What is a ‘Bond’
A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debt holders, or creditors, of the issuer.
How Bonds work
When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing other debts, they may issue bonds directly to investors instead of obtaining loans from a bank. The indebted entity (issuer) issues a bond that contractually states the interest rate (coupon) that will be paid and the time at which the loaned funds (bond principal) must be returned (maturity date). The issuance price of a bond is typically set at par, usually Rs100 or Rs 1,000 face value per individual bond. The actual market price of a bond depends on a number of factors including the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time.
Types of Bonds
Certificate of Deposit (CDs)
CDs are short-term borrowings having a maturity of not less than 15 days up to a maximum of one year. They are like bank term deposits accounts. Unlike traditional time deposits these are freely negotiable instruments and are often referred to as Negotiable Certificate of Deposits.
All scheduled banks (except RRBs and Co-operative banks) are eligible to issue CDs to individuals, corporations, trusts, funds and associations. They are issued at a discount rate freely determined by the issuer and the market/investors.
Commercial Papers (CPs)
Commercial Papers are unsecured short term borrowings by Corporates, FIs, PDs, from Money Market with a maturity period of 15 days to 1 year.
Borrowing or lending for one day upto 14 days, in the interbank market is known as call money. Entry into this segment of the market is restricted to notified participants which include scheduled commercial banks, primary dealers and satellite dealers, development financial institutions and mutual funds
Treasury Bills are short term GOI Securities. They are issued for different maturities viz. 91 days, 182 days and 364 days. Banks, Primary Dealers, State Governments, Provident Funds, Financial Institutions, Insurance Companies, NBFCs, FIIs (as per prescribed norms), NRIs & OCBs can invest in T-Bills.
A Debenture is a debt security issued by a company (called the Issuer), which offers to pay interest in lieu of the money borrowed for a certain period. In essence it represents a loan taken by the issuer who pays an agreed rate of interest during the lifetime of the instrument and repays the principal normally, unless otherwise agreed, on maturity. These are long-term debt instruments issued by private sector companies. Unlike other fixed income instruments such as Fixed Deposits, Bank Deposits they can be transferred from one party to another by using transfer from. Debentures can be secured or unsecured.
Zero Coupon Bond
In such a bond, no coupons are paid. The bond is instead issued at a discount to its face value, at which it will be redeemed. There are no intermittent payments of interest. When such a bond is issued for a very long tenor, the issue price is at a steep discount to the redemption value. Such a zero coupon bond is also called a deep discount bond. The effective interest earned by the buyer is the difference between the face value and the discounted price at which the bond is bought. There are also instances of zero coupon bonds being issued at par, and redeemed with interest at a premium. The essential feature of this type of bonds is the absence of intermittent cash flows.
Floating Rate Bonds
Instead of a pre-determined rate at which coupons are paid, it is possible to structure bonds, where the rate of interest is re-set periodically, based on a benchmark rate. Such bonds whose coupon rate is not fixed, but reset with reference to a benchmark rate, are called floating rate bonds.
While investing in bonds, investors can make money either through capital appreciation that is buying and selling, or through interest payout or through a combination of both.