Apart from stockmarket indices, the economic stability of a country can be judged by its bond market. Bonds are long-term, fixed-obligation debt securities packaged in convenient, affordable denominations for sale to individuals and financial institutions. They differ from other forms of debt, such as individual mortgages and privately placed debt obligations, as they are sold to the public rather than channeled directly to a single lender. There are two types of bonds — corporate and government.
Bond issues are considered fixed-income securities since they impose fixed financial obligations on the issuer. The issuer agrees to pay a fixed amount of interest periodically to the holder and repay the principal at maturity. Unless otherwise stated, interest on bonds is paid every six months, though some bonds pay interest every month or annually.
Intrinsic features
The coupon, maturity and principal value are the important intrinsic features of a bond. The coupon indicates the income the bond investor will receive over the life (or holding period) of the issue. This is called interest income, coupon income, or nominal yield. The term to maturity specifies the date or the number of years before a bond matures or expires. The principal, or par value, of an issue represents the original value of the obligation.
This is generally stated in Rs 1,000 and/or multiples thereof.
The principal value is not the same as the bond’s market value. Market prices of many issues rise above or fall below their principal values because of differences between their coupons and the prevailing rate of interest. If the market interest rate is above the coupon rate, the bond will sell at a discount to par. If the market rate is below the bond’s coupon, it will sell at a premium above par. If the coupon is comparable to the prevailing market rate, the market value of the bond will be close to its original principal value.
Types of bonds
In contrast to common stock, companies can have many different bond issues outstanding at the same time. Bonds can be either secured
or unsecured.
Secured bonds are backed by a legal claim on some specified property of the issuer in the case of a default. For example, a specific property is secured against the bond and, in case of default by the company, the proceeds from that property first go to the secured bond holders. Unsecured bonds are backed only by the issuer’s promise to pay interest and principal on a timely basis. As such, they are secured by the general credit of the issuer.
The type of issue has only a marginal effect on comparative yield because it is the credibility of the issuer that determines bond quality. Convertible bonds are those which can be converted into a pre-defined number of stocks whereas non-convertible bonds are just plain bonds. Government bonds are issued by government to finance its activities.
The size of the government bond market is much larger than that of the corporate bond market. Government debt is generally considered a risk-free instrument. Municipal bonds are not as popular in India as they are in western markets.
Indenture provisions
An indenture is a contract between the issuer and the bondholder specifying the issuer’s legal requirements. A trustee (usually a bank) acting on behalf of the bondholders ensures that all the indenture provisions are met, including the timely payment of interest and principal. All the factors that dictate a bond’s features, its type and maturity are set forth in the indenture.
What to consider while buying bonds
As the allotment of bonds happens in the dematerialsed form, ensure that the details regarding the depository participant and the beneficiary account are correct, and the beneficiary account is active. If the application form is submitted in two names jointly, ensure that the beneficiary account is also held in same names jointly, and the names are in the same sequence in which they appear in the application form. It is mandatory to indicate PAN and it is not advisable to send the application forms by post.
It is preferable to submit the form with the members of the syndicate or trading members, as the case may be. While submitting the form, investors need to enclose documents such as a self-attested copy of the PAN card and copy of their proof of residence. For proof of address, any one of these documents can be submitted: ration card, driving licence, recent electricity bill, landline bill, passport, voter’s identity card, bank passbook or latest bank statement or Aadhaar card.
No investment is completely risk-free, be it corporate or government bonds. bonds come with their share of risks, such as inflation,
interest rate risk, default risk, downgrade risk, reinvestment and rip-off risk. To get the best results, carefully weigh and compare risks vis-avis the expected returns.
Get a fix on bond shopping
* As bonds are allotted in the demat form, ensure that the details regarding the depository participant and the beneficiary account are correct, and the beneficiary account is active
* If the application form is submitted in two names jointly, ensure that the beneficiary account is also held in same names jointly
* It is mandatory to indicate PAN
* Submit the form with the members of the syndicate or trading members, as the case may be. While submitting the form, investors need to enclose documents such as a self-attested copy of the PAN card and copy of their proof of residence
The writer is associate professor of finance and accounting, IIM Shillong