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What is a bond?
Investors offer loans to corporate or governmental borrowers using a fixed-income instrument called a bond. Alternatively, companies may issue debt units to investors in the form of a bond. The bond can be regarded as an agreement between the investor and the borrower, essentially a document that acknowledges debt.
Bond borrowers include states, finance projects, governments, companies, and municipalities. Debt holders or creditors of the issuer often act as bond owners. A bond usually includes details, such as the end date by which the borrower must repay the principal of the loan to the bond owner. It also includes details and terms of interest payments.
Return on equity: Highlights
- Bonds are tradeable assets that companies and governments issue to raise funds.
- Bonds are known as fixed-income instruments because investors earn a fixed interest rate.
- There are many different types of bonds, like corporate bonds, municipal bonds, tax-free bonds, and more.
- Bonds have a sovereign guarantee and offer stable interest income. However, they may have lower interest rates than other instruments.
- A bond is different from a debenture.
Types of bonds
Below are the major types of bonds:
- Corporate bonds
Private and public corporations issue debt securities called corporate bonds
- Investment-grade bonds
These bonds have a high credit rating and thus, a lower credit risk as compared to high-yield corporate bonds.
- High-yield corporate bonds
The risk associated with a high-yield corporate bond is higher because they have a low credit rating. However, they offer higher interest rates than investment-grade bonds.
- Municipal bonds
These bonds are also referred to as “munis”. They are debt securities issued by countries, cities, states and other government entities. Below are some types of municipal bonds:
- General obligation bonds: These bonds are not backed by assets as security. They rely on the power of “full faith and credit” of the issuer to tax the residents to pay the bondholders.
- Revenue bonds: These bonds do not rely on taxes but on revenue from specific projects or sources, such as toll charges or lease fees as security. This category also includes non-recourse bonds. This means the bondholders cannot claim in case the revenue stream stops yielding.
- Conduit bonds: Sometimes, the Governments issue munis on behalf of private entities. This includes non-profit hospitals or colleges that are referred to as conduit borrowers. The issuer pays the principal and interest on the bonds, and conduit borrowers agree to repay. In case the conduit borrower doesn’t repay, the issuer is usually not mandated to pay the bondholders.
Below are specific bond types in India that fall under these categories:
- Capital gains bonds
These bonds allow investors to transfer profits from long-term assets like houses and land to specific bonds. This bond offers exemption from capital gains tax for up to 6 months from an asset sale. Thus, individuals must invest in capital gains bonds within 6 months of the sale or transfer of capital assets.
- Government securities: These are the bonds issued by the state and central governments. They pose no credit risk and are a safe way to earn regular interest.
- Corporate bonds: Corporate bonds in India offer more interest than bank FDs and government bonds.
- Inflation-linked bonds: The principal amount and interest payment in inflation-linked bonds are indexed to inflation. These bonds are a great way to counter inflation risk.
- Convertible bonds: The holder of a convertible bond can convert it into equity based on pre-decided terms.
- Sovereign gold bonds: These are also issued by the Government of India. They offer returns similar to physical gold but don’t pose the risk of handling. The interest is also paid periodically.
- RBI bonds: These are taxable bonds issued by the government of India and do not have a monetary ceiling.
The advantages and disadvantages of investing in bonds
Advantages
- Bonds are backed by a sovereign guarantee. Thus, the funds are stable and offer assured returns.
- Some bonds are inflation-indexed and thus increase the real value of funds by adjusting the principal amount based on inflation.
- Periodic interest payments ensure regular income.
Disadvantages
- The interest income is low compared to some other investment instruments.
- They may lose relevance over the long-term.
Bonds vs debentures
While both bonds and debentures are debt instruments and serve the purpose of generating capital from the public, they are different in many aspects. All debentures can be bonds, but not all bonds are debentures. The following table illustrates the difference between bonds and debentures based on various factors:
| Info | Bonds | Debentures |
| Issuer | A bond is issued by both private and public entities | A debenture is issued by private corporations |
| Purpose | The goal of bonds is to collect funds from people and clear the principal before the maturity | The purpose of debentures is to raise money for a specific goal. The debenture holders get first preference above stockholders to receive interest. They help to raise funds for the short or long term. |
| Risk | The risk associated with bonds is low. They are regarded as one of the most secure investments | Debentures are not backed by any security and, thus are high-risk financial instruments |
| Interest payments | Borrowers need to pay periodic interest on bonds until their maturity. The interest rate is called a coupon | The interest rate on debentures is also called a coupon but can be paid either periodically or at the time of maturity |
| Collateral | Bonds are often secured by taxes, revenue or faith and credit of bond issuers | Debentures are unsecured |
| Convertibility | Bonds cannot be converted into other financial instruments or equity | A debenture holder can convert the debenture into a predetermined number of shares after a fixed time. These conditions are based on the offering of the issuer |
| Priority | In case of liquidation or unforeseen circumstances, bondholders get priority | Debenture holders get priority over equity shareholders |
| Tenure | The bond issuer decides the bond tenure. Bonds are usually used for longer terms, and the tenure varies between 1-15 years | Debentures are used for both short and long-term based on the purpose of investing. The tenures of debentures are usually shorter than bond tenures |
Tax-free bonds
Tax-free bonds are securities usually issued by the Government or Government-backed entities to raise finances for a specific purpose. Income tax is not charged on the interest that these securities yield. According to Section 10 (15) (iv) (h) of the I.T. Act, 1961, interest is also not regarded as a part of total income.
These are low-risk investment options and have a maturity of 10 yrs or more. The Government invests money collected from these investments in housing and infrastructure projects. Munis are also tax-free bonds that offer fixed interest rates without any mere default.
Conclusion
Bonds are a safe investment option for investors who are risk-averse and looking to build wealth long term. There are many bond options that investors can choose to secure and grow their savings. Bonds are of many types, and investors must access each option carefully before investing.
