Types of Bonds and How Do They Work?
Bonds are among the most preferred investment avenues, given the stability and security of the investment they offer. However, bonds are of various types that depend on multiple factors. Besides, every bond functions uniquely. As a potential bond investor, knowing the bond types and their functioning can help you make informed investment decisions. Accordingly, this blog discusses different types of bonds and how they work.
What are Bonds?
Bonds are debt securities denoting a loan borrowed by an organization or a government to meet its objectives. Thus, when a corporation or a government issues a bond, it borrows money from investors and gives periodic interest payments and principal returns. Investors consider bonds fixed-income securities as they usually pay a fixed interest rate over the investment.
Some essential components of a bond include the following.
- Face Value: It is the bond’s principal amount the bondholder. The issuer calculates interest payments on the bond’s face value.
- Issuer: It is the entity that issues the bond. This can be a government (government bonds or treasuries) or a corporation (corporate bonds).
- Maturity Date: It is the date on which the issuer pays the investor their principal amount. Bonds have various terms.
- Coupon Rate: It is the fixed annual interest rate the issuer pays to the bondholder and is typically denoted as a percentage of the bond's face value. On the other hand, the issuer pays interest semiannually or annually.
- Market Price: It is the bond’s price at which it is currently trading in the secondary market. It may differ from the bond's face value, based on interest rate change, market circumstances, and the issuer’s creditworthiness.
- Yield: It is the effective interest rate (in percentage) the investor earns on a bond, considering the bond's current market price.
Types of Bonds
Here are some typesof bonds and an overview of how they function.
Municipal Bonds
State and local governments in India issue municipal bonds. Governments issue these securities to fund public welfare projects, including constructing roads, bridges, schools, and building healthcare elements like hospitals, etc. Municipal bonds have a fixed maturity date and interest rate. Hence, they are a low-risk investment option.
Municipal bonds help investors effectively diversify their investments, and also serve as a source of steady income to the investors.
Now, how do municipal bonds work? Essentially, they are like loans. Municipal corporations issue these bonds when they need funds for public infrastructure construction or upgrades. People investing in municipal bonds lend money to the local government and the latter pays interest with the principal amount.
However, SEBI has certain conditions and guidelines concerning municipal bonds. Some of them include but may not be limited to the following.
- Before issuing the bond, the municipal corporation should not have had a negative net worth in the past three years.
- It shouldn’t have defaulted in repaying debt securities and loans they borrowed from a bank or NBFC in the year before issuing the bond.
- Its group companies, promoters, and directors should not be enlisted in RBI’s wilful defaulters’ list.
Corporate Bonds
These are bonds that companies issue to fund projects, build infrastructure, buy equipment, or expand geographically. They are usually medium to long-term debt instruments and have a maturity period of over a year.
Corporate bonds are beneficial in various ways. They provide potentially higher yields and are low-risk investments. If the company goes bankrupt, bondholders get priority over stockholders. However, it is essential to evaluate the company’s creditworthiness, history of payments, offerings, growth potential, etc., before investing in its bond.
The price of bonds is inversely proportional to interest rates. When interest rates fall, these bonds rise in value. And when the interest rates increase, their value drops. Usually, a longer maturity period refers to a higher price volatility percentage. If you hold the bond until its maturity, you’d be less concerned about price changes. It is called market risk or interest-rate risk. That’s because you will get the bond at face value at maturity.
Perpetual Bonds
Perpetual bonds are another significant form of bonds in India. They are called perpetual as they do not have a maturity date. Perpetual bonds pay interest like all other bonds. However, you won't get the principal back on maturity. Thus, perpetual bonds would keep paying interest forever. Banks and governments issue perpetual bonds.
Some perpetual bonds in India have a call option. It means the issuer can exercise the call option, enabling investors to sell bonds to the issuer. Usually, call option dates are every five or ten years from the bond’s issue date. Besides, perpetual bonds trade on listed stock exchanges. You can sell bonds for liquidity or to address an emergency.
Perpetual bonds pay interest infinitely. However, you can assign a finite value to the bond that denotes its price. A perpetual bond’s price is the fixed interest or coupon payment divided by a constant discount rate that denotes the time value of money. The discount rate reduces the fixed coupon’s absolute value with time, lowering it to zero.
Fixed-Rate Bonds
A fixed bond offers a fixed rate of interest to the bondholders throughout the bond’s lifetime. It is a debt security where investors loan money to governments or companies for a particular period. In turn, they earn interest payments on their principal at a fixed rate. The interest rates in fixed-rate bonds remain constant despite market changes. Thus, they are a secure investment option. However, investors must note that the bond’s fixed rate may be lower than that floating-rate bond.
Now, how do fixed-rate bonds work? When an organization issues a fixed-rate bond, it outlines the interest payment investors would receive during the bond’s term. The rate would depend on the issuer’s creditworthiness and the market situation. Additionally, fixed-rate bonds can have varying maturity periods. Investors get their principal back on the bond’s maturity. But if an investor wants to cash out before maturity, they might gain or lose money based on the bond’s existing market price.
Callable Bonds
A callable bond is a bond that allows the issuer to redeem the bond before its maturity date. Thus, the issuer can call the bond back and repay the principal to the investor before the bond’s scheduled maturity date. Hence, one can also term callable bonds redeemable bonds or call bonds as the issuer can redeem them at their discretion.
Some types of callable bonds include American Callable Bonds, European Callable Bonds, and Bermudan Callable Bonds. In American callable bonds, the issuer can call back the bond at any time. On the other hand, in the case of European callable bonds, the issuer can call them only on a specific date. Bermudan callable bonds are in the middle. They allow the issuer to call back the bond on a stipulated date.
How can one calculate the price of a callable bond? It can be done by using the current value of its future cash flows, discounted at the existing interest rate. But as the issuer can call back the bond, the call feature affects the bond’s price. The callable option also signifies that the bond’s cash flows will not be paid in full. Hence, calculating a callable bond’s price accurately could be challenging.
What is the Yield of a Bond?
Investors invest some amount of money in a bond. The return they earn on the invested capital is called bond yield or yield of bond.
There exist two types of yields – coupon yield and current yield. A coupon yield is the fixed yearly interest rate while issuing a bond.
The income on a bond and the coupon rate is equal to the coupon yield. The coupon yield is denoted in percentage. For instance, if you’ve purchased a bond for Rs. 100 and you earn Rs. 10 as your annual interest, then your coupon yield on it will be 10 percent. It is worth noting that the value remains constant during the bond’s lifespan.
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Disclaimer: The contents of this article should not be construed as tax or financial advice. Readers should seek advice from their tax or financial advisor before making any investment decision.