Summary (Key Takeaways)
Bonds are fixed-income instruments where investors lend money to governments or companies in exchange for regular interest payments and repayment of principal at maturity.
They are widely used to raise long-term funds and are generally considered safer than equities.
Bond returns depend on factors such as coupon rate, maturity, yield, and credit quality, while bond prices are strongly influenced by changes in interest rates.
Because of their stability and income-generating nature, bonds play a crucial role in portfolio diversification and long-term financial planning.
What Is a Bond?
A bond is a fixed-income financial instrument in which an investor lends money to an issuer such as a government, corporation, or public institution for a specific period. In return, the issuer agrees to pay regular interest, known as the coupon, and to repay the original investment amount, called the principal, on a predetermined maturity date. Bonds represent borrowing, unlike shares, which represent ownership in a company. This makes bonds an important financing tool for issuers and a steady income source for investors.
In simple terms, when an investor buys a bond, they become a lender. The issuer uses the borrowed funds for activities such as infrastructure development, business expansion, refinancing debt, or meeting public expenditure needs. In exchange, the investor receives predictable income and the assurance of principal repayment at maturity, subject to credit risk.
For example, if an investor purchases a government bond with a face value of ₹10,000, a coupon rate of 8 percent, and a maturity of five years, the investor will receive ₹800 annually as interest. This interest will be paid every year for five years, and at the end of the fifth year, the investor will receive the original ₹10,000. This structure highlights why bonds are preferred by investors seeking stability and regular income.
What Are the Key Features of a Bond?
Every bond has certain core features that determine how it works and what return an investor can expect. The face value, also known as par value, is the amount that the issuer promises to repay at maturity. This amount remains constant and serves as the base for calculating interest payments.
The coupon rate is the fixed percentage of the face value that the issuer pays as interest. This rate remains unchanged throughout the life of the bond in the case of fixed-rate bonds. The coupon payment is the actual interest amount received by the investor at regular intervals, such as annually or semi-annually.
The issue price is the price at which the bond is initially sold to investors. A bond may be issued at par, at a premium, or at a discount, depending on prevailing interest rates and investor demand. The maturity date is the date on which the bond expires and the issuer repays the principal amount. Yield represents the total return earned by the investor, taking into account both interest payments and the price paid for the bond. Yield often differs from the coupon rate when bonds are traded in the secondary market.
Why Do Governments and Companies Issue Bonds?
Governments and companies issue bonds to raise large amounts of capital in a structured and reliable manner without giving up ownership or control. Governments use bond issuance to finance infrastructure projects, healthcare, education, defense, and social welfare schemes, as well as to manage fiscal deficits. By issuing bonds, governments can spread repayment over many years instead of increasing taxes immediately.
Companies issue bonds to fund expansion, purchase assets, refinance existing debt, or support long-term strategic projects. Compared to equity financing, bond issuance does not dilute ownership, and compared to bank loans, bonds often provide a lower and more predictable cost of borrowing. For investors, bonds offer a steady income stream and relative safety, making bond issuance beneficial for both issuers and investors.
What Are the Different Types of Bonds?
Classification of Bonds Based on Issuer
Government Bonds
Government bonds are issued by the central or state governments to raise funds for public expenditure such as infrastructure, healthcare, education, and welfare schemes. These bonds are considered very low risk because they are backed by sovereign authority, meaning the government has the power to tax or print money to meet its obligations. Due to this high level of safety, government bonds generally offer lower returns compared to other types of bonds.
Corporate Bonds
Corporate bonds are issued by private or public companies to finance business activities such as expansion, asset purchases, refinancing debt, or meeting working capital requirements. The risk associated with corporate bonds depends on the financial health and profitability of the issuing company. Since there is a higher chance of default compared to government bonds, corporate bonds usually offer higher interest rates to compensate investors for the additional risk.
Municipal Bonds
Municipal bonds are issued by local authorities such as municipalities, city councils, or urban development bodies. These bonds are used to fund regional development projects like roads, water supply systems, sewage facilities, and public utilities. Municipal bonds are generally considered low risk because they are supported by local government revenues and, in some cases, state or central government backing. Returns are moderate, balancing safety and income.
PSU Bonds
PSU (Public Sector Undertaking) bonds are issued by government-owned companies to raise funds for operational and capital requirements. These bonds carry low to medium risk because, although the issuing company operates independently, it is backed by the government either directly or indirectly. PSU bonds often provide slightly higher returns than government bonds while still maintaining relatively high safety, making them attractive to conservative investors.
Classification of Bonds Based on Interest Structure
Fixed-Rate Bonds
Fixed-rate bonds pay a constant rate of interest throughout the entire life of the bond. The coupon rate does not change regardless of fluctuations in market interest rates, which provides investors with predictable and stable income. These bonds are suitable for investors who prefer certainty in cash flows.
