In simple terms, a bond is a debt instrument issued by companies to raise funds. When you buy a bond, you are lending a certain amount to the company for a specified period of time in exchange for interest paid by the company. A bond is a fixed income security as it pays a fixed rate of interest until maturity. Interest rates could also be variable at times. Throughout the tenure of that bond, you earn interest on it and at the time of maturity, the company repays the principal amount. Bonds can be sold in the secondary market before maturity and since they can be sold their price keeps fluctuating.
Risks associated with bonds
Investors should mainly assess three types of risks; default risk which depends on the ability of the borrowers to repay their obligation, liquidity risk which indicates whether a security can be easily sold in the market this can further result in the risk of having to sell a security at lower value and interest rate risk which demonstrates the inverse relation between the price and rate of a security. While making an investment decision these risks should be assessed in contrast with your risk appetite.
Why should you invest?
Investors invest in bonds to attain a predictable income stream while preserving their wealth. Bonds are considered to have minimal risks and they provide higher returns than zero risk based securities. It’s a way to diversify your investment portfolio in order to reduce over-all risk while increasing your return on investment. Investors can nullify the default risk associated with bonds by investing in G-sec which are usually backed by government guarantee. It assures the perfect balance between risk and returns.
Who regulates the market?
Since the market includes government as well as corporate issuers, it is regulated by the RBI as well as SEBI. The RBI regulates and also facilitates the government bonds and other securities on behalf of governments. On the other hand, SEBI regulates corporate bonds, both PSU (Public sector undertaking) and private sector.
How is price determined?
Prices fluctuate in relation with demand and supply, it also depends on the macro-economic situation. Other factors that affect prices are money supply, rates of fresh issues, projected interest rates and credit quality of the issuer. Most importantly, prices are determined based on volumes as mentioned earlier. For instance, if the supply of securities is higher than the demand then needless to say, their prices will fall.
Coupon and Yield
Coupon Rate is the interest rate which remains fixed for the entire tenure of the bond and interest is paid on basis of the coupon rate. Yield is the real effective rate of return which the Investor earns basis the current market value of the bond. In other words, coupon is the rate charged on face value and yield is the rate charged on market value of the bond.
Relation between price and yield
Price and yield have an inverse relation which means as the price goes down the yield goes up and vice versa. What this means is, if you have a bond and its yield it going up it should be considered as a negative indicator. As the interest rate goes up, fresh issues become more attractive and the value of old bonds goes down. If the interest rate falls, old bonds offering higher interest rates increase in value.
Points to consider before investing
· The first and foremost point that should be checked before investing is the credit rating of the issuer. Credit ratings indicate the level of risks associated with the security. AAA rate securities are the least risky while a C rating indicates very high risk. D rates issuers are the ones that have defaulted are on the verge of defaulting.
· Frequency of interest payment should be as per your needs so that they coincide with your goals. Coupon should be based on the minimum return required for your goals. Your cash flows should be planned around your expenses so as to achieve ease in managing your finances.
· Other points like collateral, secured or unsecured nature of security, registrar and trustee of the issue and purpose of issue should also be checked.