What are different types of bonds and how do they work?

Financing is the most critical component when it comes to running a business. There are two primary ways of raising money for running a business. Either you borrow money or sell equity in open or private markets. 

Issuing bonds to potential investors is one way of raising money under borrowing options. Investors that subscribe to such bonds provide money to the business for a specified time period and in return, they get regular interest payments. 

As these instruments are a source of investment for investors, it is also called investment bonds. Read here to know more about this concept and have detailed clarity on this. 

What are bonds?

As discussed above, these are a type of debt instrument for companies and an investment option for different individuals. It acts as a contract between the corporate entities and their investors in which the money provided by the latter is used by the former to fund its business activities. 

Bond issuers have a legal obligation to provide regular monthly income in the form of interest to the investors. Apart from this, investors will be receiving the principal amount on redemption. 

The investment bond’s interest rates vary from one bond to another. It depends on many factors like the credit rating of the issuing entity, the overall macroeconomic scenario and the prevailing market interest rates. 

Many entities issue investment bonds forraising funds and they include state and federal governments, public sector units, municipalities, corporates, and others. Every bond comes with a predefined maturity date. 

Types of bonds

Here are the various types of bonds that you can invest in: 

1. Floating rate bonds
   These debt instruments do not come with a fixed return. Instead, the returns or interest differs and is tied to a set benchmark during the course of bond tenure. Suppose you have invested in a floating rate bond in the year 2019 and the interest rate on the same is 75 basis points higher than the marginal cost of the lending rate. 
   The coupon or interest amount will change as per changes occurring in the marginal cost of lending rate throughout bond tenure.  
2. Fixed rate bonds 
   As the name suggests, these debt instruments have a fixed interest rate and subsequently the interest amount is also constant over the duration of bond tenure. This works in the opposite manner to floating bonds. 
   The interest or coupon rate is predetermined in these bonds and mentioned in the bond agreement signed during the time of subscription. 
3. Perpetual bonds 
   This is an outlier in the whole concept of bonds. Under this type of investment bond, there is no redemption or maturity date. Investors and subscribers will keep on receiving monthly interest rates till the time bond issuers do not trigger the call back option and buy back the same by paying the principal amount. 
   As there is no fixed timeline, companies or those issuing such bonds keep on paying interest amounts to bondholders till perpetuity. 
4. Zero coupon bonds 
   Again, as the name goes by, these debt instruments do not come with any interest component. Now you may be wondering that if these bonds do not pay any interest, why would anyone put in their hard-earned money in these instruments?
   Here's the catch. Even though these bonds do not have any interest component attached to them, companies issuing the bonds offer a discount, i.e.; investors will have to pay less principal amount than the actual value. 
   However, on redemption, these issuing entities repay the investors at par value or the actual face value of the respective bond. This difference between discounted and the actual face value constitutes the profit for all the bondholders. 
5. Inflation-linked bonds 
   These are a special category of investment bonds that take into consideration the prevailing inflation or consumer price index of the economy. This is done to protect the investors from the negative consequences of inflation and reduce the purchasing power of their money. 
   Under this type of bond, the principal as well as the interest amount gets adjusted as per the inflation. The changes occurring in the general price level of the economy lead to corresponding changes in the principal amount. 
   Furthermore, the issuing entity pays the interest amount as the new and adjusted inflation. Suppose the face value of a particular bond stands at ₹100 at the time of issue. For the first year, the coupon amount gets calculated on the principal. 
   However, due to heavy inflation prevailing in the economy, the principal amount changes to ₹110 after the end of the first year. Therefore, for the second year, issuing entity needs to compute interest on the adjusted principal amount which stands at ₹110. This cycle keeps on repeating till the tenure of the bond ends. 
6. Callable bonds 
   This is another category of bonds which comes with very high coupon or interest rates. The major feature of these debt instruments is that bond issuers have a right to recall these debt instruments at the predetermined price before the redemption date. However, they can only exercise such call options after the completion of a specified time period mentioned in the terms and conditions segment of the bond agreement.  
7. Puttable bonds 
   It works in the opposite manner of a callable bond. Just like a callable bond gives the right to recall to bond issuers, these give bondholders or investors the right to return their respective bonds and ask for repayment at the pre-decided level and before the completion of maturity. 
   As callable bonds do not give any say to bondholders in the recall option, it comes with a high interest component. This acts as a compensating factor. However, as puttable bonds give total right of recall in the hands of bondholders, coupon rates on these are not usually high. 
8. Convertible bonds 
   As investment bonds are a type of debt instrument, there is always a risk of default on the part of issuing entities. As there is no collateral involved in these, there exists a risk of loss in case of default. However, there are some types of bonds which are convertible in nature. 
   This means that in case of a default, a part or complete percentage of these bonds gets automatically converted into equity shares. Therefore, in doing so, bondholders who were debtors of the company will change into part owners of the company with voting rights and an active say in managerial decision making. 
   Hence, we see that there are many types of investment bonds in India. You should invest in these after assessing several factors like your investment horizon and objectives, investment vision and risk appetite. 

