What is a Bond? [The complete guide for investors]

What are Bonds?

A bond is a loan made to the bond issuer by the bond purchaser, or bondholder. When governments, corporations, and municipalities want funds, they issue bonds. An investor who purchases a government bond is effectively lending money to the government. When an investor purchases a corporate bond, he or she is effectively lending money to the company. A bond, like a loan, pays interest on a regular basis and repays the principle at the maturity date.

Example of a Bond

Let's say a company wants to invest INR 1 Crore in a new manufacturing plant and decides to make a bond offering to help pay for it. The corporation may decide to offer 1,000 bonds for INR 10,000 apiece to investors. Each bond has a face value of INR 10,000 in this example. The corporation – now known as the bond issuer – selects an annual interest rate, known as the coupon, as well as a time frame for repaying the principal, or INR 1 Crore. The issuer considers the current interest rate environment when determining the coupon, ensuring that it is competitive with those on comparable bonds and appealing to investors. The issuer can choose to sell five-year bonds with a 5% yearly coupon. The bond matures after five years, at which point the firm repays each bondholder INR 10,000 in face value. The length of time it takes for a bond to mature can have a significant impact on the amount of risk and potential return an investor can expect. Because many more things can have a negative impact on the issuer's capacity to pay bondholders over a 30-year term than over a 5-year period, INR 1 Crore bond due in five years is often seen as less risky than an INR 1 Crore bond repaid over 30 years. A longer-maturity bond's added risk is proportional to the interest rate, or coupon, that the issuer must pay on the bond. In other words, for a long-term bond, an issuer will pay a higher interest rate. Longer-term bonds may thus yield higher yields, but in exchange for that return, the investor takes on more risk.

Risk with Bonds

Every bond carries the danger of the issuer "defaulting," or failing to repay the loan in full. Independent credit rating agencies examine bond issuers' default risk, or credit risk, and give credit ratings that help investors assess risk as well as determine interest rates on individual bonds. A high credit rating issuer will pay a lower interest rate than a low credit rating issuer. Investors who buy bonds with low credit ratings can possibly earn larger profits, but they also run the risk of the bond issuer defaulting.

Why Buy Bonds?

When governments and enterprises need to raise funds, they issue bonds. You're giving the issuer a loan when you buy a bond, and they pledge to pay you back the face value of the loan on a particular date, as well as periodic interest payments, usually twice a year.

Bonds issued by firms, unlike stocks, do not grant you ownership rights. So, you don't necessarily gain from the firm's development, but you also won't notice much of a difference if the company isn't doing so well—as long as it has the wherewithal to keep its loans current.

Bonds, on the other hand, can provide you with two potential benefits if you include them in your portfolio: They provide a steady stream of income while also mitigating some of the risks associated with stock ownership.