Understanding bonds

Investors seeking safety of capital and regular income can invest their money in debentures and bonds. Companies often raise capital in this form from the general public through the securities markets.

What are bonds?

A bond is a contract between the borrower (the issuer) and the lender (the investor). In other words, a bond allows a company to raise money from a large number of investors by breaking up the total amount borrowed into small, equal components. Investors can subscribe to these bonds as per their investible surplus.

Features of the bonds
Each bond has a specific denomination, called face value, and a specified period for which the company is borrowing. The face value is the principal value of the borrowing. This period of borrowing is called the maturity period of the bond. The end date of this maturity period is called the maturity date. The issuer company must pay all the dues on or before the maturity date.

The company also agrees to pay certain interest, which is mentioned as a percentage of the face value. This interest rate is known as the “coupon rate. The coupon rate as well as the payment frequency may be decided by the issuer at the time of the issue.

The issuers

While the above discussion mentioned companies, banks also issue bonds to borrow from the capital market. Even governments (including the central government, state governments, and municipal corporations) and public sector undertakings (PSUs) can borrow money from the market through the issuance of bonds.
The earnings for the investor
The primary income from bonds comes from the coupon payments received. At the same time, there is a possibility of earning capital gains through the secondary market for bonds. However, for the holder of the bonds until maturity, there are no capital gains as the entire income is in the form of a coupon.

The risk

One of the major risks for the bond investor is whether the money will be received back as per the agreed schedule. This is called credit risk, and it involves default by the borrower as well as any delay in repayment. A good indicator of this risk is the credit rating that is mandatory in all cases if the bonds are issued to the public. These ratings are issued by credit rating agencies, which are regulated by SEBI.

The other risk that the bonds are exposed to is called interest rate risk. When the interest rate in the economy rises, the market price of the existing bonds goes down, and vice versa. However, the investors that hold the bonds till maturity need not worry about this risk as they will get their cash flow as long as the company does not delay or default.