The term ‘bonds’ can be elaborated as a certificate of debt securities in which an investor purchases a security and his capital will be returned later. As such the investor will be holding the purchased bond until it comes due. In this purchase, the issuer of the bond will be bound to pay a specific interest rate to the holder.

Such different types of bonds will be issued by both government and corporate from time to time. In order to make a wise purchase of these bonds, a better understanding about bond is very essential.

Types of Bonds

Before an investment in bonds, considering they are among best investment options you must get to know about the various types of bonds that are available along with the terms that are included in each kind. I am very sure that the knowledge about the types and terms will definitely help you in coming up with a good choice. And, this classification would take into account various factors such as: issuer, redemption features along with coupon rates and priority. Most common types are:

• Government/Public Sector Undertaking Bonds

  I would recommend you to go with the government/public sector undertaking bonds if you are searching for medium to long term investments in the current Indian market. These are the kinds of bonds that will be issued and backed by Indian Government.However, in most cases they will be sold on a private basis. In simple terms, we can say that the government itself will target the investors and would offer their bonds at fixed rates. An investment banker will be employed by our government whose role will be to serve as a middleman. I would say that it will be tough for the retail individuals to invest in these bonds since the minimum amount required for investment will be huge.

• Corporate Bonds

  These are the types of bonds that would be offered by corporate houses. In technical terms, these are the fixed income securities that are issued by corporate. At most times, these bonds are open to public. There are several number of traditional bond types that are being offered by private corporations in our country. Most of them could be seen lasting up to 15 years. These bonds would have the feasibility of being bought by anyone which is not the case in government bonds. However, you must remember that there is a higher risk of default in these bonds. The risk may be based upon corporate backing, market’s volatility along with the company’s industries and investment rating. Yet, I would say that the risks would come with higher returns for you. There are several sub-types in corporate bonds which are classified based upon following five criteria:

o    Issuer: Corporate, Banks, PSUs and other Local Bodies
o    Maturity: Short term, Medium term, Long term and Perpetual
o    Coupon: Zero Coupon, Fixed Coupon and Floating Coupon
o    Option: Put option and Call option
o    Redemption: Single redemption and Multiple redemption

Bond prices in India at Moneycontrol.com

• Bonds given by Financial Institutions

  In India, the bonds that are being issued by financial institutions/banks can be considered as the most vibrant financial instrument. These kinds of bonds are making up to 80% of the total bond market in the country. The reasons for this are very simple. These bonds are well-regulated and would come to you with good ratings. Most of the large scale investors are making up the most important part in these bonds.

• Zero-Coupon Bonds

  These are the bonds that would come without any coupon/interest rates. They will be offered at discounts on face value and upon bond maturity, the investor would get back the face value. The profit you are going to get will be the difference between these two. In these bonds, there will be no intermittent payments of interest made.

• Emerging Market Bonds

  The emerging market bonds are the bonds which will be issued by the Indian government which were already issued outside the country as hard currency. The purpose is to increase the capital for economic development in those countries where it was issued. What’s making it very special is that they are issued in U.S dollars/Euro which would attract more number of investors in those countries. Also, the interest rates that are issued by the investors would be attractive. However, you must always remember that the success of these bonds would be tied to the success of the nation’s economic development.

• Junk Bonds

  As the name suggests, these bonds are the ones that will be issued by the companies that do not have a stable financial status. For this reason, the junk bonds are considered to be below the grade of investment. As these bonds are having higher risks, the rate of returns will be much higher.

• Tax Saving Bonds

  These are the types of bonds that are issued by the government of India in order to allow the Indian citizens to be released partially or completely from paying taxes. You can see that most of these bonds will be issued by Reserve Bank of India. These are the bonds that are lasting for five years and are sold at an interest rate of 6.5%. The interest would be paid to the bond holders every six months. The major advantage of purchasing a tax saving bond would be that you will be released from paying taxes on respective interest as long as you hold the bond until maturity.

There are several other kinds of bonds that are available in our country, but I would say that the above mentioned ones are the most common bond types which should be known mandatory before making an investment. Now, knowing about the terms involved in bond investments would be much more beneficial.

Investopedia article: Introduction to Bonds

Terms Involved in Bond Investments

Following is a description about various terms that are involved in bond investments. First, check out the video which will help you understand better about bonds.

