Complex World of Bonds – Types of Bonds in India

The world of bonds can be intricate and overwhelming, especially for the average investor. The variety and characteristics of bonds available make it challenging to navigate and choose the right investment. This article aims to simplify one aspect of understanding bonds by exploring the different types of bonds in India. Before diving into the types, let’ s briefly understand what bonds are and why they are issued.

What are Bonds?

Bonds are fixed-income instruments representing a loan made by an investor to a borrower, typically a corporation or government. When an entity needs to raise funds, it can either generate revenue, sell shares, or issue bonds. Issuing bonds is often the preferred option as it allows the entity to borrow money at a relatively lower cost compared to equity financing.

Example Scenario – A company wants to build a new factory to expand its business. To finance this project, it can –

1. Generate revenue and profits from its current business operations.
2. Sell shares to investors via an Initial Public Offering (IPO).
3. Issue bonds to borrow money from investors and pay them interest over time until the principal amount is repaid.

Option 3, issuing bonds, is a common method used by both corporations and governments to raise capital for various projects.

Types of Bonds in India

Bonds can be classified based on several factors. Broadly, there are nine classification factors that can help segregate bonds –

1. Issuer
2. Security
3. Seniority
4. Credit rating (or safety)
5. Interest rate
6. Maturity (or term)
7. Listing
8. Convertibility to stock
9. State guarantee

Let’ s explore the primary types of bonds based on some of these classifications.

Types of Bonds Based on the Issuer

Government Bonds – These bonds are issued by the state and central governments. Government bonds are considered extremely safe, often referred to as ‘ risk-free bonds’ because the government can print money to repay its debt obligations.

Example – In January 2023, the Government of India issued the 6 .89% GS 2025 bond, a 2-year bond with an interest rate of 6 .89% and a maturity date of January 16, 2025.

Corporate Bonds – These bonds are issued by corporations, which can be public or private sector companies. Corporate bonds are considered riskier than government bonds because the issuing company must generate sufficient revenue and profit to pay interest to bondholders.

Within corporate bonds, PSU (Public Sector Undertaking) bonds are deemed safer than those issued by private companies due to government ownership and support.

Types of Bonds Based on Credit Rating (Safety)

Credit ratings indicate the issuer’ s ability to repay bondholders. Credit rating agencies assess the financial strength of the issuer and assign a suitable credit rating.

AAA Rated Bonds – AAA is the highest credit rating and denotes the safest bonds. These bonds are highly secure and are preferred by risk-averse investors.

AA Rated Bonds – AA-rated bonds are also considered safe but slightly riskier than AAA-rated bonds. They still represent a high level of creditworthiness.

A Rated Bonds – A-rated bonds are reasonably safe and are suitable for most investors. They offer a balance between safety and returns.

BBB Rated Bonds – Bonds with a BBB rating or lower are considered low credit rating bonds. They carry higher risk, and investors should consult with investment experts before considering these bonds.

Types of Bonds Based on Interest Rate

Fixed-Rate Bonds – These bonds pay a fixed interest rate over the bond’ s tenure. The interest rate remains constant, providing predictable income to investors.

Floating-Rate Bonds – These bonds have variable interest rates linked to a benchmark rate, such as the National Savings Certificate (NSC) rate. The interest rate adjusts periodically, providing protection against inflation.

Zero-Coupon Bonds – These bonds do not pay periodic interest. Instead, they are issued at a discount to their face value and mature at par, offering the return in the form of capital appreciation.

Types of Bonds Based on Maturity (Term)

Short-Term Bonds – These bonds have maturities of up to 5 years. They are less sensitive to interest rate changes and are suitable for investors seeking liquidity.

Medium-Term Bonds – Bonds with maturities ranging from 5 to 10 years fall into this category. They offer a balance between yield and risk.

Long-Term Bonds – These bonds have maturities exceeding 10 years. They typically offer higher interest rates but are more sensitive to interest rate fluctuations.

Types of Bonds Based on Convertibility to Stock

Convertible Bonds – These bonds can be converted into a specified number of shares of the issuing company. Convertible bonds provide the potential for capital appreciation along with fixed income.

Non-Convertible Bonds – These bonds cannot be converted into equity. They offer regular interest payments without the option of converting to shares.

Conclusion

The bond market in India is diverse, offering a variety of options to suit different investment needs and risk profiles. Government bonds provide safety and stability, making them ideal for conservative investors. Corporate bonds offer higher yields but come with increased risk. Understanding the different types of bonds and their characteristics can help investors make informed decisions and build a diversified portfolio.

By carefully selecting bonds based on factors such as issuer, credit rating, interest rate, and maturity, investors can achieve their financial goals while managing risk effectively. Whether you are a risk-averse investor seeking safety or a risk-tolerant investor looking for higher returns, the Indian bond market has something to offer for everyone.