A Comprehensive Guide to Understanding Bonds

A bond is a type of debt security that represents a loan made by an investor to an organisation (typically a corporation or government). The organisation (issuer) agrees to pay periodic interest payments (coupons) and return the face value of the bond (principal) at maturity.

Bonds are used as a way for issuers to raise capital for various purposes, such as financing business operations, funding infrastructure projects, or supporting government programs. Investors who purchase bonds receive a fixed stream of income in the form of interest payments and expect to receive the return of their principal investment at maturity.

Bonds are considered relatively low-risk investments compared to stocks but also typically offer lower returns.

In addition to providing a fixed income stream, bonds can be traded on financial markets, making them a versatile investment option.

Investors can hold bonds until maturity or sell them prior to maturity, potentially realising gains or losses based on market conditions and the creditworthiness of the borrower.

Types of Bonds

Government Bonds: These bonds are issued by the Indian government to finance its various programs and projects. They are considered the safest form of debt investment and generally offer lower returns compared to other types of bonds. Government bonds are highly liquid and are widely traded on the stock exchanges in India. Examples of government bonds in India include the 7.75% 2022, 8.20% 2030, and 7.80% 2031 bonds issued by the Indian government.
Municipal Bonds: These bonds are issued by local governments, such as cities and municipalities, to finance infrastructure projects. They offer investors the opportunity to invest in the development of their local communities and earn a fixed income from their investment. Municipal bonds are considered to have a lower credit risk compared to corporate bonds and are often tax-free. Examples of municipal bonds in India include the Mumbai Municipal Corporation Bonds and the Delhi Municipal Corporation Bonds.
Corporate Bonds: These bonds are issued by companies to raise capital for business operations, expansion, or other purposes. Corporate bonds offer higher returns compared to government bonds but also come with higher credit risk. The creditworthiness of the issuing company and its ability to repay its debts can impact the value of corporate bonds. Examples of corporate bonds in India include the bonds issued by companies such as Tata Steel, Reliance Industries, and HDFC Bank.
Tax-free Bonds: These bonds are issued by public sector undertakings (PSUs) and municipal bodies that offer tax-free interest income to investors. They are a popular choice among investors looking to minimise their tax liability and earn a stable income. Tax-free bonds are considered to have a moderate credit risk and offer moderate returns. Examples of tax-free bonds in India include the bonds issued by public sector undertakings (PSUs) such as the Indian Railways Finance Corporation (IRFC) and the Housing and Urban Development Corporation (HUDCO).
Infrastructure Bonds: These bonds are issued by infrastructure development companies and other organisations involved in infrastructure development. They offer investors the opportunity to invest in the growth and development of the Indian infrastructure sector and earn a fixed income from their investment. Infrastructure bonds have a higher credit risk than government bonds but also offer higher returns. Examples of infrastructure bonds in India include the bonds issued by infrastructure development companies such as the National Highways Authority of India (NHAI) and the Power Finance Corporation (PFC).
Floating Rate Bonds: These bonds have a floating interest rate that adjusts based on changes in a benchmark interest rate, such as the Reserve Bank of India’s policy rate. They offer investors the ability to benefit from rising interest rates and have a lower credit risk than fixed-rate bonds. Examples of floating rate bonds in India include the bonds issued by financial institutions such as State Bank of India (SBI) and Housing Development Finance Corporation (HDFC).
Masala Bonds: These are rupee-denominated bonds issued by Indian entities and targeted at international investors. They offer international investors the opportunity to invest in the Indian bond market and earn a fixed income in rupees. Masala bonds are considered to have a moderate credit risk and offer moderate returns. Examples of masala bonds in India include the bonds issued by Indian entities such as the National Highways Authority of India (NHAI) and the Housing Development Finance Corporation (HDFC).
Green Bonds: These bonds are issued to finance environmentally-friendly projects, such as renewable energy or clean transportation. They offer investors the opportunity to invest in projects that contribute to a sustainable future and earn a fixed income from their investment. Green bonds are considered to have a moderate credit risk and offer moderate returns. Examples of green bonds in India include the bonds issued by organisations such as the Indian Renewable Energy Development Agency (IREDA) and the State Bank of India (SBI)

How bonds are issued and traded

Bonds are typically issued through a formal process called underwriting, where an investment bank acts as an intermediary between the issuer and investors. The underwriter helps the issuer determine the terms of the bond offering, such as the coupon rate, maturity date, and face value. The underwriter also assumes the risk of not being able to sell all of the bonds to investors and may purchase any unsold bonds for its own portfolio.

