How Do Bonds Work?

When you purchase a bond, you are essentially providing a loan to the issuer. The key components of a bond include:

Principal: The amount of money you lend to the issuer, also known as the face value or par value of the bond.

Coupon Rate: The interest rate that the issuer agrees to pay you, usually expressed as a percentage of the principal. This interest is typically paid semi-annually or annually.

Maturity Date: The date on which the bond’s principal amount is to be repaid to the bondholder. Bonds can have short-term (less than 5 years), medium-term (5-10 years), or long-term (more than 10 years) maturities.

Types of Bonds in India

Government Bonds: The Government of India issues these bonds which are considered very safe. They are backed by the government’s credit. Examples include Treasury Bills (T-Bills), Government Securities (G-Secs), and Sovereign Gold Bonds (SGBs).

Corporate Bonds: Issued by companies to raise capital for business operations, expansion, or other needs. These bonds typically offer higher interest rates compared to government bonds but come with higher risk. Examples include Non-Convertible Debentures (NCDs) and Convertible Debentures.

Municipal Bonds: Issued by local government bodies or municipalities to fund public projects like infrastructure development. These bonds can be a good investment for those looking to support local development.

Tax-Free Bonds: Issued by government-backed entities, the interest earned on these bonds is exempt from taxes, making them attractive to investors in higher tax brackets. Examples include bonds issued by the National Highways Authority of India (NHAI) and the Indian Railways Finance Corporation (IRFC).

Why Invest in Bonds?

Safety: Government bonds are considered one of the safest investments due to the low risk of default.

Regular Income: Bonds provide a steady stream of income through periodic interest payments, which can be beneficial for retirees or those seeking stable returns.

Diversification: Including bonds in your investment portfolio can help reduce overall risk by balancing more volatile investments like stocks.

Tax Benefits: Certain bonds, such as tax-free bonds, offer tax advantages that can enhance your overall returns.

How to Buy Bonds in India

You can purchase bonds through various channels:

Stock Exchanges: Bonds are listed and traded on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). You can buy and sell bonds through your brokerage account.

Banks and Financial Institutions: Many banks and financial institutions offer bonds for sale. You can purchase bonds directly from these institutions or through their online platforms.

Primary Market: Bonds can be bought directly from the issuer during the initial offering. This is known as the primary market. Government bonds are often sold through auctions conducted by the Reserve Bank of India (RBI).

Mutual Funds: Investing in bond mutual funds allows you to pool your money with other investors to buy a diversified portfolio of bonds. This can provide professional management and diversification benefits.

Risks Involved

Interest Rate Risk: Bond prices are inversely related to interest rates. When interest rates rise, bond prices fall, and vice versa. This can affect the market value of your bonds if you need to sell them before maturity.

Credit Risk: The risk that the issuer may default on interest payments or fail to repay the principal amount. Government bonds have low credit risk, while corporate bonds may have higher credit risk depending on the issuer’s financial health.

Inflation Risk: Inflation can erode the purchasing power of the interest payments and principal repayment. If inflation rates are higher than the bond’s coupon rate, the real return on investment may be negative.

Liquidity Risk: Some bonds may be difficult to sell quickly without affecting their market price. This can be a concern if you need to access your funds before the bond matures.