Explained: What Are Bonds? How Do They Work?
Bonds can be considered a good investment product for investors who are looking at investments to achieve short-term financial goals. Bonds are generally considered a less risky investment compared to equity and hence many investors who do not have a high appetite for risk invest in bonds.
The primary goal of the bond market is to provide a mechanism for long term funding of public and private expenditures.
Bonds are a debt security under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay the interest and or repay the principal at a later date, which is termed the maturity.
Many investors tend to forget that the bond market offers such a wide range of possibilities and forget to include this asset type in their investment portfolio. However, an investor should know the different types of bonds in detail, in order to make the right investment choices.
There are many different types of securities depending on the issuer – government, municipal, corporate as well their maturity, returns, and many other factors.
So what is the best strategy when it comes to investing in bonds?
Your strategy, goals, and risk management should determine what kind of bonds you would like to include in your investment portfolio.
Types of Bonds
The two most important types of bonds are Corporate bonds and Government bonds.
Government Bonds
A government bond is a debt instrument issued by the Central and State Governments of India. Issuance of such bonds occurs when the issuing body (Central or State governments) faces a liquidity crisis and requires funds for the purpose of infrastructure development. Government bond in India is essentially a contract between the issuer and the investor, wherein the issuer guarantees interest earnings on the face value of bonds held by investors along with repayment of the principal value on a stipulated date.
Corporate Bonds
Corporate bonds are issued by corporations to raise capital. They are safer than equities. These bonds are offered by corporate houses and are open to everyone. However, these bonds are not as safe as government bonds as the issuing companies are subject to market volatility, industry ups, and downs, etc.
Benefits of Investing in Bonds
Bonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and a variety of term structures. The most important advantage of investing in bonds is that it helps diversify and grow your money.
Bonds also have a clear advantage over other securities. The volatility of bonds (especially short and medium dated bonds) is lower than that of equities (stocks). Thus bonds are generally viewed as safer investments than stocks.
Bondholders also enjoy a measure of legal protection. If a company goes bankrupt, its bondholders will often receive some money back.
The risks involved in investing in bonds include rising interest rates, market volatility, and credit risk. Bond prices rise when rates fall and fall when rates rise. Your bond portfolio could suffer market price losses in a rising rate environment. Bond market volatility could affect the prices of individual bonds, regardless of the issuers' underlying fundamentals.
The rate of interest of tax saving bonds is relatively low or the same compared to other tax-free instruments like PPF, NSC, etc.
There are various types of bonds available in the market. On the whole, bonds offer diversification in the portfolio along with tax benefits. You can invest in bonds that are suitable in aiding to achieve your financial goals and requirements.
Happy investing!