Bonds are a type of investment that typically offers a fixed return and serves as a source of regular income. Bonds are a popular investment option among investors who prefer to invest in low-risk instruments. Different types of bonds are available in the market, each with different features and characteristics that cater to the needs of diverse investor groups. In this article, we will discuss the different types of bonds that are commonly available in the market.
List of Different Types of Bonds
The following are the different types of bonds:
1. Fixed-rate bonds
Fixed-rate bonds are the most common type of bonds. These bonds pay a fixed interest rate over the life of the bond. This ensures that the bondholder receives a fixed amount of income for the period of the investment.
2. Floating-rate bonds
Floating-rate bonds are bonds whose interest rate is adjusted periodically according to the market conditions. The interest rate on these bonds fluctuates with changes in the market rate.
3. Zero-coupon bonds
Zero-coupon bonds are bonds that do not pay interest. Instead, these bonds are offered at a discount to their face value, and the investors receive the full-face value of the bonds at maturity. These bonds are also called deep discounted bonds.
4. Puttable Bonds
These bonds grant the bondholder the right to compel the bond issuers to repurchase the debt securities prior to their predetermined maturity date. However, whether to avail this right is entirely at the discretion of the bondholder. They are not obligated to exercise this option.
5. Convertible Bonds
Convertible bonds are a type of hybrid security that offer both fixed interest payments and a pre-determined option to convert to a specific number of equity shares within a specific timeframe at a set price. The investor has a voluntary option to convert, which creates an opportunity for them to become a shareholder of the company. Additionally, convertible bonds offer investment flexibility for companies as they provide a lower interest rate than traditional corporate bonds and the potential for future equity.
6. Callable Bonds
These bonds offer greater flexibility to corporations or governments to redeem the bond issue before their scheduled maturity date. Callable bonds typically offer higher interest rates to compensate investors for the additional risk, but the bond price may rise less if interest rates fall. Investors must review the bond prospectus carefully before investing to understand the terms, conditions, and early redemption clause associated with the callable bond.
7. Perpetual bonds
Perpetual bonds are bonds that do not have a maturity date. They provide a fixed interest payment to bondholders indefinitely. Perpetual bonds are popular for their steady and reliable income stream.
8. Inflation-linked bonds
Inflation-linked bonds are bonds that offer a return that is indexed to the inflation rate. As inflation rises, so does the interest rate on these bonds. This ensures that the return on the investment keeps pace with inflation.
9. Treasury bonds
Treasury bonds are issued by the central government. This makes them the safest bond type as they do not have any credit risk. Mostly, these bonds mature in ten to thirty years and offer a fixed interest rate, which is influenced by market conditions.
10. Municipal bonds
Municipal bonds are issued by local and state governments, mostly to finance projects like schools, hospitals, and highways. Investors must note that these bonds offer tax exemptions, and some offer short-term and long-term maturities.
11. Corporate bonds
Corporate bonds are issued by companies to raise capital for their operations. They are rated based on the creditworthiness of the issuer. Hence, they are riskier than treasury bonds. Furthermore, their maturities and interest rates vary based on market conditions and issuer credibility
12. High-yield bonds
High-yield bonds are also called as junk bonds. Mostly, they are issued by companies with lower credit ratings. These types of bonds are riskier than investment-grade bonds due to a high risk of default. Thus, to attract investors, these bonds offer higher yields to offset the higher risk.
13. Mortgage-backed securities
Mortgage-backed securities are created by real estate firms. You can think of them as a basket holding several home loans. These securities pool several mortgages and issue bonds against them. They derive cash flow from the mortgages, which makes them safer than corporate bonds due to reduced credit risk.
Features of bonds
Bonds exhibit distinct features that set them apart from other investment vehicles. Here is an elaboration on these features:
1. Interest rate
The interest rate on a bond represents the coupon payments made by the bond issuer to the bondholder. This rate is generally a fixed percentage of the bond's face value and is disbursed at regular intervals over the bond's lifespan.
2. Maturity date
The maturity date signifies the redemption date when the bond issuer is obligated to repay the bond's principal amount to the bondholder. It is the point at which the bond reaches its full term, commonly known as "maturity."
3. Face value
The face value denotes the sum that the bond issuer commits to pay the bondholder upon maturity. It is also referred to as the par value of the bond.
4. Yield
Yield represents the rate of return on a bond, expressed as a percentage of the bond's current market price. It takes into account both the coupon rate and the prevailing market value of the bond.
5. Credit rating
Credit rating agencies evaluate and assign a bond rating based on the creditworthiness of the issuer. This rating serves as an indication of the likelihood of the issuer defaulting on its bond payments.
