Loans form an integral part of the world economy. They allow individuals to reach their life milestones of buying a car, house, funding their children’s higher education, and more. Loans also help businesses set up, sustain, and grow.
But you don’t always approach a bank when you need money, do you? Sometimes, you may reach out to a friend or a family member. Similarly, when a company wants to take out a loan, it doesn’t always go to the bank either. It reaches out to the public for a loan and this type of loan is called a bond.
How does a bond work?
When companies require funds, they issue bonds to the market. Investors buy these bonds and help the company raise the money they need. Since a bond is essentially the company borrowing money from the investors, the investors earn interest on the bonds. The interest rate is fixed and is paid at predetermined intervals. Hence, bonds are fixed-income securities.
But companies alone don’t issue bonds. The state and central governments, too, issue bonds. Usually, the government issues bonds to raise funds to carry out various infrastructure projects such as building roads and for social initiatives. These are called government security bonds (G-Secs).
Bonds come with a maturity date and a face value. Face value is the price at which the bond is initially issued. The maturity date is when the principal has to be paid back to the investors. Bonds can be short-term and mature within 3 to 5 years or medium and long-term with a maturity period of more than 10 years.
Bonds can be secured or unsecured bonds. Secured bonds are backed by certain assets of the company so that the investors can get their money back in case the company is unable to pay. Unsecured bonds don’t have any such guarantee. In the case of G-Secs, they are backed by the government and are secured bonds. They form a part of the government’s formal debt obligation and are backed by the government’s line of credit. This means that the government is liable to repay all the bonds issued as per the promised terms.
How are bonds different from shares?
Shares and bonds are both ways for a company to raise money. However, shares are equity and bonds are debt instruments. When an investor buys shares of a company, they are buying a stake in that company and thereby become part owners of the company. Shares form a part of the owned capital of the company.
With bonds, investors are lending money to the company and bonds form a part of the owed capital of the company. As an investor, the risk-return tradeoff in bonds is vastly different than in shares. The risk in shares is higher owing to the volatility of the stock market. The reward in terms of returns may also be higher as compared to the interest rate on bonds.
Should I invest in bonds?
Investing in bonds can help strengthen your investment portfolio. Here are three solid advantages of investing in bonds:
- Diversification
Including bonds in your investment portfolio will help hedge risk since debt instruments are more stable compared to stocks. Investing in bonds will help balance out the volatility of shares and reduce your overall portfolio risk.
- Fixed-income
Bonds have the advantage of offering regular income at a predetermined interest rate and schedule. This stability may help you with financial planning and offer a sense of certainty when working towards your goals.
- Safety
Your risk appetite doesn’t need to be high to invest in bonds since they are considered to be one of the safest investments. They also have liquidation preference, which means that you’ll get priority over shareholders in getting back your money in case the company goes bankrupt.
A prudent investment for a balanced portfolio
Overall, owing to low volatility and risk compared to other investment classes such as shares, it may be a good decision to invest in bonds. If you’ve heavily invested in stocks, investing in debt instruments such as bonds will help you achieve a balanced portfolio, which is essential when it comes to investing.
The best part is you can further diversify when investing in bonds. In addition to investing in bonds in India, you can also invest in bonds of other countries such as the U.S. The easiest and most convenient way to do that is through ETFs (Exchange Traded Funds). You can read more about investing in ETFs here.
