What are Bonds and How do they Work?

"The individual investor should act consistently as an investor and not as a speculator." 

- Ben Graham

 

 

What are Bonds?

 

In simple terms, a bond is like a loan issued to the borrower by the investor. It is a fixed instrument through which money is raised by the borrower. It is similar to I.O.U. Now what is an I.O.U?

 

“I owe you” i.e. I.O.U, is an acknowledgment that a debt exists. So, a bond is an I.O.U between two parties that is the borrower and the lender/investor. It contains the information about the loan and its payment.

 

When you purchase a bond, you lend money to the borrower. This borrower can be either any corporate entity or government or even municipality. The person giving money is called creditor, issuer, investor or even the debt holder. In return of the money lent, the borrower will promise to pay you interest at an agreed rate.

 

He will pay you the principal value along with the interest accumulated during the lifetime of the bond. The principal value is also called the “face value”. When the bond matures or its set period comes to an end, the borrower will have to pay the face value plus the interest.

 

Also Read | Dynamic Bond Funds

 

Reasons of Issuing Bonds

 

What are the reasons for which bonds are issued by people? Here are some of them:

 

From Investor’s Perspective

 

1. Bonds are like a stable and fixed source of income. Interest on bond accrues twice in a year and is paid.

 

2. Bonds are also a way to block and preserve capital for a longtime. If the bonds are held till their set period then the investor gets both the face value and the interest. Therefore, instead of keeping cash in hand and spending it, it is better to purchase bonds.

 

3. If you are into the stock market, then you know how volatile they can be. Therefore, in order to set-off the losses or volatility in stocks, you can keep bonds.

 

From Borrower’s Perspective

 

(Here, borrowers are corporates, government, municipalities etc.)
 

1. By issuing bonds, you can ensure a regular cash-flow supply in the company.

 

2. It is a source of financing debt.

 

3. Governments and Municipalities can use the money to finance projects like- schools, roads, hospitals etc.

 

 

Perks of Issuing Bonds
 

1. Bonds make your portfolio more diversified. 

 

2. They are less volatile as compared to stocks and if you hold them till maturity they will become a stable source of income for investors.

 

3. The rate of interest on bonds is higher in relation to savings accounts, fixed deposits, post office deposits, CDs and even money market related accounts.

 

4. Even when stocks decline, bonds perform well.

 

Also Read | Green Bonds Explained

 

Why is Bond preferred over Stock?

 

"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets."

 — Peter Lynch

 

You can differentiate between stocks and bonds through one phrase- Debt vs Equity. Equity means stock and debt means bond. One of the primary advantages of issuing bonds comes from this phrase.

 

You might know how risky equity investment can be. Bonds being debt are safer to invest money. Infact, debt holders are always given preference over the equity holders. 

 

In short, if a company is liquidated then the debt holder will be given priority over the stockholders at the time of payment. The worst case scenario can be that debt holders are given less than what is due to them.

 

But when this happens, stockholders are given zero. At least being a bondholder will give you some of your money back. Don’t you think how advantageous it is for you to invest in bonds instead of stocks?

 

History tells us that stocks give more returns than bonds. But during the economic cycle, a phase comes when stocks decline and it is then, when people want something to smoothen the bumps and recover the losses.

 

Bonds are always more secure, stable and predictable. When people need security, bonds are their go to option rather than stocks. If you are retired then also bonds will provide you security of having a constant income flow.

 

If you only invest in stocks then your portfolio won’t be very diverse and unique. It won’t end well when you retire in the bear market. In order to remove such disappointments in later stages, investing in bonds can be a simple solution for you.

 

If you are a college student then instead of putting your money in banks, you can use a small portion of it to buy bonds. It is much safer and moreover your savings will increase faster. The interest rate offered by banks on savings accounts is quite lower than the bonds. 

 

Buying stocks with your pocket money can be risky as you never know when it starts declining. Putting money in banks is better than stocks and buying bonds is better than parking funds in a bank.