6. Liquidity
Bonds are tradable in the secondary market, allowing investors to buy or sell them before reaching maturity. The liquidity of a bond refers to the ease with which it can be transacted in the secondary market, providing investors with flexibility.
Advantages of bonds
Different types of bonds offer distinct advantages and disadvantages. Usually, they are favoured by risk-averse investors for their reliable interest and principal repayments. Let us look at some major advantages that make them a stable investment choice:
1. Stable income
Bonds usually offer a stable income by paying regular interest. This makes them appealing to conservative investors who want consistent earnings.
2. Diversification
Bonds allow investors to diversify their portfolios. Since bonds have zero or low correlation with other financial instruments, like stocks, they help investors reduce the overall portfolio risk.
3. Low risk
Bonds are safer than stocks. In the event of liquidation, bondholders enjoy a higher priority right over equity shareholders. This means they are paid back first in cases of bankruptcy. This priority makes them less risky compared to stocks.
4. Predictability
Investors must note that bonds have a set term and interest rate. Thus, they are more predictable and stable, making them appealing to investors seeking low-risk investment options.
5. Issuer flexibility
Bonds can be issued in different forms and terms. This gives the bond issuers flexibility in raising capital. Also, this benefit of customisation helps companies meet their specific needs, like arranging funds for long-term projects or short-term cash management.
Limitations of Bonds
Despite their many advantages, bonds also have some limitations.
1. Interest rate risk
As a rule of thumb, the prices of bonds decrease with an increase in the interest rates in the economy. Thus, if investors sell their bonds before maturity, they will incur losses. Most types of bonds suffer from interest rate risk during the phase when interest rates are rising.
2. Inflation risk
Inflation refers to an increase in the general prices of goods and services. It affects the real return generated by the bonds and results in less purchasing power for bondholders.
3. Credit risk
It refers to the possibility that the issuer of a bond might not be able to repay the borrowed money. If the issuer defaults, bondholders may not get back all their invested money or receive the promised interest payments. To mitigate credit risk, investors must invest in bonds from more financially stable issuers. However, remember that you might need to accept lower returns, as most high-rated bonds offer lower interest rates.
4. Liquidity risk
This risk represents the difficulty of quickly selling certain bonds, particularly those with infrequent trading. Lack of liquidity poses challenges for investors who need to sell their bonds before they mature.
5. Limited capital appreciation
Generally, bonds offer limited potential for price growth. While some bonds see value increases, these gains are usually modest. Hence, if you as an investor are looking for substantial capital growth, you may need to explore alternative investment options, like stocks, ETFs, and options.
Things to consider before investing in bonds
Before investing in bonds, it is important to consider the following factors:
1. Credit Rating
The credit rating of the bond issuer is an important factor to consider while investing in bonds. It indicates the issuer's creditworthiness and the risk associated with the investment.
2. Interest Rate
The interest rate offered by the bond matters as it affects the returns on investment. Bonds with higher interest rates provide a higher return on investment, but they also have a higher risk.
3. Maturity
The maturity period of the bond reflects the time until the principal amount is repaid. Longer maturity bonds offer higher interest rates but carry a higher risk.
4. Inflation
Inflation affects the value of the bond. Investing in bonds that provide inflation protection can help investors maintain the purchasing power of their investment.
5. Tax implications
The income earned from bonds is taxable as per the income tax rates. Investors must consider the tax implications before investing in bonds.
6. Liquidity
Liquidity is essential while investing in bonds. Investors must consider whether the bond can be sold readily in the secondary market.
7. Diversification
Diversifying the investment portfolio is crucial while investing in bonds. Investing in bonds across sectors and different types of bonds can help investors spread the risk.
Careful consideration of these factors can help investors make intelligent investment decisions in bonds in India.
How to invest in bonds in India?
Investing in bonds can be done through different avenues, such as banks, post offices, online trading platforms, and mutual fund companies. However, before investing, make sure you understand the different types of bonds available and their associated risks and potential returns.
Also, to make sound investment decisions and pick the best bonds, assess your:
- Investment objectives
- Tolerance for risk
- Investment horizon
Remember that bonds provide a stable income stream. They can help diversify your portfolio by offering stability in uncertain market conditions.
Conclusion
Bonds are a popular investment option among investors looking for a fixed and reliable income stream. Different types of bonds are available in the market, each with different features and characteristics. Investors should consider various factors such as credit risk, interest rate risk, yield, and tax implications before investing in bonds. By understanding the different types of bonds and considering the risks and benefits associated with each, investors can make informed decisions and diversify their portfolio.