Once the bond offering is complete, the bonds are then made available for trading on financial markets, such as stock exchanges or over-the-counter (OTC) markets. In these markets, bonds are bought and sold between investors, and the price of a bond can fluctuate based on market conditions and the issuer’s creditworthiness.

Factors such as changes in interest rates, the creditworthiness of the issuer, and overall market conditions can influence the price of a bond. When interest rates rise, the prices of existing bonds tend to fall as investors demand higher yields to compensate for the increase in interest rates. Conversely, when interest rates fall, the prices of existing bonds tend to rise as their fixed coupon rates become more attractive relative to new bonds with lower coupon rates.

When an investor wants to purchase a bond, they can do so through a broker, similar to purchasing stocks. The investor pays the bond’s market price at the time of purchase, which may be higher or lower than the bond’s face value. The investor then receives periodic coupon payments until the bond matures, at which time they receive the face value of the bond.

Bond pricing and yield calculations

Bond pricing refers to the process of determining the market value of a bond based on various factors such as interest rates, coupon rates, maturity date, and the issuer’s creditworthiness. The market price of a bond can fluctuate over time as these factors change. For example, if interest rates rise, the demand for bonds with lower coupon rates may decrease, causing the price of these bonds to drop. Conversely, if the creditworthiness of the issuer improves, the demand for their bonds may increase, causing the price of these bonds to rise.

Bond yield refers to the return that an investor receives from a bond investment, expressed as a percentage of the bond’s face value. There are several ways to calculate bond yield, including:

Coupon yield: This is calculated as the coupon payment divided by the bond’s face value. For example, if a bond with a face value of Rs. 10,000 pays a coupon rate of 8% per year, the coupon yield would be Rs. 800 divided by Rs. 10,000, or 8%.
Current yield: This is calculated as the coupon payment divided by the bond’s market price. For example, if a bond with a face value of Rs. 10,000 pays a coupon rate of 8% per year and is currently trading at a market price of Rs. 9,000, the current yield would be Rs. 800 divided by Rs. 9,000, or 8.9%.
Yield to maturity (YTM): This is the total return expected from a bond if the investor holds it until maturity, including both the periodic coupon payments and the appreciation or depreciation of the bond’s price. Yield to maturity is expressed as an annual rate and is considered the most comprehensive measure of a bond’s yield. For example, if a bond with a face value of Rs. 10,000 pays a coupon rate of 8% per year and is currently trading at a market price of Rs. 9,000, the yield to maturity may be higher or lower than the current yield, taking into account the potential appreciation or depreciation of the bond’s price until maturity.

It’s important to note that bond pricing and yield are interdependent, as changes in one can impact the other. For example, if the market price of a bond decreases, its yield will increase, and vice versa. This relationship is known as the inverse relationship between bond price and yield.

Interest payments and maturities

Interest payments on bonds are typically made at fixed intervals, such as semi-annually or annually, and the amount of the payment is determined by the bond’s coupon rate. For example, if a bond has a face value of Rs. 10,000 and a coupon rate of 8%, the interest payment would be Rs. 800 per year.

Maturity refers to the date on which the bond’s face value becomes due and payable to the bondholder. At maturity, the bond issuer repays the bond’s face value, assuming that the issuer is able to fulfil its obligations. The length of time until a bond matures is referred to as the bond’s term or tenor, and bonds with longer terms typically offer higher coupon rates as compensation for the longer period of time that the bondholder’s funds are being lent.

Credit risk and ratings

Credit risk refers to the possibility that a bond issuer may default on its obligations to make interest payments or repay the bond’s face value at maturity. This risk varies based on a number of factors, such as the issuer’s financial stability, the stability of its industry, and macroeconomic conditions.

To help investors assess this risk, credit rating agencies like Moody’s, S&P Global, and Fitch Ratings provide credit ratings for bonds. A credit rating is a formal evaluation of the issuer’s creditworthiness and ability to fulfil its obligations and typically ranges from “AAA” (high creditworthiness) to “D” (in default). For example, a company with a AAA rating is considered to have a very low credit risk, while a company with a B rating is considered to have a higher credit risk.

When investing in bonds, it’s crucial to consider the credit rating of the bond, as well as other factors such as the bond’s coupon rate, maturity, and the issuer’s financial condition. Higher-rated bonds generally carry lower credit risk but may offer lower yields compared to lower-rated bonds. On the other hand, lower-rated bonds may offer higher yields but carry a higher risk of default.

