What are bonds? Basic understanding of bonds.

Bonds 26 December 2020 5:54:PM

Hello Readers, In today's blog we will be learning about the Bonds. As bonds historically pay a fixed interest rate (coupon) to debt holders, a bond is referred to as a fixed income instrument. Also, variable or floating interest rates are very prevalent now. Let's take a deep dive to understand what are bonds?

Bonds in India.

A bond is an agreement between the Issuer and an Investor, where the issuer agrees to pay interest on the face value of the bond for a specified period of time. The issuer can pay interest on the bond either annually; semi-annually; monthly or in cumulative nature as per the specified terms when the bond is issued. Therefore, it is rightly classified as the Fixed Income Product which carries a fixed rate of interest for a specified period of time.

Features of Bonds

Nomenclature.
Par-Value.
Coupon.
Maturity Value & Date.

Bonds – Classification:

Government Bonds
Corporate Bonds

Government Bonds or Securities:

To meet their fiscal deficit the Central and State Government issue Central Government Securities; Treasury Bills and State Development Loans as per the plan and which is being managed by the Reserve Bank of India. These instruments are categories as a “Sovereign Bonds” and are risk-free.

Central Government Securities are issued for a period of 2 to 40 years and basically classified as Long-Term Bonds whereas the Treasury Bills are Money Market Instruments are issued for a period of 91; 182 & 364 Days currently. State Development Loans are too long-term bonds and issued by the various states of the country to meet their fiscal deficit.

What are Corporate Bonds:

These bonds are issued by the PSU corporates; Private Corporates; Nationalized Banks or Private Banks or NBFCs from time to time to meet their capital requirement. These bonds are issued in either form.

Taxable Bonds
Tax-Free Bonds
Perpetual Bonds
Zero-Coupon Bonds
Floating Rate Bonds
Capital Gain Bonds (Benefit u/s 54EC)

Corporate Bonds are measured and priced in both Primary and Secondary Market on basis of the “Rating” assigned by the different rating agencies in the country like CRISIL; CARE OR ICRA. The bonds carry the highest rating “AAA” considered to be the safest and priced accordingly. The Tax-Free Bonds are highly demanded in the market by the corporates; HNI & Retail Investors as the interest receivable on these bonds are Tax-Free and mostly all the Tax-Free Bonds carry highest rating AAA and are issued by the PSU corporates like National Highway Authority of India Ltd (NHAI); Rural Electrification Corporation (REC) etc. Perpetual bonds do not have a specified date of maturity. The issuers can buy back the bonds after a certain period, and it is generally five years or 10 years. Like other bonds, these bonds are also listed on the stock exchanges and provide exit opportunities to the Investors. Zero-coupon bonds are issued at discount and redeemed at par for example NABARD has issued many Zero-Coupon Bonds which has a face value of Rs.20,000 and issued at a discounted price of say Rs.8,000 for a period of 10 years. In Floating Rate Bonds, the interest rate is not fixed it keeps on changing throughout the maturity of the bonds as per the prevailing interest rates in the banking system. These bonds are best when interest rates are bottoming out and an investor will get the higher interest if interest rates move up in the system and the best example of such bonds are RBI Floating Rate Bonds which are linked to the interest rates of the National Saving Certificate (NSC) + 35 bps and are issued for a period of 7 years and interest is paid semi-annually. Through Capital Gain Bonds an investor can save tax if he or she has sold some property or any assets. These bonds get benefit under section 54 EC of the Income Tax Act.

How and where to invest in bonds:

Initially, bonds are issued either through Private Placement or Primary Issuances, and after allotment, the bonds are listed on the exchanges either NSE or BSE or both in the secondary market.

What determined the Price of the Bonds?

Bonds are inversely related means if interest rates go up in the banking system the prices of the bonds fall and vice versa. But the coupon of the bonds remains the same throughout the tenor of the bonds if it is not a floating rate bond. Let’s take an example, suppose the Government of India issued 10 years Central Government Security at a coupon of 5.85% at Par means Rs.100 (5.85% GOI 2030) and currently the repo rate set by the RBI MPC is at 4% and one year down the line if repo rate moves up by 50bps to 4.50% the price of the bond which is issued at PAR at a coupon of 5.85 will trade in the secondary market at a discount and the YIELD on this bond will be higher from the coupon rate 5.85% and if interest rates fall by 50 bps to 3.50% the price of this bond will be higher than the Par and Yield will be lower than the coupon rate.

Ideal Investment for an Investor in Fixed Income Asset Class

At the current juncture, we strongly recommend investing in the RBI Floating Rate Bonds because of the following reasons.

Issued by the Reserve Bank of India on behalf of the Government of India
Risk-Free Investment as no chance of default
Interest Payable Semi-Annually
Interest Rate or Coupon is Floating in nature and linked to NSC.
Interest rates are very near to bottoming out and if Interest rates move up the Investor will get the benefit of the same by a higher coupon rate.

The only disadvantage of this instrument has a lock-in period of 7 years. Like other bonds, these bonds are not tradable and not having an exit route before a maturity period of 7 years.

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