• Par Value:

  This can be defined as the amount on which the bond issuer will pay the interest. Most commonly, this value must be repaid to the bond holder at the end of term. In few of the structured bond types, there will be a redemption amount which will be different from the par value and is linked to the performance of the particular asset. This would result in receiving more or less than the original investment at maturity by the investor.

• Maturity:

  The bond issuer will have to repay the nominal amount to the bond holder on the date of maturity. The length of duration until the date of maturity will be referred to as the maturity of a bond. It can be of any length with most of the bonds having a term of up to thirty years.

• Coupon:

  This is the interest rate that an issuer would pay to the bond holder. More usually, this rate will be fixed throughout the term. Upon reaching the due date, the bond holder would hand over the coupon to the bank in exchange of interest payment.

• Yield:

  This can be defined as the rate of return received from the bond investment. There are two different entities to be defined:

                   Current Yield=Annual Interest Paid/Current Market Price of Bond

                                      Yield to Maturity =  C + [(F-P)/n]/((F+P)/2)

Where C – Coupon, F – Par value, P – Price and n – years to maturity
Example: If the price of bond is 920 INR with the par value of 1000 INR and assume that coupons are 100 INR (10% coupon rate) and there are 10 years to maturity. Your yield to maturity can be calculated as:

YTM = {100 + [(1000-920)/10]}/[(1000+920)/2] = 11.25%

And,

Current Yield = 100/920 = 10.86%

•  Credit Quality:

  This may be defined as the probability that the holder will receive the promised amount at the due dates. Various crediting rating agencies like Moodys, Standard & Poor in US rate them as AAA or AA+ or B. CRISIL and ICRA do the same in India. The higher the rating the better the safety of principal.

To find more information on terms related, check Bonds Glossary

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Pros with Bond Investment:

You may be having a thought that since the bonds are having lower returns than stocks, you need not include it in your portfolio. There are some reasons why you should go for bonds. They are:

• Visible Diversity: You could see that the bonds are less volatile when compared with the stocks. Due to this nature, your bonds can stabilize your portfolio by optimizing asset allocation value at times when the stock market is struggling. I would suggest you to have a combination of both these types over a long period of time. This could provide you with comparable returns provided with lesser risk.

• Higher Level of Stability: When you are sure that you will need a large sum of money in the near future, then it would not make sense if you want to invest in stocks as they are highly volatile. You must always remember that the majority of returns on your bond would come from the interest payments and any fluctuations in the bond price would have only lesser impact on the value of your investment. Hence, it is good that you go for bond investment than stocks.

•  Your Income is Consistent: In case of bonds, the coupon payments will be distributed consistently at regular intervals which will not be the case in your stock dividends. If you are a person who is seeking a consistent income would find the bonds as a better alternative when compared with the dividend payments that are offered by some stocks. Check FREE Interest Calculator to find your interest

• Tax Exemption: This is the most important advantages of all. With the payment from some types of bonds, you will be exempted from federal/income taxes. If you are one among the high tax bracket, bond investments will be an excellent vehicle for you to free yourself from the burden of paying taxes.

Disadvantages with Bond Investment:
There is nothing like you don’t have any disadvantages with bond investments. The disadvantages of these investments will take the form of risks mentioned here. Some of the risks are:

• Risk due to Interest Rate: In case of bond investments, the price of bonds will be inversely proportional to interest rates. Hence, if the increase in your interest rate would mean that your bond price is decreasing. It is due to this reason; it could be quite risky to buy long term bonds during the time of low interest rates.

• Risk due to Credit: Occasionally, you will come across the default on loans or mortgages. Likewise, in some cases the organizations that are issuing bonds may default on their obligations. If this happens, then you have to lose the remaining value of your investment. It is to be noted that those bonds that are issued by the federal government will be immune from the default. I would recommend you to look at the rating system which will enable you to know the level of risk entailed by each type of bond.

• Risk due to Inflation: Most times, the interest rate will be set when the bonds are issued. If we are coming across any significant inflation when you are holding the bond, the real value of the investments made will be suffered.Check out our post on What is Inflation – How it affects you

Conclusion:
Hence, a little knowledge about the bond types, pros and cons should be known by any individual in order to invest money in a proper bond. I hope this section from SmartMoneyGoal would have served this purpose for you. Let us know what you think in your comments below. They help us keep going and post what readers ask for.