Bonds and Debentures
A Bond is a loan given by the buyer to the issuer of the instrument. Bonds can be issued by companies, financial institutions, or even the government. Over and above the scheduled interest payments as and when applicable, the holder of a bond is entitled to receive the par value of the instrument at the specified maturity date.
Bonds can be broadly classified into
- Tax-Saving Bonds
- Regular Income Bonds
Tax-Saving Bonds offer tax exemption up to a specified amount of investment. Examples are: ICICI Infrastructure Bonds under Section 88 of the Income Tax Act, 1961 NABARD/ NHAI/REC Bonds under Section 54EC of the Income Tax Act, 1961 RBI Tax Relief Bonds.
Regular-Income Bonds on the other hand in consonance with their name suggests provide a stable source of income at regular, pre-determined intervals. Examples are Double Your Money Bond, Step-Up Interest Bond, Retirement Bond, Encash Bond, Education Bonds, Money Multiplier Bonds/Deep Discount Bond.
When the bonds are issued by companies, they are called debentures.
Features of Bonds:
- Bonds are suitable for regular income purposes. Depending on the type of bond, an investor may receive interest semi-annually or even monthly, as is the case with monthly-income bonds. Depending on one's capacity to bear risk, one can opt for bonds issued by top-ranking corporates, or that of companies with lower credit ratings. Usually, bonds of top-rated corporates provide lower yield as compared to those issued by companies that are lower in the ratings.
- In times of falling inflation, the real rate of return remains high, but bonds do not offer any protection if prices are rising. This is because they offer a pre-determined rate of interest.
- One can borrow against bonds by pledging the same with a bank. However, borrowings depend on the credit rating of the instrument. For instance, it is easier to borrow against government bonds than against bonds issued by a company with a low credit rating.
- There are specific tax saving bonds in the market that offer various concessions and tax-breaks. Tax-free bonds offer tax relief under Section 88 of the Income Tax Act, 1961. Interest income from bonds, upto a limit of Rs 9,000, is exempt under section 80L of the Income tax Act, plus Rs 3,000 exclusively for interest from government securities. However, if you sell bonds in the secondary market, any capital appreciation is subject to the Capital Gains Tax.
- Bonds are rated by specialised credit rating agencies. Credit rating agencies include CARE, CRISIL, ICRA and Fitch. An AAA rating indicates highest level of safety while D or FD indicates the least. The yield on a bond varies inversely with its credit (safety) rating. As mentioned earlier, the safer the instrument, the lower is the rate of interest offered.
Risks In Bonds
In certain cases, the issuer has a call option mentioned in the prospectus. This means that the issuer of the bond has the option of redeeming the bonds before their maturity in certain cases. In that case, while you will receive your principal and the interest accrued till that date, you might lose out on the interest that would have accrued on your sum in the future had the bond not been redeemed. Inflation and interest rate fluctuation affect buy, hold, and sell decisions in case of Bonds.
Note: If interest rates go up, bond prices go down and vice-versa.
Buying, Selling and Holding of Bonds:
Investors can subscribe to primary issues of Corporates and Financial Institutions (FIs). It is common practice for FIs and corporates to raise funds for asset financing or capital expenditure through primary bond issues. Some bonds are also available in the secondary market. The minimum investment for bonds can either be Rs 5,000 or Rs 10,000. However, this amount varies from issue to issue. There is no prescribed upper limit to your investment-you can invest as little or as much as you desire, depending upon your risk perception. Bonds offer a fixed rate of interest. The duration of a bond issue usually varies between 5 and 7 years.
Liquidity of a Bond:
Selling in the debt market is an obvious option. Some issues also offer what is known as 'Put and Call option.' Under the Put option, the investor has the option to approach the issuing entity after a specified period (say, three years), and sell back the bond to the issuer. On the contrary, in the Call option, the company has the right to recall its debt obligation after a particular time frame.
For instance, a company issues a bond at an interest rate of 12 per cent. After 2 years, it finds it can raise the same amount at 10 per cent. The company can now exercise the Call option and recall its debt obligation provided it has declared so in the offer document. Similarly, an investor can exercise his Put option if interest rates have moved up and there are better options available in the market.
Market Value of a Bond:
Market value of a bond depends on a host of factors such as its yield at maturity, prevailing interest rates, and rating of the issuing entity. Price of a bond will fall if interest rates rise and vice-versa. A change in the credit rating of the issuer can lead to a change in the market price.
Mode of Holding Bonds
Bonds are most commonly held in form of physical certificates. Of late, some bond issues provide the option of holding the instrument in demat form; interest payment may also be automatically credited to your bank account.