Bond Definition: How do Bonds Work | Types of Bonds

What Are Bonds? | How Do Bonds Work?

5 Min Read |  April 01, 2021

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Once you hear the term ‘bond’ I am sure many of you would think about the series of spy movies starring the famous fictional character James Bond.

Well, sorry to pause your imagination but the term bond implies a different meaning in the investing world.

Anyone with even the basic knowledge about ways of investment must have heard that one should have a balanced investment portfolio that includes both bonds as well as stocks.

But, why so?

What are bonds?

What are the types of bonds?

How do bonds add value to your portfolio?

What is a bond safe investment?

To everything about bonds and their importance in a portfolio, keep reading!

Bond Definition: How do Bonds Work? 

The popularity of stocks is undoubtedly more than bonds but you would be surprised to know that globally, the bond market is bigger in terms of market capitalization as compared to the equity market.

As an investor, every individual has different acceptability of the risks involved with all kinds of investment product. To many investors, stock markets offering high risk and return is attractive, then there are other investors who would choose bonds that belong to a fixed income asset class.

In the end, the choice is yours as to how you want your investment portfolio to be.

Let us now dive right in and understand, what are bonds!

Bonds are those investment products that are categorised as debt instruments. In the finance sector, it denotes a loan given by the investors to the borrower. In simple terms, whenever an investor lends money to government entities, companies (for funding expansion or launch of new products), states (for funding future projects) in exchange for an interest income, is termed as a bond. 

Please note that the money lent by the investors is for a set period of time and once the bond reaches maturity, the money is returned to the concerned investors.

Are you wondering why the term ‘fixed income’ is mentioned in the definition of bonds?

Well, this is simply because whatever the investment you make in the bonds, in return you receive a regular interest payment until and unless the bond reaches its maturity.

Risks Involved with Bonds

Risks Involved With Bonds

Yes, the bonds are relatively safer investment options as compared to equity and let me make it clear that they are not risk-free. They come with their set of certain risks which are mentioned as follows:

  • There can be instances where the company that issues the bonds might not pay back the principal amount when the maturity is attained.
  • The bond yields are flexible in nature as they fluctuate as the bond prices change.

Bond Terminology: Basic Terms You Must Know

Before we get on with the types of bonds that exist in the market, it is important to understand basic terms related to bonds. Have a look at them one by one.

Bond Yield

Bond yield is nothing but the rate of interest on the bonds. A bond yield is variable in nature and it depends majorly on the price of the bonds in the secondary market.

Coupon

A coupon is the payment of annual interest paid to the bondholders on the annual basis. The coupon is paid on either a monthly, quarterly, bi-annually or annual basis until the maturity of the bond.

A coupon is fixed whereas bond yield is not fixed, so do not get confused between these two terms.

Bond Issuer

The bond issuer (or borrower) is the company or any government entity, that sells the bonds to the interest investors and in return raises funds to fulfil its financial needs. Therefore a bondholder is a  lender who gives money to the bond issuer.

Maturity

Whenever any company or government issues bonds, they agree to return the principal amount to the bondholder/investor on a pre-decided date. This pre-defined date is trimmed and the maturity of the bond. After maturity, the bondholder will not receive any interest payments.

Face Value

The face value is defined as the worth of the bond when it reaches maturity. Further, the face value of any bond serves as the basis for calculating the interest payments that are to be paid to the bondholders.

Market Value

The market is defined as the current value at which it is either bought or sold in the market. The market value depends on the prevailing economic condition and value of the bond issuer in the market.

Types of Bonds

Now that you have acquainted yourself with the definition, risks and basic terminologies with regards to bonds, it is time to see the main types of bonds that exist in the Indian market.

So, hop on and keep reading!

Types of bonds

Traditional Bonds

The traditional bonds are those bonds in which the bondholders have the option to withdraw the principal amount in a single go after it matures.

