What is a Bond: Meaning & How Do Bonds Work? | Espresso

What Is a Bond?

Many investors assume that investing in stocks is the only way to make money over time. But what if the stock market plummets? You will either lose all of your money or the majority of it. In this scenario, investing in bonds is the most viable option. Today in this post, we will talk about the fundamentals of bonds. 

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Bond Definition

Bonds are a sort of debt that corporate, or the government raises from the general public to meet specific goals. In exchange, the bond issuer gives interest rates to the investors till maturity. Bonds are perfect for investors who want to make a decent profit without taking much risk.

Jargons Used in Bonds

Before proceeding ahead, you must first comprehend the bond's jargon.

  • Face value: 

It refers to the bond's issuance price on which the interest is computed.

  • Coupon rate:

The interest rate you receive on your bond's face value is called the coupon rate. It is paid either half-yearly or annually.

  • Redemption year:

It is the bond's maturity year. And it is during this year you can redeem it for a premium or par value.

  • Redemption at par: 

Under this, the bond's redemption price and face value are both equal.

  • Redemption at a premium:

Under this, the bond's redemption price is higher than its face value. So, for example, if you redeem a ₹100 bond for ₹105, then ₹5 is premium here.

  • Yield to maturity (YTM):

YTM is the total return you expect from your bond if held till maturity. The YTM fluctuates based on your secondary market buying price.

How Do Bonds Work?

Bonds are sometimes recognised as fixed-income assets. The reason being they provide you with a regular income through the coupon rate.

Assume you bought a bond worth Rs 20,000 with a maturity period of ten years. It has a coupon rate of 10%. In this case, your bond will pay you Rs 2,000 annually for ten years. On the maturity date, the bond issuer will repay your principal investments (face value) of Rs 20,000. 

Different Types of Bonds

  • Convertible bonds: 

Such bonds allow you to convert your holdings into equity shares. These bonds have a predetermined conversion ratio. For example, if your bond has a 2:1 conversion ratio, you will get two equity shares in return for one bond.

  • Callable Bonds:

These bonds give the issuer an option to buy back the bond from the investor before it matures. The issuer usually calls off the bond for refinancing it at lower rates.

  • Puttable Bonds:

These bonds give you an option to surrender your investment before it matures. Investors usually exercise this right if they are unable to find a buyer in the secondary market.

  • Zero-coupon bond: 

These bonds do not pay any interest throughout the bond life. The issuer sells the bond at a lower price than its face value. For example, if you purchase a zero-coupon bond for ₹90, you can redeem it for ₹100. The discount of ₹10 on the face value is what you earn here.

Key Highlights of Bonds

  • As the interest rate rises, so does the coupon rate on new bonds, making it a more profitable investment. Though, the situation leads to a drop in the resale value of the existing bonds.
  • The bond's coupon rates are influenced by the issuer's credibility. In general, the riskier the bond is, the higher will be its return. You may have also noticed that government bond rates are usually lower than corporate bonds.
  • The duration till which you hold your bond also plays a role in deciding your returns. If you want to sell your bond on the secondary market, you run the risk of not recouping your initial investment or principal, especially if interest rates are rising.

To Conclude

Bonds clubbed with other assets in your portfolio can help to balance your risk and reward. Even if you are not diversifying your investments, plan your portfolio with a mix of different sorts of bonds. It will assist you in multiplying your profits.

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Frequently Asked Questions

You can invest in bonds through an initial bond offering, secondary market, or via mutual funds or exchange-traded funds (ETFs). 

The key factors that determine the bond price are the issuer's creditworthiness, demand and supply, and market interest rates. In the case of the secondary market, the prices are based on the par or face value. 

Bonds provide numerous advantages. The following is a list of a handful of them.

  • Bonds provide a steady stream of income.
  • Bonds are considered long-term investments. It aids in the accumulation of wealth for retirement.
  • Even if the market is not in your favour, this investment alternative aids in capital preservation.
  • Bonds come with several tax advantages.