 

So, in short bonds are a better option than stocks and even banks (in some cases).  The reasons given above justify why Bonds are always preferred over Stocks in both the long run and short run.

 

Types of Bonds and their Working

 

For investors there are different types of bonds. These varieties can be on the basis of rate of interest, coupons, issuer conditions or some other factors. Given below are 4 different types of bonds issued by the borrower. 

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Types of Bonds

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1. Zero Coupon Bonds

 

Zero Coupon Bonds are special types of bonds that do not pay interest during the set life of the bond. These bonds are bought for a long term. Some do not even mature after 10-15 years.

 

The benefit of having such a long term maturity date is that the investor can plan his goals. He can think about his child’s education plan, foreign tours and retirement plans. It is a very good option to deposit small amounts and let it grow for a long period.

 

There are many Zero Coupon bonds in the market, issued by multiple sources like the U.S Treasury, State entity, Local entity and even Corporations. Due to the fact that no interest is accrued during the life, the fluctuations in these bonds is higher in the secondary market as compared to other bonds.

 

No payment is done before maturity but the investors have to pay tax on the imputed interest every year. In order to not to pay the tax, some investors prefer buying municipal bonds or bonds of those corporations that are exempted from tax.

 

 

2. Convertible Bonds

 

Just as the name suggests, Convertible Bonds can be converted anytime during their life. Conversion means that bonds can be converted into stock/equity shares. There is a pre-decided number of shares of a company that are exchanged for convertible bonds.

 

There are multiple disadvantages of having convertible bonds. When the price of stock rises, companies offer low yields on these bonds. In case the stock declines then the company does not exchange the bonds.

 

Investors get stuck with bonds that offer sub-par returns. Issuing convertible bonds to investors is because of two main reasons. One is to reduce the interest/coupon rate on the bond. 

 

When people get the option of conversion they purchase the bonds instantly despite the low coupon rate. This way companies can save a lot of money that would otherwise be spent as interest expense.

 

Second reason is to postpone dilution. Issuing convertible bonds instead of equity shares allows the company to delay dilution. In case the price of equity rises, companies can force the exchange at higher prices.

 

In short, by issuing convertible bonds companies get the advantage of saving interest expenses and taking stock at an appreciated value. It is up to investors to invest in such bonds. Reviewing the credit rating of the corporation is very much necessary before taking investing decisions.

 

 

3. Callable Bonds

 

It is also called “Redeemable Bond”. A Callable Bond just like a normal bond is a debt security but here the issuer has the option to redeem the money before the set period of the bond.

 

For companies, a Callable Bond provides the option to set off its debt earlier. It is totally at the discretion of the issuer whether or not he wants to redeem the bond. These bonds offer benefits to both parties.

 

The issuer gets the option to pay debt early whereas the investor gets his money before maturity along the interest due up to the date of redemption. Instead of non-callable bonds, Callable bonds are considered better.

 

These bonds are issued either for expansion/funding needs or to settle off the debt/loan. The call value of these bonds is slightly higher than regular bonds. It depends on the redemption period. If you redeem early, then call value will be higher.

 

The earlier you redeem, the higher will be the call value. For example- A bond which is to mature in 2030, will have higher call value if it is redeemed in 2021. If you redeem it in 2018 then its call value will be even higher.

 

 

4. Puttable Bonds

 

Puttable Bonds are completely opposite to Callable Bonds. Here the bond holder has the right to ask for payment prematurely. These bonds benefit the investors greatly. It acts as an incentive for the debtholders.

 

If we look from the borrower's perspective then these bonds will permit them to pay less yield on the principal value. It is human nature that if we have the option to withdraw money earlier we will do it. 

 

Irrespective of the low rates we will do it. The mindset of investors is that they get their investment along with extra money on it. If someone faces urgent cash needs then having Puttable bonds will solve your issues.

 

Even though these bonds are great for investors, there is always a drawback of not being able to get complete yield value on the principal amount. People in most cases withdraw their money earlier.

 

Also Read | Dynamic Bond Funds

 

In order to raise money, bonds are the best options for municipalities, corporations and governments.