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What is a Bond? What are its Pros and Cons?

02 Nov 2021 0 COMMENT

Introduction

A good investor keeps themselves abreast with the different investment avenues available. A thorough understanding of investment avenues helps diversify your portfolio and make the right investment choices based on your risk appetite. One crucial investment option is Bonds. Governments and corporate firms issue Bonds when they need funds. When you buy them, you give the issuer a loan, and they pay the face value back on a specific date. Additionally, they must make periodic interest payments, usually twice a year.

Bonds do not give you ownership rights like stocks. So, you may not benefit from the growth of the company. On the other hand, you do not see much impact if the market is down or when the company is not doing well. In short, you enjoy two benefits of investing in Bonds it provides an assured stream of income, and you avoid market volatility.

How does a bond work?

Bonds are debt instruments that are issued by entities on the primary market to raise capital. This is a type of loan capital or borrowed capital raised from the general public. Investors who purchase bonds receive a regular interest payment on their principal amount. The interest rates on bonds is fixed and predetermined and is called ‘Coupon’. The payment schedule of this coupon is also predetermined.

Who are the issuers of bonds?

Bonds are generally issued by entities like companies, governments, municipal corporations, etc. Different issuers have differing goals for issuing bonds and thus the maturity period also varies accordingly.

What are the different types of bonds?

The different types of bonds include the following:

Corporate bonds: Corporate bonds are issued by companies to borrow funds from investors to raise capital. These bonds are issued for a fixed period and offer investors interest during the tenure.

Government bonds: These are debt instruments that are issued by the Government of India. The state governments also issue their respective bonds. They fall within the category of G-sec and offer long-term investments. Interest rates can be floating or fixed.

RBI bonds: The Reserve Bank of India issues the floating rate saving bond which is also referred to as the RBI Taxable bond. They have a tenure of 7 years and they offer interest at a floating rate.

Sovereign Gold Bonds: Sovereign Gold Bonds or SGBs are also issued by the RBI on behalf of the Central Government of India. These are issued against the grams of gold and allow investors to invest in gold without the hassle of dealing with the physical form of the metal. The returns generated by SGBs depend upon the prices of gold in the market, while investors are also paid an interest of 2.5 percent per annum.

What are the different bond categories?

The four major types of bond categories are:

  • Fixed-interest bonds: They accrue coupon rates during their tenure and investors can enjoy predictable returns regardless of alterations in market conditions.
  • Floating-interest bonds: Similar to fixed-interest bonds, they also offer coupon rates but are subject to market fluctuations.
  • Inflation-linked bonds: These debt instruments serve the purpose of managing the effect of inflation on returns. The coupon rates offered are usually lower than fixed-interest bonds.
  • Perpetual bonds: Although these are fixed-security instruments, the issuers do not return the principal amount to investors. There is no maturity period and investors get to avail of steady interest payments for perpetuity.

Let us understand the other pros and cons of investing in Bonds

Pros

Alternative investment option

Bonds allow diversification of the portfolio, and you can find the one that fits your requirements. There is flexibility, and you can choose from short or long-term Bonds based on your investment criteria. You can also pick the preferred coupon structure and decide whether you want to receive the interest annually, bi-annually, or at the time of maturity. 

Low risk

A significant benefit of investing in Bonds is they are low risk. Government Bonds carry less risk than Corporate ones, and you need not worry about losing your money even if the market is down. If you have a low-risk appetite, it is best to invest in bonds. 

Higher liquidity

You will find many investors in the secondary market who are keen to buy Bonds. This way, you can get the principal before its maturity and profit from them. Check the trading history of the Bond before buying them to ensure that you get the liquidity when you need it. 

Cons

Credit risk

Government Bonds have a high credit rating and low risk, while some Corporate Bonds have a lower credit rating and higher risk. With Bonds, it comes down to the issuer's credit quality and when you buy them, monitor the credit rating of the issuing company. A Bond with a low credit rating should be avoided.

Interest rate risk

The Bond prices and interest rates are inversely related. Hence, when the Bond price is high, the interest rates fall, and when the Bond price is down, the interest rates rise. If the interest rates are falling, investors try locking in the highest rates possible and buy every Bond they can. It leads to a rise in demand and a subsequent increase in the Bond yield.

In the opposite case, if the interest rates rise, the investors sell the Bonds that pay low-interest rates, which could cause the Bond prices to fall.

Conclusion

Now that you know what is Bond consider it as a secure and safe investment option. No investment is risk-free, but Bonds have low risk and generate regular income. It helps diversify your portfolio and provide steady interest income.

Disclaimer: ICICI Securities Ltd.( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Centre, H. T. Parekh Marg, Churchgate, Mumbai - 400020, India, Tel No : 022 - 2288 2460, 022 - 2288 2470.  I-Sec is acting as a distributor to solicit bond related products. All disputes with respect to the distribution activity, would not have access to Exchange investor redressal forum or Arbitration mechanism. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.