What is a ‘Bond’
A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debtholders, or creditors, of the issuer.
How Bonds Work
When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing other debts, they may issue bonds directly to investors instead of obtaining loans from a bank. The indebted entity (issuer) issues a bond that contractually states the interest rate (coupon) that will be paid and the time at which the loaned funds (bond principal) must be returned (maturity date).
The issuance price of a bond is typically set at par, usually 100 or 1,000 face value per individual bond. The actual market price of a bond depends on a number of factors including the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time.
Characteristics of Bonds
Most bonds share some common basic characteristics including:
Face value is the money amount the bond will be worth at its maturity, and is also the reference amount the bond issuer uses when calculating interest payments.
Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage.
Coupon dates are the dates on which the bond issuer will make interest payments. Typical intervals are annual or semi-annual coupon payments.
Maturity date is the date on which the bond will mature and the bond issuer will pay the bond holder the face value of the bond.
Issue price is the price at which the bond issuer originally sells the bonds.
Types of Bonds :
Government bonds are issued by Government to finance their activities. In India, the Government bond market size is much larger than the corporate bond market size. They are also known as G-Sec. The bonds’ return depends on the prevailing interest rate. Usually, Government bonds pay a return of 7% to 10%. The maturity can be anywhere between 3 months to 30 years. To buy a government debt is a low-risk activity as long as you deal with the government itself or some other reputable institution.
Corporate bonds are issued by corporations to raise capital. They are safer than equities. The bondholders get a specified return every period. 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: Non-convertible bonds are just plain bonds.
Zero coupon bonds
Usually, most types of bonds are offered at a fixed interest rate. However, zero coupon bonds do not come with any specific coupon rate or interest rate. They are offered at a discount on the face value, and on maturity, investors get the face value back. The difference between the two is the profit.
These bonds are issued by companies that are financially not very stable. These bonds are considered below the investment grade. Since it is a risky trade for an investor to put money in such bonds, the issuing company usually offers a high rate of return.
By investing in this type of bond, you receive exemption from paying taxes on the interest income as long as you hold the bond or until its period of maturity.
While there are many other types of bonds available in the market, the ones mentioned above are some of the most common ones in India.
Tax Free Bonds
These bonds, generally issued by Government backed entities, are exempt from taxation on the interest income received from such instruments under the Income Tax Act, 1961. Some of the public undertakings which raises funds through issue of tax free bonds are IRFC, PFC, NHAI, HUDCO, REC, NTPC, NHPC,Indian Renewable Energy Development Agency (IREDA) etc.
Capital Gain Bonds
There are instruments like capital gain bonds, in which the profit arising from the sale of a property can be invested. These have a lock-in period of three years and the maximum limit for investing in such instruments is Rs 50 lakhs. As per provisions of Income Tax Act, 1961, any long term capital gains arising from transfer of any capital asset would be exempt from tax under section 54EC of the Act if invested in Capital Gain Bonds.