Floating-Rate Bonds
Floating-rate bonds have interest rates that change periodically based on a reference benchmark such as the repo rate or government bond yields. When market interest rates rise, the interest payments on these bonds increase, and when rates fall, the payments decrease. This structure helps investors manage interest rate risk, especially in a rising interest rate environment.
Zero-Coupon Bonds
Zero-coupon bonds do not pay any periodic interest during their tenure. Instead, they are issued at a significant discount to their face value and are redeemed at face value at maturity. The difference between the purchase price and the face value represents the investor’s return. These bonds are suitable for long-term goals where investors do not require regular income.
Inflation-Indexed Bonds
Inflation-indexed bonds are designed to protect investors from the negative impact of inflation. In these bonds, either the interest payments, the principal amount, or both are adjusted according to inflation rates. This ensures that the real purchasing power of the investor’s returns is maintained over time.
Classification of Bonds Based on Convertibility
Convertible Bonds
Convertible bonds give investors the option to convert their bonds into a predetermined number of equity shares of the issuing company after a specific period. Until conversion, investors receive regular interest like a normal bond. This feature allows investors to benefit from potential capital appreciation if the company performs well, making convertible bonds attractive to those seeking both income and growth.
Non-Convertible Bonds (NCBs)
Non-convertible bonds remain pure debt instruments throughout their entire tenure and cannot be converted into equity shares. Investors receive fixed or floating interest payments and the principal amount at maturity. These bonds are suitable for investors who prefer stable income without exposure to equity market risk.
Classification of Bonds Based on Credit Quality
Investment-Grade Bonds
Investment-grade bonds are issued by financially strong governments or companies that have high credit ratings from recognized rating agencies. These ratings indicate a low probability of default. As a result, investment-grade bonds offer stable and predictable returns and are preferred by conservative investors who prioritize capital safety.
High-Yield Bonds (Junk Bonds)
High-yield bonds are issued by entities with lower credit ratings, indicating a higher risk of default. To compensate investors for this increased risk, these bonds offer higher interest rates. High-yield bonds are suitable for investors with a higher risk appetite who are willing to accept the possibility of default in exchange for higher potential returns.
How Do Interest Rates Affect Bond Prices?
Interest rates have a significant impact on bond prices, and the relationship between the two is inverse. When interest rates rise, newly issued bonds offer higher returns, making existing bonds with lower coupon rates less attractive. As a result, the market price of existing bonds falls. Conversely, when interest rates fall, existing bonds with higher coupon rates become more valuable, leading to an increase in their prices.
This inverse relationship is particularly important for investors who trade bonds in the secondary market or plan to sell bonds before maturity. Long-term bonds are generally more sensitive to interest rate changes than short-term bonds, making interest rate risk a key consideration in bond investing.
What Are the Risks Involved in Bonds?
Although bonds are considered safer than equities, they are not free from risk. Interest rate risk arises from fluctuations in market interest rates that affect bond prices. Credit risk refers to the possibility that the issuer may fail to make interest payments or repay the principal. Inflation risk occurs when rising inflation reduces the real purchasing power of bond returns. Liquidity risk arises when investors are unable to sell bonds quickly at a fair price due to low market activity.
Understanding these risks helps investors choose bonds that align with their risk tolerance and investment horizon.
Why Should Investors Invest in Bonds?
Investors include bonds in their portfolios to earn stable income, preserve capital, and reduce overall portfolio volatility. Bonds provide predictable cash flows and act as a stabilizing force during periods of equity market volatility. For conservative investors and long-term financial planning, bonds play a vital role in achieving income generation, diversification, and financial stability.
FAQs
1. Are bonds safer than shares?
Bonds are generally safer than shares because they offer fixed income and priority repayment, though corporate bonds still carry default risk.
2. Can individuals invest in bonds in India?
Yes, individuals can invest in bonds through platforms such as RBI Retail Direct, mutual funds, and online bond platforms.
3. What is the difference between coupon rate and yield?
The coupon rate is the fixed interest paid on the face value of the bond, while yield reflects the actual return based on the bond’s market price.
4. Do bonds guarantee returns?
Government bonds are relatively safe, but corporate and high-yield bonds carry varying levels of risk.
Final Key Takeaway
Bonds are a fundamental part of the financial system, enabling governments and companies to raise long-term funds while offering investors stable income and relatively lower risk compared to equities. With multiple bond types available based on issuer, interest structure, credit quality, and convertibility, investors can select bonds that match their financial goals and risk appetite. When used wisely, bonds serve as a powerful tool for income generation, diversification, and long-term financial security.