Financial instruments are assets or contracts that have some credible value and can be traded, or; they can also be seen as the packages of capital that can be traded between the buyers and sellers. Derivatives ( Futures and Options ), Bonds, Stocks; all are some of the famous examples that can be given for Financial Instruments.
Financial Instruments can be classified in two ways:
a) i) Cash Based ii) Derivative Based
b) i) Equity Based ii) Debt Funds
Bonds are definitely Debt Fund Instruments. To learn more about Financial Instruments and its types, you may follow the article in blue link- Financial Instruments and types
What is a bond in simpler terms?In the above discussion, we have figured out that bonds are debt funds that company uses to generate money. But what does this exactly mean? How do Bonds help government or corporates to generate money? To understand this, consider a hypothetical company that needs an amount of Rs.50 crore to carry out their future plans. To get this amount of money, they can take loans from Banks or other corporates. One other way to accomplish this is by issuing Bonds. Company will divide this amount of 50 crore into 5 lakh (this number of 5 lakh is not fixed, it is decided by the bond issuer) equal portions of Rs.1000 (1000 X 5 lakh = 50 crore) and name them as bonds.
Now company will sell these bonds to buyers for a fixed period of time at a fixed rate of interest. As this period of time is over, you will get your money back with your fixed earnings as guaranteed by the company at the time of issuing bonds. A very simple analogy to this can be given as follows - I need money for something and I ask my friends to help me by lending some money and after some time , i will pay them back after some time with some extra money . Bonds work in same way.
So we can say that Bonds are small units of the corporate debts which company or any government organization take from investors and provide them fixed interest rates like the bank does. Even if the company or government loose that whole money, you as an investor will get your whole money back with that fixed interest. As you buy shares in equity market, you become a small owner of the company and your profits depend on the performance of the company. I f share prices fall, you lose your money and if share prices rise, you win. But, this is not the case with Bonds. Company wants to expand it’s business and that is way, it is borrowing money from you. You as an investor , with a more sense of security in Bonds, can lend money to the company.
The interest generated by bonds are not given to you only on maturity. Rather, you get the interest generated after every quarter, every month or every year based on the policies decided by the organization.
Some basic terms related to bondsGovernments at al levels whether central, state or municipal and corporations use Bonds to borrow money form masses. Corporation want money to grow there business and government use it for building infrastructure like roads , hospitals etc. But for investors, they can be a fixed source of income as they get their interest on regular interval of time. People often use them as their retirement income. Let us discuss some of the basic terminologies used in Bonds trading:
1. Issue Price
The issue price is the price at which the bond issuer originally sells the bonds.
2. Face Value of Bonds
A bond’s face value refers to the amount it will be worth on its maturity date. In other words, it’s the value that the investor will receive on maturity (assuming that the issuer doesn’t call the bond or default). The price at which you can buy bonds vary daily. If today you can buy them at Rs.1000, may be tomorrow they cost you Rs. 980. But the Face value at which you once buy the Bond does not change.
So, here we draw one more conclusion, the price that you get after maturity may or may not be equal to the price you pay to buy the Bonds ( don’t consider this due to the interest you earn because the interest has already been put in your account every fixed period of time).
3. coupon Rate
The coupon rate is the rate of interest the bond issuer will pay you every year on the face value of the bond, expressed as a percentage. Let say the coupon rate is 10% and the face value of the Bond is Rs.1000, than you will get Rs.100 every year till the maturity of your Bond. This amount of Rs. 100 can be given to you in any number of installments in a year. Like every three months, you get Rs.25 .
Are bonds a good investment?When an investor purchases a bond, they are "loaning" that money (the initial amount is called the principal) to the bond issuer, who is usually raising money for a project.
Let’s say a new company is ready to expand but doesn’t have enough funds for expansion. They may turn to the public for their financing needs. One of the way that can work to gain more capital is by issuing bonds and borrowing money for some fixed interval of time.
Whether it is a good decision or bad for you to invest in bonds totally depends on your condition . Before investing in Bonds directly, you should study the pros and cons of investing in bonds.
What are advantages of investing in bonds ?Bonds have a clear advantage over other securities in terms of risk. People who generally don’t trust stock market can also invest in Bonds.
They might not provide as much return as stocks can provide to an experienced trader , but they are an essential part of everyone's retirement portfolio. Here are some of the benefits that Bond investors enjoy :
1. Stability or Low volatility : Comparing the bonds and stocks, Bonds are less likely to lose money than stocks. The volatility of bonds (especially short and medium dated bonds) is far lower than what equities (stocks) have. Thus bonds can be considered as the safer investments than stocks. In addition, bonds do suffer from less day-to-day volatility than stocks, and the interest payments of bonds are sometimes higher than the general level of dividend payments.
3. Security : Next to cash, Bonds are the safest, most liquid investments. Bondholders also enjoy a measure of legal protection as under the law of most of the countries, if a company goes bankrupt, it will have to give some money back (the recovery amount) to its bondholders, whereas the company’s equity stock often ends up valueless and share market investors ends up in total loss of money.
Furthermore, bonds come with indentures (An indenture is a legal and binding contract usually associated with bond agreements, real estate, or bankruptcy) and covenants (Covenants exist in financial contracts, such as bond issues, that set out certain activities that will or will not be carried out. Covenants are legally binding clauses, and if breached will trigger compensatory or other legal action.). Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing.
4. Tax savings : Certain bonds provide tax-free income. These bonds usually pay lower yields than comparable taxable bonds, but may provide higher after-tax income to investors in high tax brackets.
What are Disadvantages of investing in Bonds ?1. Risk of calling : Some bonds are callable, meaning that even if the company has agrees to make payments with the interest on the debt taken from you for a certain period of time, the company can choose to pay off your money back before maturity date which creates a reinvestment risk. This means that the investor is now automatically forced to find a new place to put his money. As a consequence, the investor might not be able to find as good a deal, especially because such things happen only when the interest rates are falling in the market. Generally , government bonds don’t entertain such things.
2. Money after maturity only : This is the basic condition of bond investments that you can not get your money back before a fixed period of time i.e. till the maturity date as the company have took this money from you to extend its business. That is why, the money given by you to the company must have been invested in there new projects.
This may cause a problem when you require an urgent extra cash. If you would have invested in equity, you could atleast sell them whenever you want no matter what the loss may be. So, it is always advised to invest your money in Bonds only when you have extra money that you will not require in near time.
Can you loose money In bondsThough, Bonds can be considered very much safe to put your money in but why to ignore the worst possibilities. What’s the harm in learning the losses you can deal with in bonds investment . So, I found this article very much helpful to learn about this very topic which you may prefer to read.
How do I buy and sell bonds in India?Before the November of 2017, it was not virtually possible for the common citizen of India to buy and invest in the government securities ( G-SECS) , but then RBI started the “Non-competitive Bidding Facility” which made G-secs more accessible for common men ( small investors).
You can visit the web-app on NSE website or download the “NSE goBID” on your mobile for trading bonds.
You can buy two types of bonds there :
- Long-dated government bonds: holding time: 5 to 40 year.
- Treasury bills (T-bills): holding time less than 1 year.
In USA, Stocks are traded publicly on a large, centralized exchange such as NASDAQ or the NYSE. Conversely, bonds are typically sold over the counter (OTC) and treasuries can be bought directly from the the US government’s website, Treasury Direct .