Fixed Return Bonds

The bonds in which the coupon rate remains the same until the maturity of the bond is reached, are termed as fixed return-bonds.

Floating Rate Bonds

Unlike fixed return bonds, the bonds in which the coupon rate keeps changing through the time period of investment, are termed as floating-rate bonds.

Callable Bonds

The bonds in which the issuer of the bond exercises its right to redeem the bond before the maturity date, are termed as callable bonds. As the term ‘callable’ denotes, the bond issuer chooses to call out its right of redeeming the bonds.

Puttable Bonds

Just like with callable bonds, the bond issuer has the right to redeem the bond before it matures, puttable bonds give the power of redeeming into the hands of the bondholders/investors.  Therefore, whenever the bondholder decides to sell his/her bonds before the maturity date, then the bonds are termed as puttable bonds

Mortgage Bonds

The bonds that are issued by securities like real estate firms are termed as mortgage bonds. These bonds can also be called as asset-backed securities when the bonds are issued by any financial institution or banks. 

Zero-Coupon Bonds

As the name suggests, the bond that comes with a zero-coupon rate and the bond, the issuer has to pay back only the principal amount to the bondholder after the maturity date is termed as zero-coupon bonds. 

Extendable Bonds

The bonds that come with the flexibility of extending the maturity date are termed as extendable bonds. The option of extending the maturity date lies with the bondholder or investor.

Inflation-Linked Bonds

Whenever the economy faces inflation, the purchasing power of investors automatically reduces due to rising prices. Under such conditions the bonds that are used to protect the investors from the ill-effects of inflation are termed inflation-linked bonds.

Convertible Bonds

The bonds that allow the investor or bondholder to swap his/her debt into stock (equity) during the entire time period of investment is termed as convertible bonds.

Important Takeaways

Two bonds that are most common and popular among the Indian investors’ community are defined as follows.

Government Bonds

The bonds that are issued by either state or central government in order to collect funds (for infrastructure development, upcoming projects, etc) are termed as government bonds. The involvement of government authority makes it one of the safest bonds for investors through which you can earn regular interest payments.

Corporate Bonds

The bonds issued by companies in order to fulfil their financial needs are termed as corporate bonds. These bonds come with credit risk but they tend to pay relatively higher interest as compared to your bank FDs as well as government bonds.

What Role do Bonds Play in a Portfolio?

If you wish to have a balanced portfolio then bonds are one of the important components to add. A properly - fabricated bond portfolio not only gives you a  regular passive income but brings about diversification because it is less volatile as compared to asset classes like stocks.

Apart from giving a balance to your portfolios let us understand the role of bonds in a portfolio.

Generates Income

As you must have understood by now, bonds tend to provide a regular income source and it is in the form of coupons. The payment is made either quarterly, bi-annually or annually. The investor can use this coupon payment either for re-investment or for fulfilling his/her financial goals.

Acts as a Hedge Against Slowdown in the Economy

Generally, the investors who have invested in the stock market, do not really wish to see an economic slowdown as it affects their investment. But, if you talk about the bondholders then economic slowdown is rather an amicable thing for them.

You must be wondering, how?

Am I right?

Well, an economic slowdown implies low inflation and lower inflation proves to be good bond income.

Enables Capital Preservation

For those of you who are wondering how a bond helps in capital preservation, let me break it down for you!

Whenever you invest a principal amount in bonds you know you would get in back at the time of maturity. On the other hand, when you invest in stocks there is absolutely no guarantee that you would get back the initially invested amount. So, if you are worried about losing your capital while investing, go ahead with investment in bonds where you get back the principal amount.

Conclusion

Bonds are known to be a crucial source of capital preservation and appreciation in the investing world, especially for people who are retired from their jobs.

Unfortunately, the popularity of bonds is fading with time, rather it is being overshadowed by stocks.

But, investors must not forget the fact that bonds still come with many features for better portfolio management. Bonds have the ability to act as the bedrock for all your investment strategies.


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