Understanding Bonds – Part 1

When we think about investment, the first thing comes in the people’s mind that they should invest in the share market or real estate for making rapid and huge profit. Stories of investors gaining great wealth in the stock market and real estate are common. The other side for bond market, the picture is different and not very exciting for common investor. People are not much excited about bond market due to lack of knowledge and less media coverage. People often think bonds are much more boring - especially during bull markets, when they seem to offer less return compared to stocks.

In the bear market investors want invest in bonds for safety and stability. In my opinion, for many investors it makes sense to have at least part of their portfolio invested in bonds. So we are starting a series of articles related bonds in the many parts to understand  what bonds are, the different types of bonds and their important characteristics, how they behave, how to purchase them.

In our lives we need money at some point and we borrow that money from our relatives, friends or banks. Just like that companies need money for expand of business and government need money for development and welfare for citizen. The solution is to raise required money by issuing bonds (or other debt instruments) to a public market. Basically, A bond is nothing more than a loan for which you are the lender and companies or govt are borrower. The companies and government that sells a bond is known as the issuer (borrower).

As in simple case borrower pay some interest to lender for lending money at predetermined rate and specified time. In case of bond the interest rate is often known as the “coupon rate”. The date on which the issuer (borrower) has to repay the borrowed amount known as “maturity date “ and  borrowed money know as “face value” of bond . Bonds are known as fixed income securities because you know the exact amount of cash you'll get back if you hold the security until maturity. For example, if you buy a bond with a face value of Rs 1,000, a coupon of 8%, and a maturity of 10 years. It means you'll receive a total of Rs 80 (Rs 1,000 * 8%) of interest per year for the next 10 years. If bonds pay interest semi-annually, you'll receive two payments of Rs 40 in a year for 10 years. When the bond matures after 10 year, you'll get your Rs 1,000 back on maturity date.

Difference between Debt and Equity:

The main difference between bonds and equity are that bonds are debt and stocks are equity. By owning equity (stock) an investor becomes an owner in a company. It means owner of stocks has right of voting and the right to share future profits if any.   By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). The primary advantage of being a creditor is that you have a higher claim on assets than shareholders. In the case of bankruptcy, a bondholder will get paid before a shareholder. However, the bondholder only entitled for principal amount (face value of bond) and interest (coupon amount). Bondholder does not share in the profits if a company does well in future.

It means debts are lower risky instrument with lower return and stocks are higher risky instrument but uncertain return. Now the question is for whom debt instruments are suitable and for whom stocks (equities) are good. For retired person who need fixed income with capital protection debt instruments are ideal. For those who are worried about of stock market volatility in near term and don’t want risk to wipe out of capital amount debt instruments are suitable. These instruments are the best option for short term horizon’s investment with lower risk.

In the next article we will understand bonds in more detail.

Regards,

Arvind Trivedi

Certified Financial planner