What are bonds, and should you invest in them? - Part 1

As per Live Mint, the corporate bond market in India could reach Rs. 65-70 lakh crore by 2025!

But what is this bond market, and how does it work?

I’ll try and simplify this in this article.

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(Please note that this is the first article that will discuss the basics of a bond, and not go into the technicalities of it. I’ll be writing a series of articles where we’ll cover those in much more detail. So if you know the basics of a bond, you can skip this article. But again, our newsletters are under 5 minutes, so why not just have a glance?)

Alright. So let’s begin.

When a company needs money to expand, one option to get this money is to borrow from the public and financial institutions. Which is when, these companies issue a product known as a BOND. And investors (which can be both, individuals like you and me, or institutions like banks or Mutual Funds) BUY these bonds from these issuers.

In return for buying the bond, the bond issuing company (known as the issuer) promises to pay a certain interest to the buyer of the bond. This interest is known as the coupon, generally paid yearly. The bond generally comes with a fixed time limit (known as maturity period of the bond) after which the company repays the face value of the bond to the buyer (more on this later).

So the buyer buys a bond, and the issuer keeps paying them an interest (coupon) every year. At the end of the maturity period, the issuer pays the face value to the buyer.

Now this may seem like a very simple transaction, but here’s where it gets slightly complex.

(Don’t worry, as always, we’re going to simplify it in 5 minutes and make sure you understand it well)

You see, bonds, like company stocks, are traded in the bond market. This means that you, as an investor, can buy the bond directly from the issuer on the initial issue date, or later from another investor (similar to a company’s stock). However, the price at which you can buy and sell a bond fluctuates, depending on a lot of factors (which we won’t be discussing in detail here, as it’ll get too much to digest).

For today’s article, it will suffice to know that there is an initial price of the bond that the issuer sets, known as the face value. The bond can be issued either at face value, or lower or higher, depending on various conditions. After initial issuance, the bond can then be traded.

So once you’ve purchased a bond, you keep getting interest (coupon) every year and then after the maturity period of the bond is over, the issuer will repay the face value of the bond back to you.

Now, the coupon rate is calculated on the face value only, so irrespective of what price you pay for the bond, the interest that you get, will be calculated on the face value. So for example, for a bond with face value = Rs. 100 and 7% coupon, you will get Rs. 7 every year. However, if the price you have paid for it is Rs. 120, then your actual ROI is not 7%. It will be less than 7% since the principal you paid is more than the face value. Which means that your actual Return on Investment (or ROI) is not the same as the coupon. The actual return that you get on a bond is called the bond yield and is calculated based on a lot of factors, purchase price being just one of them.

We’ll discuss these details in next week’s article. However, for now, it should suffice to know that the ROI of a bond is the bond’s yield and not it’s coupon (interest) rate.

Different bonds have different maturities and depending on a lot of factors, the yield can change. A bond can be issued by a private company or the government where the purpose is generally the same - to raise money from the public.

Now, the last concept to understand the basics of a bond is the rating. So depending on the company which is issuing the bond, the project, the past history etc., each bond has a rating assigned to it. This rating denotes how much risk a bond carries with it. Because eventually, you are LENDING money to someone with a promise that it will be paid back, so you need to know how safe or risky that promise is. That’s where rating of the bond will help you decide.

A bond rated as AAA is assumed to be relatively safer and least risky, compared to a bond rated A, BBB, B, C or D. Ratings are typically given by another set of companies called Credit Rating agencies, such as S&P, Moody’s etc. Obviously, lower the rating, higher will be the coupon that the bond gives. Here’s a chart of risk v/s rating for bonds:

Well, that’s about it for today. This article covers the basics of bonds. We’ll cover other aspects in the upcoming posts.

Do let me know if there’s any topic you want me to write about. Or even if you have any queries on this one, feel free to reach out!

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