Demystifying Bonds: Your Ultimate Handbook To Understanding Different Types Of Bonds

Introduction On Bonds

In today's dynamic financial landscape, investors must diversify their portfolios and explore different investment avenues. One such option is bond investment. Bonds are debt securities issued by entities like governments or corporations to raise capital. You lend money to the issuer for a specified period when you purchase a bond. In return, the issuer agrees to pay a fixed interest rate and return the borrowed capital upon maturity. 

Bonds are considered safe investments because the issuer must repay the principal. They are often referred to as fixed-income securities and are popular among investors seeking steady returns and lower risk.

This article will explore the world of bonds, focusing on different types of bonds to invest in and corporate bonds in India. Let us discover how you can invest in bonds in India.

Different Bond Categories In India

In India, bonds can be classified into various types based on the following factors:

1. Issuer
2. Security
3. Seniority
4. Credit rating (or safety)
5. Interest rate
6. Maturity (or term)

What Are The Different Types Of Bonds

The major classification of bonds based on the above-mentioned criteria are:

1. Types Of Bonds Based On Issuer

a. Government Bonds

Government bonds, also known as sovereign bonds, are issued by the central or state governments. They are considered one of the safest investment options because the government backs them. Government bonds come in various maturities, such as short-term Treasury bills (T-bills) and long-term government securities. They offer fixed interest payments regularly and return the principal amount at maturity.

Features

• Guaranteed repayment by the government.
• Typically have lower yields compared to other types of bonds.
• Considered less risky due to the government's creditworthiness.

Suitability

• Ideal for conservative investors seeking stability and capital preservation.
• Suitable for those looking for a regular income stream.

Pros

• Lower risk compared to other bonds.
• Assured repayment.

Cons

• Relatively lower yields.
• Interest income may be taxable.

How To Invest: You can invest in government bonds through various channels, including banks, post offices, and stock exchanges. You can purchase them in primary market offerings or from the secondary market.

b. Corporate Bonds

Corporate bonds are debt securities issued by companies to raise capital. These bonds are an essential part of the corporate financing ecosystem. By investing in corporate bonds, individuals lend money to corporations in exchange for regular interest payments and the return of principal at maturity.

Features

• Higher yields compared to government bonds.
• Varying credit ratings based on the issuer's financial strength.
• Multiple maturities range from short-term to long-term.

Suitability

• Suited for investors seeking higher returns than government bonds or traditional fixed-income options like FDs.
• Ideal for those willing to take on moderate levels of risk.

Pros

• Potential for higher returns compared to government bonds.
• Diversification opportunity by investing in bonds of different companies.
• Stable and predictable returns. 

Cons

• Higher credit risk is associated with the issuer's financial health.
• Liquidity may be lower compared to government bonds.

How To Invest: Corporate bonds can be purchased through various channels, including platforms like Grip, stock exchanges, mutual funds, and bond brokers. Before investing, it is essential to research the issuing company's creditworthiness and consider the prevailing market conditions. At Grip Invest, a SEBI-regulated online bond-providing platform (OBPP), you can invest in rated and listed corporate bonds for as little as INR 10,000.

c. Municipal Bonds

Municipal bonds, commonly known as "munis," are issued by state and local governments or agencies. These bonds finance public infrastructure projects such as schools, highways, and hospitals. Municipal bonds offer tax advantages to investors, making them attractive to specific individuals.

Features

• Tax-exempt interest income for investors (subject to specific conditions).
• Municipalities and their agencies issue them.
• Varying maturities and interest payment frequencies.

Suitability

• Suitable for investors seeking tax advantages.
• Individuals looking to contribute to local infrastructure development.

Pros

• Tax benefits on interest income (as per prevailing tax laws).
• Support local development and public projects.

Cons

• Credit risk associated with the issuer.
• Limited liquidity in specific municipal bond markets.

How To Invest: You can use a Demat account with an online broker to buy and sell municipal bonds. Be wary of the default risk and understand its tax implications on your income. 

2. Types Of Bonds Based On Interest Rate

a. Zero-Coupon Bonds

Zero coupon or discount bonds are fixed-income securities that do not pay regular interest like traditional bonds. Instead, they are sold at a discount to their face value and provide a lump-sum payment at maturity. The difference between the purchase price and the face value represents the bondholder's return.

