Not heard about bonds? It’s only the most reliable and one of the oldest form of investments! Bonds have been a form of investment that have been around for many millenniums! Bond investing has been known to exist since as early as 2400 B.C. Bonds are believed to be the most simple form of investment. They are the most widely used form of investment, with each and every country of the World having a thriving bond market.
What are Bonds?
In financial terms, a bond is considered as a fixed income instrument which represents a loan made by an investor to a borrower (typically government or corporate). A bond can also be considered as an IOU between the lender and borrower which includes all the details of the loan and payments. A Bond has an end date and the desired principal of loan due has to be paid to the bond owner, which usually includes terms for variable or fixed deposit interest which has to be made by the borrower.
Bonds are also referred to as fixed income securities and are one of three asset classes individual investors are familiar with, along with stocks (equities) and cash equivalents. Many government and corporate bonds are publicly traded; whereas the others are traded only over-the-counter (OTC) or privately between a borrower and a lender.
Bonds are used in all sectors of industries whether it is by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are the debt holders/ creditors of the issuer.
Functioning of a Bond :
When companies or entities need funds for financing new projects or to maintain ongoing operations, or clear existing debts, they issue bonds directly to investors. The borrower issues a bond which includes the terms of the loan, interest that will be made and the time at which the loaned should be paid back (maturity date). The interest payment is the part of the return that bondholders get for loaning their funds to the issuer. The interest rate determines the payment which is called the coupon rate.
Imagine a bond which is being issued with a coupon rate of 5% and a Rs.1000 par value. The bondholder will be paid Rs.50 in interest income annually. As long as there is no change in the rate of interest environment the price of the bond remains at its par value, but as the interest rates start to fall and same bonds are now issued at 4% coupon, the value of your bond increases.
Investors who now wish to get a higher coupon rate will have to pay extra for the same bond in order to entice the original owner to sell. The total increased price will thus bring the bond’s total yield down to 4% for new investors because of which they will have to pay an amount above the par value to purchase that bond.
On the other hand, if interest rates rise and the coupon rate for bonds increases up to 6%, the 5% coupon is no longer popular. The price of the bond will gradually decrease and begin selling at a discount compared to par value until its return is 6%.
The interest rates are usually determined by the ability of the issuer to repay the bond amount. If the markets believe that the issuer can repay the bond easily, the bond is a safe investment and hence will attract a low rate of interest. Conversely, the bond will attract a higher rate if interest if the issuer is not considered to be in a financially sound position.
India’s biggest lender State bank of India(SBI) is planning to raise up to USD 1.25 Billion by issuing bonds through various modes. The public sector bank has said that they will raise this fund between January and March the next year. It is believed that the bank is raising funds for some unseen contingencies, which could be a provision for NPAs.
Investing in bonds is sometimes the most lucrative form of investing for some investment banks as it ensures a steady stream of income year after year. This is why investing in bonds is considered to be one of the most important activity for investors and financial houses.
BSE Institute offers a wide range of short-term online courses for all students and professionals on topics ranging from Algo trading, Machine Learning, Risk Management, etc. It’s online platform bsevarsity.com has over 50 courses on offer for finance enthusiasts. BSE Institute offers a basic course on Bonds and Valuation, which can help students and investors learn and gain deep insights about Bonds as an investment vehicle.