What are Bonds — the fixed income investing?

What are Bonds — the fixed income investing?

There has been so much buzz around the EQUITY side of investing in Finance.

We find tons of videos, stories and experiences on how people invested in EQUITY and caught FIRE!🔥for the rest of their life…(pun intended)

While all that is true, one must not forget to ‘not to follow the crowd blindly’

Investing is a very personal journey simply because One size doesn’t fits all

While many would be tempted to go ALL IN with equities, it truly depends on your goals, your family goals and your(/family) risk appetite.

When it comes to investing, we have so many options available with us..

A smart move is to not to get confused with so many options, rather leverage them to our best.

In this article, I will help you to understand one such available option, which is BONDS and it belongs to a different class than EQUITIES!

So, what are these?

Well, BONDS belong to fixed income class.. and if you ask what the hell is that?

It’s just like an average student in a class, who once in a while may get good marks or poor marks, but in general performs average.

As the name ‘fixed income’ implies, these are products that deliver likely fixed returns( i.e. less volatility).

So that means that for people who need a fixed amount every month or would not want to take much risk with their money can explore the fixed income class of investment products.

These products generally give lesser returns that Equity, BUT BUT provide more safety in terms of capital risk.

Now that you know what is a fixed income product, let’s come to BONDS.

So, in plain and simple words, these are loans.

Just like you take home loan from the bank for your home. Governments or companies take loan from the public( i.e. people like me and you) to run themselves.

Now, you may ask, how is this different than a share?

Well, as the name says, holding a share of company means holding a part of that company(in that proportion) and being able to vote in some of the decision making processes in the company.

Whereas, holding a bond does not give you any partnership in the company.

It’s just a loan that you are giving to the company and in return you will get a fixed interest (mostly monthly) along with the principal which is paid back to you after a period of time.

But, how does this work?

The company which needs the money issues a bond and is called as BOND ISSUER.

The person who pays the money (as a loan) by purchasing these bonds is called a BOND OWNER.

As you see in the image above, the government issues a bond at a price of 100 INR. This price is called the FACE VALUE OF THE BOND

It sets the interest to be 10% P.A. This is called as the COUPON RATE.

NOTE: COUPON RATE IS ALWAYS A PERCENTAGE OF FACE VALUE.

The period in which the principal is paid back is the Tenure or the repayment date.

In Bonds, the interest is paid out earlier than the principal, usually monthly.

So, this is how the math will work:

For the bond with face value of 100 INR, the coupon rate is 10%. The total interest to be paid is 10 INR over a period of 12 months, which is approximately 0.83 INR every month. The principal of INR 100 will be paid back after 12 months.

Now, an interesting fact is that just like shares, bonds are also traded in secondary markets ( i.e. a person who purchased a bond from government can sell a bond to someone else during the bond tenure )

However, bonds have lesser liquidity as compared to shares 🙁

In the secondary market, a bond may be sold at a rate lesser or higher than its face value.

So the bond above can be sold at 150 or 75 INR.

This happens primarily because of 2 reasons:

1. The Central bank (RBI for India) increases/ or is about to increase the interest rates which leads to new bonds issuances with higher coupon rate leaving the existing bonds with lesser yield.
2. The bond issuer is financially not doing well and may default on the repayment.

In both these cases, the person who is purchasing the bond in the secondary market may end up getting a different rate of return than the coupon rate, because coupon rate is on the face value, whereas the price at which the bond was purchased in the secondary market is mostly different than the face value. The actual rate of return that the purchaser will get is called the YIELD TO MATURITY(YTM).

In the image above, an investor purchased a bond at a face value of 100 INR. She now plans to sell this bond in the secondary market for 102 INR.

The total interest to be paid is still 10 INR over a period of 12 months since the time the bond was first purchased (in the primary market), which is approximately 0.83 INR every month and the principal of INR 100 will be paid back on the repayment date.

As the new investor is buying the bond 2 months after it was first issued. He will receive the monthly interest for remaining 10 monthly only, which will still be 0.83 INR. However, he is purchasing the bond at 102 INR, so total gains he will make is 8.3 INR instead of 10 INR.

So for him, the cost price = 102 , gains = 8.3, profit % or YTM = 8.13% for 10 months.

Hence, his yield to maturity(YTM) is 8.13%, which is lower than the coupon rate of 10%.

Now, if you get what bonds are! Your next question should be

how do we buy bonds?

To understand how to buy bonds, you need to understand how to choose bonds!

This is done by looking at the credit rating of the bond. Each bond is given a credit rating by credit rating agencies in India, these agencies are regulated by SEBI.

Credit Rating of a bond issuer is just like the credit score of an individual.

It tells how likely the bond issuer will repay the loan and the interest.

Higher the rating, lesser the chances of defaulting on the loan.

The highest rating is AAA, followed by AA, A and so on…

As a retail investor with minimum risk appetite, it is recommended by experts to invest only in AAA rated bonds.

Now, to purchase bonds, there are several online websites to check which can be found by a simple google search.

And that's the end of the story…

Hope you have got the basics of bond investing and it would be much easier for you to deep dive into this topic after reading this article!

Thank you!

Always happy to look for your feedback!