Features

• No periodic interest payments.
• Sold at a discount to face value.
• Returns generated through capital appreciation.

Suitability

• Suitable for long-term investors who do not require regular income.
• Individuals looking for potential capital appreciation.

Pros

• Potential for higher returns due to purchasing at a discount.
• Minimal reinvestment risk as there are no coupon payments.

Cons

• Lack of regular income during the bond's tenure.
• Interest income is subject to taxation on an accrual basis.

How To Invest: Zero-coupon bonds can be purchased through banks, financial institutions, and stock exchanges. Before investing, it is essential to consider the maturity period, credit rating, and potential tax implications.

b. Fixed Rate Bonds

These bonds pay a predefined fixed interest rate throughout maturity, giving investors a predictable fixed income. They become more appealing when prevailing interest rates are low. Investors might earn a substantially larger return with these bonds than other investment options, as their fixed interest rate could be higher than the existing market rates. 

Furthermore, investors seeking stability and security in their investments may find receiving a fixed income over time highly beneficial in a low-interest-rate environment.

Features

• Periodic interest payments.
• Predictable fixed-income.

Suitability

• Suitable for investors seeking low-risk regular income.

Pros

• Non-market linked fixed returns.
• Higher returns than FD.

Cons

• Lower returns than performing stock market.
• Interest income is subject to taxation on an accrual basis.

c. Floating Rate Bonds

A floating-rate bond has an interest rate that changes regularly. The reference rate determines it. For example, the London Interbank Offer Rate (LIBOR) or the government bond yield are benchmarks. 

Features

• Periodic interest payments.
• Less sensitive to interest rate risk than fixed-rate bonds.
• Floating rates are typically adjusted regularly, often every 3, 6, or 12 months.

Suitability

• Suitable for investors seeking low-risk regular income.

Pros

• Higher returns than fixed-rate bonds.
• Less volatile during interest rate changes. 

Cons

• Lower returns than performing stock market.
• Interest income is subject to taxation on an accrual basis.

d. Convertible Bonds

Convertible bonds are unique instruments that offer a blend of debt and equity characteristics. They allow bondholders to convert their bonds into a predetermined number of shares of the issuing company's common stock, which provides the potential for capital appreciation if the stock price rises.

Features

• Option to convert into equity shares of the issuing company.
• Fixed interest payments until conversion or maturity.
• Varying conversion ratios and terms.

Suitability

• Suited for investors seeking both fixed income and potential equity participation.
• Individuals with a positive outlook on the issuing company's stock.

Pros

• Opportunity for capital appreciation if the stock price rises.
• Offers downside protection through fixed interest payments.

Cons

• Lower interest rates compared to non-convertible bonds.
• Potential dilution of equity if the conversion occurs.

How To Invest: Convertible bonds can be purchased through stock exchanges or bond brokers. They have a predetermined conversion price and are a fixed-income investment. However, be careful when investing in convertible bonds, as they tend to be riskier or more volatile.

3. Types Of Bonds Based On Credit Rating (safety)

Credit ratings can be broadly classified into two categories:

1. Investment-grade ratings: These ratings indicate a low risk of default and are generally assigned to financially stable issuers.
2. Non-investment-grade or speculative ratings: These ratings signify a higher risk of default and are usually given to issuers with weaker financial profiles.

Read more on Decoding Credit Ratings In Indian Bond Market

Conclusion

Bonds offer investors a range of opportunities to diversify their portfolios and achieve financial goals. While government bonds provide safety and stability, corporate bonds offer higher yields with varying levels of risk. Municipal bonds provide tax advantages, zero coupon bonds offer potential capital appreciation, convertible bonds combine debt and equity features, and foreign currency bonds offer diversification and currency exposure.

Explore Grip Invest to stay updated on various high-yielding fixed-income investment options.

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Disclaimer - Investments in debt securities/municipal debt securities/securitised debt instruments are subject to risks including delay and/ or default in payment. Read all the offer related documents carefully. The investor is requested to take into consideration all the risk factors before the commencement of trading.
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