How do bonds work?

There are a significant number of investors that are confused about the working of bonds. They invest in bonds but do not actually know how prices and yields of bonds keep  changing regularly. 

Many fresh and budding investors do not actually know that the prices of these investment bonds regularly change just like any others security that is traded publicly on different stock exchanges. 

Yields refer to returns that you as an investor will receive from the total investment amount. You can also compute prospective yields that you may receive from bonds in which you have invested. The formula for the same is as follows: 

Yield = (The interest or coupon amount)/Bond prices

When the bond price changes and comes at the par or face value level, the yield is equivalent to the coupon or interest rate of the same. Therefore, we can conclude that corresponding yields from bonds change as per fluctuations in the bond prices. 

As an investor, you can also determine the final yield that you would be getting on the maturity and redemption of the bonds. However, it involves certain complex calculations and several fixed factors. 

Advantages of bonds

The different advantages of investing in bonds are as follows: 

1. Consistent income 
   One of the major benefits of investing in these debt instruments is that they give  consistent and systematic income to bondholders. Such organised and consistent income allows individuals to plan their investment better. Apart from this, the investment bond monthly income is an efficient source of earning for senior citizens to lead a peaceful and hassle-free retirement life. 
2. Diversification
   Another advantage of investing in these debt instruments is that it gives a semblance of diversification to your overall investment portfolio. It acts as an effective balancer of your investment basket and works as a shock absorber. Moreover, it makes the portfolio more resilient to vulnerabilities of investing. 
3. Low risk 
   Bonds are relatively safer investment instruments as compared to other avenues like equities and derivatives. Government bonds are the safest as they come with a sovereign guarantee. On the other hand, several independent rating agencies provide certain ratings to corporate bonds and it helps investors to put their money in high quality and safe instruments. 

Limitations of bonds

Some limitations of investing in bonds are as follows: 

1. Low liquidity 
   The liquidity associated with bonds is quite less. It can become very difficult for investors to exit the bond investment by simply selling it to another prospective buyer due to a number of restrictions like withdrawal restriction on the total investment amount. 
   Additionally, if creditors go ahead with selling the bonds before the stipulated time period, they are likely to incur heavy losses and penalties. 
2. Low returns 
   As the risk associated with these investment instruments is quite less, the level of return on these is also quite less. The returns are low to moderate in comparison to other investment avenues like equities, derivatives, real estate, commodity trading, etc. 

Conclusion

Investment in bonds presents an efficient and steady stream of income for investors. On the other hand, it is an efficient source of financing for companies as well as for those who want to raise funds but don't have the equity left to further divest. 

However, it is imperative that if you are considering investing your money in these instruments, you should consider your investment goals and appetite before taking any decision regarding it.