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What Is A Bond?

IndianMoney.com Research Team | Posted On Tuesday, December 18,2018, 03:16 PM

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What Is A Bond?

 

 

Bond is a debt security in which the issuer of the bond (This could be the Government or a Corporate), owes the holder of the bond and is obliged to pay interest on the bond. Interest is also called coupon rate. Principal would be repaid at a later date called the maturity date.

In simple terms the bond is a formal contract in which the Government or a Company promises to repay the borrowed money with interest. Interest is paid at regular intervals like annually, semi-annually and even monthly.

Why bonds? Bonds offer the borrower, funds to finance long-term investment needs. The Government uses the money to finance current expenditure. The Government issues bonds as part of the borrowing programme. When a bond is purchased, the investor becomes a creditor to the Government or Company. The Government or large Corporations need a lot of money, more than banks can lend. They would raise money by issuing bonds to the public.

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What Is A Bond?

What is bond fund? A bond is just like a loan. The holder of the bond is the lender or creditor. The issuer of the bond is the borrower or debtor. The bond holder has a higher right over the residual assets of a Company, when compared to the shareholders of the Company. If a Company goes bankrupt, the bond holder has a higher claim on the assets of the firm vis-à-vis shareholders. The bondholder has no share in the profits of the firm.

How Bonds work?

Take a look at the basic concepts of bonds:

Face Value: The face value or par value of the bond is the amount paid to the bondholder at maturity.

Coupon rate: The coupon rate on the bond is the periodic interest payments the bondholder receives from the time the bond is issued till maturity.

Maturity Date: The maturity date is when the principal (this is the face value) is paid back. On the maturity date, the final coupon rate (interest rate) and the face value is repaid.

Bond Price: If you invest in a bond and hold till maturity, (HTM), the interest rates, the changing prices, the yields have no effect. Many bond holders do not hold till maturity. Bonds are traded (bought and sold) on the secondary or stock market.

SEE ALSO: What is term deposit?

Working of bonds:

When you buy bonds, you lend money to the issuer of the bond for a fixed period of time. You (bond holder) receive periodic interest payments which may be monthly, semi-annually or annually. The issuer repays the borrowed amount (principal) and the last coupon on the maturity date. When a bond is issued, it has a face value. It also has a market value which fluctuates with time. You can measure the returns from the bond through bond yield.

Let’s understand how bonds work with an example. A Company issues a bond with face value of Rs 100 at a coupon rate of 6% for 8 years. The issuer of the bond will pay an interest of 6% each year to the bond holder. The principal (face value) is repaid on maturity.

Now, the bonds are transferrable through a sale in the bond market. They can be traded in the secondary market. This results in a fluctuation in value. The returns of a bond are measured through bond yield. Bond Yield is the rate of interest paid as a coupon.

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How to calculate bond yield?

Yield = Coupon rate of the bond / Face Value * 100.

Take a look at the earlier example. Let’s say the face value of the bond fell to Rs 90. The yield would rise to 6/90 * 100 = 6.66%. What happens if face value rises to Rs 110? The bond yield would be 6/110 *100 = 5.45%. The yield would drop to 5.45%.

In a bond, the price and interest are inversely correlated. When bond prices rise, interest falls and vice versa. Do note that even if the value of the bond fluctuates, the amount redeemed at maturity is the face value. As bond yield rises, the current market price of the bond falls.

SEE ALSO: What is eWay Bill?

Bond Yields and the Economy:

You can gauge the strength of the economy by looking at inflation, repo rate, GDP and National Income. But, bond yields have a very important role to play as far as the trajectory of the economy is concerned.

If investors sell Company Bonds, the prices fall and the yields rise. A higher yield means more risk.  If the yield of the bond is much higher than the issue price, then the Company gets financially stressed. It could struggle to repay the borrowed amount. Consequently, the opposite is also true. As yields rise, public interest in these bonds also rises.

Why is bond yield important?

The 10-year benchmark Government Bond yield is very important for India. The current India - 10-Year Government Bond Yield, is around 7.8%. Rising Government Bond Yields are bad for the stock market. This is because investors get higher returns and prefer bonds to stocks.

So why does this happen? When Government Bond yields rise, the cost of debt rises. This increases Company borrowing costs. This is bad for Companies and conversely the stock markets.

What are masala bonds?

Masala Bonds are rupee-denominated bonds, issued by Indian Entities in Overseas Markets. They are used to fuel the growth of the country, fund Infrastructure Projects and strengthen the rupee vs Dollar. These bonds are pegged to the rupee and are vulnerable to currency risk.

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