What is Bond?

Bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debt holders, or creditors, of the issuer.

Bond terms to know (Ingredients of Bonds)

  • Coupon Payment: They are fixed amount of interest that an investor receives after prescribed frequency.
  • Yield: This is a measure of interest that takes into account the bond’s fluctuating changes in value. There are different ways to measure yield, but the simplest is the coupon of the bond divided by the current price.
  • Price: This is the amount the bond would currently cost on the secondary market. Several factors play into a bond’s current price, but one of the biggest is how favorable its coupon is compared with other similar bonds.
  • Maturity Value: It could be a face value or a value more or less than the face value of a bond.
  • Face value: This is the amount the bond is worth when it’s issued, also known as “par” value.
  • Discount Rate: It is a market interest rate or cost of capital of a bond. It derives its rate from a comparable listed bond. The comparison is done with respect to risk and tenure of the bond. For example, if we are valuing a bond which is unlisted and have 5 years of life, then we should look for a bond which is similar in risk profile.( that is same credit rating)

Types of Bonds:

There are two types of bonds, corporate bonds and Government bonds.

Corporate bonds: Corporate bonds are issued by corporations to raise capital. They are safer than equities. The bondholders get a specified return every period. These bonds can be of two types.

  1. Convertible Bonds
  2. Non-Convertible Bonds

Government bonds: Government bonds are issued by national government to raise capital. These bonds can also be of two types.

  1. Tax Saving Bonds
  2. Tax Free Bonds

Understanding Tax Free Bonds

What are tax-free bonds?

Tax-free bonds are types of goods or financial products, which the government enterprises issue. One example for this is the municipal bonds. They offer you a fixed interest rate, and hence is a low-risk investment avenue. Tax-free bonds generally have a long-term maturity of typically ten years or more. Government invests the money collected from these bonds in infrastructure and housing projects.

Characteristics of Tax Free Bonds

Tax benefits:

The income by way of interest on tax-free bonds is fully exempted from income tax. The interest earned from these bonds does not form part of your total income. There is no deduction of tax at source (TDS) from the interest, which accrues to the bondholders. But remember that no tax deduction will be available for the invested amount.

Interest rate:

The coupon (interest) rates of tax-free bonds are linked to the prevailing rates of government securities. So these bonds become attractive when the interest rates in the financial system are high.

Interest payment:

The interest on these bonds is paid annually and credited directly in the bank account of the investor.

Liquidity:

The tax-free bonds get listed and then traded on the stock exchange(s) to offer an exit route to investors. But these bonds might not enjoy high liquidity as they are long-term in nature.

Who should invest?

Tax-free bonds are suitable for investors looking for a steady source of income annually and can afford to lock-in their capital for the long term. (Disclaimer: Investors are advised to make their own assessment before acting on the information.)

Things you should keep in mind before buying bonds

  • Understand all the costs related to buying & selling of bonds.
  • Bonds investors should not just aim for higher Yield. Yield is the value of the bond. Bond Investors might get tempted by higher value/yield of the bond when the rate of interest is low. They should also consider the credit worthiness of the issuer because higher yield also leads to higher risk.
  • The investors need to plan to reinvest their coupon interest amount. The final sum will be high because of the power of compounding.
  • The investors should read bond’s offering statement. It is very important because it where you will find bond’s important features, from yield to call schedule.
  • Ask your broker about the history of the price movement of the bond last traded. This will tell you about the bond’s liquidity.