Basics of bonds, types, and how to get started

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Equirus Wealth

23 Dec 2022 5 min read

Investment#Investment

Bonds have found the limelight recently, given the jittery environment and the looming possibility of a recession ahead. Bonds are relatively safe instruments as compared to equities and other risky assets. Adding them to your portfolio will bring in an element of safety and security which can go a long way during the recession. Here we discuss all the basics you need to know about bonds and how to get started.

Basics of bonds

Bonds can help you diversify your portfolio & they add a balance and a calming effect to the otherwise volatile portfolio. However, the dynamics of bond markets are starkly different from that of equity markets. Here are a few aspects you need to be aware of while investing in bonds.

What are bonds?

Bonds are loans taken by the company, which they promise to repay along with an annual interest rate on the principal amount borrowed. Companies may choose to borrow from investors instead of going to the bank. The interest paid on the amount borrowed is known as the interest coupon, which the investor receives annually.

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Types of bonds

  1. Government Securities:

A debt instrument issued by India's central or state governments is a government securities bond. Hence, G-Sec or Government securities are designed as long-term investments with tenure ranging between 5 and 40 years. The default risk is lower in the case of these types of debt instruments. State Development Loans are another name for the state government issuing bonds. These bonds have different interest payout cycles in the semi-annual mode, which would be variable or even fixed.

  1. Corporate bonds:

Big companies sometimes issue corporate bonds to borrow money from the public, i.e. investors for a specific time, and issue bonds in exchange for the money borrowed. There is a coupon, i.e. interest payable on the face value of these bonds, which is payable to the investor at the end of the tenure.

This is an alternate means of funding projects or expansions by companies. They raise funds from the public, often at a higher interest rate as compared to that of financial institutions, including banks.

  1. Convertible bonds:

These provide benefits of equity as well as debt to the investors, but not at the same time. The bondholders of convertible bonds can convert these bonds into shares of the company and thereby become shareholders. Then they would receive all designated benefits as shareholders after the conversion.

  1. Zero-coupon bonds:

This is a specific type of bond which doesn't offer any interest payout, i.e. “zero” coupon or interest. These bonds are also called “pure discount” or “deep discount” bonds which do not provide any rate of interest till the bond matures. The bond is purchased at a discount to the face value. Upon maturity, the bond would repay the principal amount.

  1. Inflation-linked bonds:

This bond is designed to reduce the inflation risk of an investment that is primarily issued by the central government and offers protection against inflation. Thus, inflation-linked bonds are tied to inflation and see their principal, along with interest rates, fluctuate in line with inflation.

  1. RBI Bonds:

The floating rate saving bonds 2020 (FRSB) issued by the RBI are also known as RBI Taxable bonds. They have a 7-year term, and the interest rate fluctuates over that time. When interest rates in the economy increase, the floating interest rate may as well. The interest rate is reset every 6 months. The interest is paid every six months rather than at maturity, as in the case of other bonds.

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  1. Sovereign Gold bonds:

The government issues the SGB, i.e. Sovereign Gold Bonds, to its investors who would like to invest in gold in the virtual format. Regarding the gold quality, safety, interest payments, and return on investment at maturity term, the SGB is backed by the sovereign guarantee of the Government of India. Therefore, investing in SGB has no risks.

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How to start investing in bonds?

The primary or secondary market is an option for investing in these financial products. You can purchase major firms' public issues on the primary market. Another option is to buy this financial product from the secondary markets traded on exchanges. Bonds are often retained until they mature since they are thought to be illiquid. However, some bonds may be traded on the stock exchange, where you can buy or sell before maturity.

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Conclusion

Bonds are a great means to diversify your portfolio. Typically, you could look at bonds with a very long perspective, especially if the interest rates are at an all-time high. You should consider investing in bonds when the interest rates are high. This will help you to lock in the high-interest yield, which will be beneficial in optimizing returns on your portfolio.

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