Bond, the Money Bond

Financial market is a place where you can explore opportunities not only to multiply your savings, but also to protect it. Even as there are financial risks associated with the market, there are guiding principles, if followed, can navigate you as an investor to create wealth with safety.

One of the major playing arenas for the investors is the capital market – a market for equity and debt (bonds). This is the market where a company and government can raise funds for their activities – to expand a line of business or enter into a new business, or for other capital projects – on long-term basis.

Companies may decide either to raise money by issuing equity on the stock market or may issue debt in the form of corporate bonds. Similarly, governments may issue debt in the form of government bonds. Notably, governments do not usually issue equity.

Within the capital market we have primary market and secondary market. When a company or a government first time places its securities in the market for sale, then the market is known as the primary market. Contrary to this, when the securities, equities or debt instruments are already available in the market and are being traded, then the market is known as the secondary market.

The capital market is a part of financial markets which also covers money market. The money market is yet another wing of the financial market where funds are raised on short-term basis through debt securities like treasury bills, commercial papers, etc. Main players in money markets include banks among others. The companies mostly take route of money market money on daily basis to strike appropriate level of liquidity ‘without falling short and needing a more expensive loan or without holding excess funds and missing the opportunity of gaining interest on funds.’

On the other hand, risk-adverse investors capitalise on the readily-available liquidity feature of the money market to minimize their risk. The money market is considered a low risk and safe parking place for investment. Precisely, market experts consider money market a good place to invest funds that are needed in a year or less period.

Meanwhile, from economic point of view, development of a country is reflected through development of its securities market. We all know, production plays a vital role for the revival and conducive growth in any economy. Production of output depends upon material inputs, human inputs, and financial inputs. The proper synchronization of these inputs encourages the economic growth process and this leads to the well-being and improved standard of living of people. It’s here the investors in the securities form backbone of the economic development of a country.

Coming back to the capital market, we find heterogeneous people in terms of their investment capacity, knowledge of the market and risk tolerance as players in the market. They trigger the activities of the market based upon their confidence, based on growth of their wealth and anticipated capital appreciation from their investment.

Notably, an investor should keep three basic things in mind while entering into the financial market: safety of the money invested, to get the money back as and when required (liquidity) and highest return on their investment.

What are bonds?

Before explaining the meaning of a bond, let me tell you something about an abbreviation -‘IOU’. In phonetic terms, it’s “I owe you.” Investopedia defines ‘IOU’ as an informal document that acknowledges a debt owed. The debt owed does not necessarily involve a monetary value but can also involve other products. With IOUs being informal, those issuing the IOU are given free reign when writing and issuing an IOU. Things like time, date, interest, and payment type are not mandatory but may be implied.

Experts call a bond simply as an ‘IOU’ in which an investor agrees to loan money to a company or government in exchange for a predetermined interest rate for a pre-determined length of time.

A company needs funds to expand its existing business or to foray into new markets. A government may need money to raise infrastructure or run some projects for the benefits of its people. The quantum of money needed is so huge that typically an average bank cannot provide such huge finance. Under these circumstances, the company or the government raise loans from the public by issuing debt instruments and bond is one such debt instrument.
So, the basic thing about a bond is that it is a loan where borrower (company or the government) is the issuer and the lender is the investor. In return, the issuer promises to pay a set amount of interest every year, plus the capital at a set date (maturity date) in the future.

The interest payments are made at a predetermined rate and schedule. By investing in bonds you know the exact amount of cash you will get back while holding it till maturity. And that’s why bonds are known as fixed-income instruments or securities.

On the basis of interest rates, bonds are classified into fixed interest bonds (these are the bonds which carry a fixed rate of interest), floating rate bonds (these are the bonds which have a variable rate of interest) and zero-coupon bonds (there is no interest payment). Notably, zero coupon bonds are offered at deep discounts and therefore are also known as deep discount bonds. However, they are redeemable at the face value itself. Thus, the difference amount between the discounted value and the face value indicates the investor’s return.

What are corporate bonds?

The bonds issued by companies or corporate to raise capital are called corporate bonds. These bonds have a higher rate of interest. These can be secured or unsecured however care should be taken before investing here about the credit ratings given by the credit rating agencies to these types of bonds.

These bonds can be of two types. Convertible bonds: They can be converted into a pre-defined number of stocks as and when required by the investor. Non-Convertible bonds: These are just plain bonds.

What are government bonds?

The bonds issued by Government (State or central government) or Public Sector Undertakings (PSUs) to fund their projects are called government bonds. Also referred as Government securities (G-Sec), these bonds constitute larger portion of the bond market than the corporate bonds. Generally, these bonds are secured and have a low rate of interest.

Notably, the Government of India also floats tax saving bonds for the benefit of investors in saving their taxes. The investors, along with getting regular interest payment also get tax benefits, thus enjoying a dual advantage as compared to the other types of bonds.

What is Sovereign Gold Bond (SGB)?

SGBs are government securities denominated in grams of gold. They are substitutes for holding physical gold. Investors have to pay the issue price in cash and the bonds will be redeemed in cash on maturity. The Bond is issued by Reserve Bank on behalf of Government of India.

The quantity of gold for which the investor pays is protected, since he receives the ongoing market price at the time of redemption/ premature redemption. The SGB offers a superior alternative to holding gold in physical form. The risks and costs of storage are eliminated. Investors are assured of the market value of gold at the time of maturity and periodical interest. SGB is free from issues like making charges and purity in the case of gold in jewellery form. The bonds are held in the books of the RBI or in demat form eliminating risk of loss of scrip etc.

Do banks and other financial institutions issue bonds?

Yes, the banks or any financial institution can issue bonds.  Since the financial market is well regulated, the majority of the bond markets are from this segment.

Does investment in bonds give ownership rights to the investor?

Investment in bonds doesn’t give you ownership rights in a company. When you buy shares of a company, you become an owner of that company. You enjoy voting rights and share in profits. By purchasing bonds, you become a creditor to the company. As a creditor you enjoy higher claim on assets of the company. In the case of bankruptcy you will get paid before a shareholder. However, you as a bondholder are not entitled to share in the profits. Your entitlement is fixed that is, principal plus interest.

Is investment in bonds risk free?

Even as bonds are among the safest investments avenues, they are not risk free. Some of the risks inherent in fixed-income investing include inflation risk, interest rate risk (if rates have risen since you “locked in” your return, the price of the security will fall), default risk (default is the worst thing that can happen to a bondholder), etc. There is downgrade risk also. Sometimes you buy a bond with a high rating, only to find that the credit rating agencies lower their ratings on a bond, the price of those bonds will fall. That can hurt an investor who has to sell a bond before maturity. Liquidity risk and reinvestment risk are other risks associated with bonds. Reinvestment risk means that the bond issuer reserves the right to “call” the bond before maturity and pay off the debt. That can lead to reinvestment risk.

To be precise, there is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.