Looking to build a more stable investment portfolio? Bonds can help reduce risk and bring balance by offering diversification beyond Stocks. However, many investors find the Bond market intimidating due to complex terms and financial jargon. The good news is that Bonds are straightforward debt instruments that can be a smart addition to your investment strategy. So, how do Bonds work, and what should you know before you invest in Bonds?

How do Bonds work?

A Bond is essentially a Loan. Instead of borrowing directly from a bank, companies and governments issue Bonds to raise funds from several investors. In return, the issuer pays interest at regular intervals and repays the principal amount at maturity. Unlike Stocks, Bonds come with set terms that define how they function. The key features include:

• Maturity: The date when the principal gets repaid, marking the end of the Bond’s lifecycle.
• Coupon rate: The interest paid to bondholders, calculated as a percentage of the Bond’s face value.
• Credit rating: An assessment of the Bond’s risk level, indicating its reliability.
• Tax status: Whether the interest earned is taxable or exempt.
• Callability: Whether the issuer has the option to repay the Bond early.

Types of Bonds

Understanding different Bonds can help you make informed investment decisions:

• Corporate Bonds: Issued by companies to raise money, these Bonds offer varying yields based on the company’s creditworthiness. High-risk Corporate Bonds, also known as Junk Bonds, offer high potential returns but come with greater risk. Interest earned from Corporate Bonds is usually taxable.
• Sovereign Bonds: Governments issue Sovereign Bonds to manage national expenses. Because governments are less likely to default, these Bonds generally have high credit ratings and lower interest rates. In India, Government-issued Bonds are part of Government Securities and are considered relatively safe investments.
• Municipal Bonds: Local governments issue Municipal Bonds to finance infrastructure and public services. These Bonds may be exempt from taxes, making them attractive for investors in high tax brackets.

Key Bond terms to know

To confidently navigate the Bond market, here are some essential terms that you should understand:

• Maturity: It defines the Bond’s lifespan. It can be short-term (one to three years), medium-term (four to 10 years) or long-term (10+ years)
• Secured vs. Unsecured Bonds: Secured Bonds are backed by assets, providing more security. Unsecured Bonds (debentures) rely solely on the issuer’s ability to repay, making them riskier.
• Liquidation preference: If a company goes bankrupt, bondholders are paid before shareholders.
• Coupon rate: The interest paid to bondholders, typically at fixed intervals.
• Tax status: Certain Government Securities and Municipal Bonds offer tax exemptions. Corporate Bonds are generally subject to taxation.
• Callability: Some Bonds allow issuers to repay early, often when interest rates drop.

Conclusion

Though the Bond market may seem complex at first, understanding these key aspects can help you invest in Bonds wisely. Whether considering Government Securities or Corporate Bonds, understanding the terms and risks can help you make more informed investment choices. Once you get familiar with the basics, the rest becomes easier!