Bonds & Debentures
Let’s understand the concept Bonds & Debentures. These two words can be used interchangeably. In Indian markets, we use the word bonds to indicate debt securities issued by government, semi-government bodies and public sector financial institutions and companies. We use the word debenture to refer to the debt securities issued by private sector companies.
- Bonds - Debt securities issued by Govt. or Public sector companies
- Debentures - Debt securities issued by private sector companies
In other words we can tell that a bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, or Public entity known as the issuer. The issuer promises to pay you a specified rate of interest during the life of the bond, in return for the loan. They also promises to repay the face value of the bond (the principal) when it "matures."
What is Bond Fund?
A Bond Fund is a fund invested primarily in bonds and other debt instruments. The exact kind of debt the fund invests in will depend on its focus, but investments may include government, corporate, municipal and convertible bonds, together with other debt securities like mortgage-backed securities.
Types of Bond Funds
Bond mutual funds can be actively managed or indexed, open-end, closed end or exchange traded funds. For more details, see the comparison table.
- Actively managed bond funds
- Index bond funds
- Sponsors of open-end bond funds
- Closed-end bond funds
- Exchange traded funds (ETFs)
- Unit investment trusts
Actively managed bond funds
As their names suggest, actively managed bond funds have fund managers who buy and sell bonds in pursuit of their investment objective. They sometimes sell bonds at a profit, creating a capital gain, or at a loss if they need cash to pay shareholders who want to sell their shares.
Index bond funds
Index bond funds are not actively managed but build to match the composition of a given bond index. When the index changes the portfolio also changes automatically.
Open-end bond funds
Open-end bond funds are usually managed by mutual fund companies. They offer new funds and redeem existing funds continuously, requiring their managers to invest cash coming into the fund and liquidate positions when they need cash to meet redemptions. Investors in open end funds have the choice to collect their interest income and capital gains or reinvest them automatically in new funds shares.
Closed-end bond funds
Closed-end bond funds have a limited number of shares that trade on exchanges similar to stocks at a price that may be above or below net asset value (NAV) depending on supply and demand. Closed-end bond funds can be actively managed or passively managed.
Exchange traded funds (ETFs)
Exchange traded funds (ETFs) represent shares in a “basket” of bonds that reflects an index, but the number of shares is not fixed. ETFs trade on an exchange, with shares bought and sold through brokers who charge commissions.
Unit Investment Trusts (UTIs)
Unit investment trusts are a portfolio of bonds in custody of a trust that sells a fixed number of shares. On the maturity date, the portfolio is liquidated and the proceeds are returned to unit holders on a pro rata basis. Unit Investment Trusts (UTIs) are usually created by brokerage firms that retain a limited secondary market for the units. Unit holders who want to sell before maturity may gat less than they paid.
How to Invest in Bonds
There are several ways to invest in bonds. You can buy any of the following;
- Individual bonds
- Bond funds
- Money Market Funds.
There are a variety of individual bonds to choose from. Before investing you should find a bond that matches your investment needs and expectations. Most individual bonds are bought and sold in the over-the-counter (OTC) market. The OTC market comprises hundreds of securities firms and banks that trade bonds by phone or electronically.
Bond funds are another way to invest in the bond markets. Bond funds, like stock funds, offer professional selection and management of a portfolio of securities. They permit an investor to diversify risks across a wide range of issues and offer a number of other advantages, such as the option of reinvesting the interest payments, distribution of interest payments periodically, etc.
Money Market Funds
Money market funds refer to pooled investments in short-term, highly liquid securities. These securities include Treasury Bills, Municipal bonds, Certificates of deposit issued by major commercial banks, and commercial paper issued by established corporations. Normally, these funds consist of securities and other instruments having maturities of three months or less. Money market funds also offer convenient liquidity, since most allow investors to withdraw their money at any time.
What You Should Know Before Deciding to Invest in Bonds?
When you are investing in a bond, you are buying the debt of its issuer, which might be the India government or an affiliated entity, a state or Municipal government or a corporation. Every bond has certain features they are:
- A definite maturity date, on which bond issuer promises to repay the bondholder.
- A promise to pay taxable or tax-exempt interest at a stated “coupon” rate.
- A yield, or return on investment, which is a function of the bond’s coupon rate
- A credit rating indicates the possibility that the issuer will be able to repay its debt.
Risks Associated with Bond Investment
Generally bonds guarantee safer and more stable returns than stocks, but bonds have certain risks. Such as;
- Interest rate risk
- Liquidity risk
- Credit risk
- Call risk or reinvestment risk
Interest rate risk
When interest rates rise in the market, bond prices fall. If you need money and have to sell your bond before maturity for a higher rate you will be disappointed because you will probably get less than you paid for it. Interest rate risk declines as the maturity date gets closer.
If the bond issuer’s credit rating falls or prevailing interest rates are much higher than the coupon rate, it may be difficult for an investor who wants to sell before maturity to find a buyer. Bonds are normally more liquid during the initial period after issuance because during that period trading volume of bonds will be larger.
If the issuer runs into financial difficulty or declares bankruptcy, it could default on its obligation to pay the bondholders. In fact the buyer won’t get anything back.
Call risk or reinvestment risk
If a bond is callable, the issuer can redeem it prior to maturity, on defined dates for defined prices. Bonds are generally called when interest rates are falling, leaving the investor to reinvest the earnings at lower rates.