they may not easily comprehend how bonds work. If you are also unfamiliar with the features of bonds and how they work, let’s break down the key components of these securities. 

  • Face Value

The face value of a bond, also known as its par value or principal, is the amount that the investor will receive at maturity. Typically, the par value is the purchase price that you have to pay. However, in some cases (as with zero coupon bonds), the purchase price and the par value are different, as you’ll see. 

  • Coupon Rate

The coupon rate is the rate at which the bond issuer pays interest to the investor. The coupon rate is calculated on the face value of the bond rather than its market price or current price. These rates can be fixed or floating. 

  • Maturity Date

The maturity date is the date on which the bond issuer will have to repay the par value of the security to the investor. In other words, this is simply a repayment of the principal. After a bond matures, investors will no longer receive interest or coupon payments. 

This sums up the fundamentals of how bonds work. To give you more clarity on the subject, let’s discuss an example. 

Say you purchase a bond with a face value of Rs. 1,00,000 with a 5-year maturity date and a 6% coupon rate per annum. This means the bond will pay you Rs. 6,000 per year for 5 years. At the end of the 5-year period, you will receive the face value of Rs. 1,00,000. This is how most bonds work — by distributing the coupon payments throughout the lifetime of the bond and repaying the principal at maturity. 

Different Types of Bonds 

To get more insights into the bond market and how bond trading works, you need to be aware of the different types of bonds. These debt securities can be classified based on different criteria as outlined below. 

Types of Bonds Based on the Issuing Entity

Depending on the nature of the entity that issues a bond, you can find two types of securities — government bonds and corporate bonds. 

  • Government Bonds

Government bonds are debt securities issued by the central and state governments to raise funds for different kinds of public expenditure. They are considered to be extremely low-risk securities because they are backed by the sovereign guarantee. The interest rates on these bonds are generally lower than those of corporate bonds. 

Additional Read: Sovereign Gold Bond

  • Corporate Bonds

Corporate bonds are debt instruments that are issued by corporate entities. These corporate entities could be banks, financial institutions or other publicly listed companies. The level of risk varies from one corporate bond to another depending on the creditworthiness of the issuing entity. Broadly, however, corporate bonds carry higher coupon rates and more risk than government bonds. 

Types of Bonds Based on the Interest Rate

The manner in which the interest rate is levied also varies among bonds. Based on this, we have fixed and floating rate bonds. 

  • Fixed Rate Bonds

As the name indicates, the coupon rate in fixed rate bonds is fixed beforehand. When you invest in these bonds, you know exactly how much interest you will earn until bond maturity. On the flip side, the interest rates remain the same even in a booming economy, so you cannot benefit from the economic growth. 

  • Floating Rate Bonds

Floating rate bonds have variable coupon rates that are linked to economic benchmarks like the repo rate. The coupon payments also vary depending on the changing market rates. Due to the uncertainty involved, floating rate bonds are riskier than fixed rate bonds. This is why they are only suitable for investors with a slightly higher appetite for risk. 

Types of Bonds Based on the Structure

Bonds can also be structured in different ways. Based on this parameter, we can identify two types of bonds that deviate from the typical structure of how bonds work.

  • Zero Coupon Bonds

As is evident from the name, zero coupon bonds do not offer any coupon or interest payments during the bond’s lifetime. Instead, these bonds are issued at a discount to the face value. Thereafter, at maturity, these bonds are redeemed at their face value. The difference between the issue price and the face value is the benefit the investor earns. 

  • Convertible Bonds

Convertible bonds are debt securities that can be converted into the stocks of the issuing company after a given period of time. The terms and conditions of the conversion may vary from one entity to another. However, the essence remains that these securities combine the features of bonds and stocks. 

Advantages and Limitations of Bonds

While you may now be clear about the different types of bonds and how they work, you can broaden your understanding of the subject by learning about the key advantages and downsides of these instruments. They include the following. 

Advantages of Bonds

  • They offer a stable income 
  • The income is known beforehand (except in the case of floating rate bonds)
  • They help reduce the overall portfolio risk
  • They are easy to purchase and sell

Limitations of Bonds 

  • They are vulnerable to inflation risks
  • They may not be ideal for short-term investment 
  • They offer lower returns than potential stock market returns

Conclusion

The bottom line is that bonds have many beneficial features for different kinds of investors. Once you understand how bonds work and what their key features are, you can create a plan to include these debt securities in your portfolio. 

If you are a conservative investor, the guaranteed returns on these instruments align with your risk tolerance levels. On the other hand, if you are an aggressive investor who is willing to take on more risk, you can make use of bonds to bring some stability to your overall portfolio. 

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