Many of us are active investors in the stockmarkets. But how many of us actively trade in bonds? Many investors believe that bonds are predictable and boring. However, such securities can form a vital component of a well-diversified securities portfolio.
What exactly are bonds? A bond, also termed as a fixed income security, is an IOU issued by the borrowing entity, where the acronym stands for ‘I OWE YOU’. As can be surmised, it represents a loan from the acquirer to the issuer.
Unlike a shareholder, a bondholder does not become a part owner of the business by acquiring such securities and, consequently, is not entitled to a share of the profits. Unlike shares, which yield income in the form of dividends, bondholders receive what are termed as coupon payments, which represent interest on the face value of the security.
The term arose because in earlier days, the acquirer was issued a booklet of post-dated coupons. At periodic intervals, he was expected to detach a coupon and claim his interest for the preceding period. These days, of course, in most cases, the issuer will credit the bank account of the bondholders as and when payments become due. Bonds are also referred to as ‘debentures’ in certain cases. In India, we often use the terms interchangeably, but, in the US, the term debenture represents an unsecured debt security, whereas bond is used to describe a secured debt security. In the case of secured debt, the issuer will pledge specific assets as collateral.
In the event of a default, the holders can have these assets attached and sold to recover their investment. However, in the case of unsecured debt, the investor can only hope that the issuer will have adequate solvency and liquidity when the time comes for repayment.
Interest from a bond is independent of the profits made by the issuer and is usually set right at the outset. Even in the case of ‘floating-rate’ bonds, where the coupon is linked to a benchmark, such as Libor, once the interest is fixed at the start of the period to which it applies,