For instance, consider a bond issued by Company A with a AAA credit rating and a 5% coupon rate and another bond issued by Company B with a B credit rating and a 7% coupon rate. Although Company B offers a higher yield, its higher credit risk means that there is a greater likelihood that the company may default on its obligations, leading to potential losses for the bondholder.

It’s important to note that credit ratings are not a guarantee of the bond’s creditworthiness and can change based on changes in the issuer’s financial condition or economic conditions. As such, investors should regularly review the credit ratings of their bond holdings and seek the advice of a financial advisor when making investment decisions.

Taxation of Bond Income

In India, the taxation of capital gains on bond investments depends on the holding period of the bonds and the type of bond.

For resident individuals, short-term capital gains on bonds are taxed as per the applicable income tax slab, while long-term capital gains on bonds are taxed at 20% after indexation.

Indexation is a method used to adjust the cost of investment for inflation, which helps to reduce the tax liability on long-term capital gains from bonds. It is a method of adjusting the original cost of investment to its equivalent value in the year in which the capital gains are realised, based on the Consumer Price Index (CPI).

For example, consider an individual who purchased a bond for Rs. 100,000 in January 2015 and sold it for Rs. 120,000 in January 2023. If the CPI for January 2015 is 100 and the CPI for January 2023 is 150, then the indexed cost of investment would be calculated as follows:

100,000 * (150/100) = Rs. 150,000

So, the long-term capital gain would be calculated as:

120,000 – 150,000 = -30,000

As the indexed cost of investment is higher than the sale price, there would be no long-term capital gain in this case and hence no tax liability.

For non-resident individuals, short-term and long-term capital gains on bonds are subject to withholding tax at the rate of 20%, subject to tax treaties.

It’s important to note that these rules are subject to change, and investors should seek the advice of a tax advisor for the most up-to-date information on the taxation of capital gains on bond investments.

Market dynamics affecting bond prices

Interest Rates: Bond prices have an inverse relationship with interest rates. When interest rates rise, bond prices fall and vice versa. For example, consider a bond with a coupon rate of 5% and a face value of Rs. 100. If interest rates rise to 6%, then the bond’s yield will increase to 6%, making it less attractive to investors. As a result, the bond price may fall to a level that will bring its yield in line with the current interest rate.
Inflation: Inflation expectations can also affect bond prices. High inflation expectations can lead to lower bond prices as investors demand higher yields to compensate for the eroding value of their investments. For example, if inflation is expected to be 4% and a bond has a yield of 3%, the real yield would be negative, making it less attractive to investors. As a result, the bond price may fall.
Economic Growth: Economic growth can also impact bond prices. Strong economic growth may lead to higher inflation expectations, which can lead to lower bond prices. For example, if the economy is growing rapidly and inflation is expected to rise, investors may demand higher yields on bonds, which could lead to lower bond prices.
Credit Risk: The creditworthiness of the issuer can also affect bond prices. If the issuer’s credit rating is downgraded, it increases the perceived risk of default, which can lead to lower bond prices. For example, if a bond issuer’s credit rating is downgraded from AAA to AA, it may signal to investors that there is a higher risk of default, which could lead to a decrease in the bond price.
Supply and Demand: The bond market is also affected by supply and demand dynamics. An increase in the supply of bonds or a decrease in demand for bonds can lead to lower bond prices. For example, if there is an oversupply of bonds in the market, bond prices may fall as investors sell off their holdings to find buyers.

How Indian investors can invest in bonds

Government Bonds: The Indian government issues bonds through the Reserve Bank of India (RBI) for fixed tenures ranging from 2 to 30 years. These bonds are considered to be one of the safest investment options in the country as they are backed by the government. Indian citizens can invest in government bonds directly or through their bank or a broker.
Corporate Bonds: Indian companies also issue bonds to raise funds. Investors can invest in corporate bonds directly by purchasing them on the stock exchange or indirectly through a bond fund. Corporate bonds offer higher returns than government bonds but come with a higher credit risk as they are not backed by the government.
Bond Funds: Bond funds are mutual funds that invest in a diversified portfolio of bonds. These funds are managed by professional fund managers, who make investment decisions based on market conditions, interest rate trends, and credit quality of the bonds held in the fund. By investing in bond funds, investors can benefit from diversification and professional management, reducing the risk associated with investing in individual bonds.
National Pension System (NPS): NPS is a pension scheme for Indian citizens that allows investors to accumulate savings for their retirement years. NPS invests in a mix of equity and debt, including government and corporate bonds. NPS is considered to be a long-term investment option and can be a suitable choice for investors who want to build a retirement corpus.