AN INTRODUCTION TO BONDS

A Bond is a debt instrument that is used by governments to raise funds so that they can carry projects for developmental purposes. Government bonds are issued by the government with maturity ranging from medium to long term. In return, the investors get assured return in the form of interest or coupon rate, annually or bi-annually, till the maturity of the instrument. This return is also known as Bond Yield. The principal amount is paid to investors at the end of the bond tenure. It’s not only the government who can issue bonds, corporations can also raise funds through bonds to meet their operational expenses. Non-convertible corporate bonds offer coupons and work like any other bond.

In the past, only institutional investors like insurance companies, mutual funds, banks, and provident funds were authorized to buy bonds (also known as Government Securities or G-Sec). But after the commencement of the “Non-Competitive Bidding Facility” in 2017, even small retail investors can also buy G-Secs. For that, they need to register on the NSE website or mobile application along with the requisite details.

G-Secs are considered to be much safer investments compared to equities. Some investors use G-Secs to diversify their portfolios comprising equities. By doing so, investment in G-Secs balance the risk involved inequities. However, return on investment in G-Secs cannot be compared to return in equities. The former involves lesser risk but also lesser returns while the latter involves much larger risk with a much larger potential for return.

It should be noted that the bondholder can sell the securities in the bond market (also known as secondary market) before maturity and this leads to fluctuation in the bond value. When an investor purchases bonds directly from the issuing authority, the transaction is said to be a primary market transaction.

Let us understand the relationship between bond price and bond yield with the help of an example.

Suppose the government or a corporation issues a bond with a face value of Rs.100 and a coupon of 6.23% (the current 10-year bond yield in India at present) for a period of 10 years. It would mean that the issuer has been assuring an interest of 6.23% per year along with the principal at the end of a 10-year tenure. Bond yield or the return owed to the investor is calculated by dividing the coupon by the face value of the bond.

Yield = (Coupon / Face value) *100. In our case, Yield = 6.23 / 100*100 = 6.23

If the bond in the above case is auctioned at a higher price, say 110, the bond yield will decrease.

Yield = 6.23 / 110 * 100 = 5.66

Similarly, if the bond is auctioned at a lower price, say 90, the bond yield will increase.

Yield = 8 / 90 * 100 = 6.92

Thus there comes out to be an inverse relationship between the bond yield and the bond value. A higher bond yield means a lower bond price and that would attract institutional investors towards the debt market. Thus a higher bond yield is not good for equities as it hurts investors’ appetite for the riskier asset class. However, investors may opt to go for stocks with good fundamentals trading at a relatively lower price-to-earnings ratio.

Conversely, the lower bond yield would mean higher bond prices and hence equities may look more attractive to investors than debt instruments. This would lead to money inflow into equities and outflow from bonds. However, many investors would like to hold government securities till maturity and would get yield to maturity in return.