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What is the Bond and How It Works?

Bond

All of us have heard about bonds. Most of us also know that it gives more returns than FD, but still, we hesitate in investing our money in bonds. The reasons we hear are regarding the risk factors, or it's not easy to invest in bonds or lack of proper knowledge about bonds. Today we are here to clear all your doubts regarding bonds. Bonds play a crucial role in the financial market as debt instruments that allow entities to raise capital.

We will discuss everything related to bonds today, what are bonds, how a bond work,  and what are bonds investments in a very simple yet detailed manner. In this step-by-step guide, we will explore the basics of bonds, their types, the process of bond issuance, pricing and yield calculations, as well as the risks and rewards associated with bond investments.

Bond Basics  

First, we have to learn the ABCs of the bond market before jumping into complex scenarios. The basic terms used in the world of bonds are available below:

A. Principal: 

The principal is the amount you are going to give to the bond-issuing party. This is also known as the face value of the bond. This is the amount of money from which you will get the interest back based on the interest rates.

B. Coupon Rate: 

The coupon rate is the interest rate the issuing party will pay you on a fixed period of intervals. This is specified on the bond itself. 

C. Maturity Date:

The maturity date is the time after which the issuing company will give you back your principal amount. After this, the bond reaches its full term and the issuing company is no longer obligated to give you interest.

Types of Bonds

There are several types of bonds available in the market, each with a different purpose to serve and have different risk factors associated with them.

Government Bonds 

A debt that is issued by the government of a nation and sold to locals and investors to support the spending of the government on various projects for the welfare of the nation. Government bonds are the lowest-risk investment that you can make since these are given to the government itself. Government is the safest authority you can give money to, as the chances of government downfall are near-net zero. If the government no longer exists then any other borrower whom you are paying your money also will not exist because the nation is falling will the government. As these bonds are low-risk bonds, the government pays low-interest rates to the lenders.

Corporate Bonds 

Corporations don't want to collect money by selling their shares, that's when corporate bonds come into the picture. Here the company issues a debt to the investors to raise its capital. These corporate bonds are more riskier as compared to government bonds. Different corporate bonds come with different levels of risk depending on the financial condition of the issuing company. Before investing in a corporation it's important to check the credit score of the corporation you are investing into."Triple A bonds (AAA) are the best quality of bonds where the risk factor is less, whereas the list worth is termed as "Junk".Since these bonds are riskier than government bonds, they usually provide higher interest rates as compared to government bonds.

Municipal Bonds 

A municipal bond is a debt security issued by local government bodies like municipalities to fund various projects of development in the local area such as schools, hospitals or roads. Usually, such bonds come with a maturity period of approximately 3 years. These local bodies return this debt with the interests mainly from property tax collected or from the revenues that are being generated from local projects in the area. Municipal bonds offer tax-free bonds, where the investors can be exempt from taxes collected by local and state bodies. Generally, these bonds can be categorised into two categories. One is generally obligation bonds and the second is revenue bonds. General obligation bonds are issued by local governments to raise capital to cover expenses and can be a little more riskier. While the revenue bonds are used by local bodies to generate income to fund various new development projects.

Comparison Between the Three  Types of Bonds 

Just understanding different types of bonds is not enough. We need a comparative analysis between the three types of bonds to invest our money. Here's a comparison of these bond types

1. Government Bonds:

  1. Issued by: These are issued by the  Governments or government-occupied agencies.
  1. Purpose: The purpose of issuing such bonds is to accelerate the development of the country.
  1. Safety: One of the safest ways available to put your money. They are fully backed by the government.
  1. Risk Level: The risk level of government bonds is very low as they are issued by stable governments.
  1. Interest Rates: Here you will find that the rates are generally lower than the corporate interest rates because the risk factors associated with such bonds are very small.
  1. Liquidity: Liquidity means the ease of trading these bonds in the market. Government bonds are usually highly liquid and you will easily find buyers for your government bonds.
  1. Taxation: Generally these bonds are subjected to income tax but sometimes you may get exempt taxes by state and local governing bodies.

2. Corporate Bonds:

  1. Issued by: These are issued by companies and big corporations to raise their capital for various purposes related to their business.
  1. Purpose: These bonds provide alternative ways for companies to raise their capital instead of choosing contemporary options of bank loans or share distribution.
  1. Safety: The risk associated with such bonds varies depending on the financial health of the company. One of the best ways to analyze the risk factor is by checking the credit score of the company. 
  1. Risk Level: the risk level ranges from moderate to high risk as explained above, depending on the creditworthiness of the company.
  1. Interest Rates: Rates are higher here as compared to government bonds because the risk factor is higher.
  1. Liquidity: The liquidity varies with some bonds trading widely while for others finding a trader is hard. It all depends on the corporation.
  1.  Taxation: Interest income from corporate bonds is generally subject to income tax as it is coming from the private corporate world.

3. Municipal Bonds:

  1. Issued by: These are issued by local governing bodies and municipalities. Sometimes agencies that are occupied by the state government also issue bonds. 
  1. Purpose: Mostly this money collected is used to finance infrastructure projects in the local area or for providing public services. Sometimes to pay the previous expenses, the government issues bonds.
  1. Safety: Each municipality differs from the other in financial health and thus the safety of municipal bonds also varies from one municipality to another.
  1. Risk Level: Risk is moderate here which depends on the creditworthiness of the governing body.
  1. Interest Rates: The interest rates here lie somewhere between the interest rates of government bonds and corporate bonds.
  1.  Liquidity: Bonds of some municipalities are actively traded while others are less liquid.
  1. Taxation:I nterest income from municipal bonds is often exempt from income taxes and sometimes exempt from state and local taxes too if the bond is issued within the investor's domicile state.

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 Bond Issuance and Trading

After knowing about the issuing authorities of bonds, the next step is to understand the different options available from where you can buy these bonds. The name of this process is Bond Issuance through which a government or corporation offers bonds to investors. There are two places available from where you can buy these bonds, one is the primary market and the second one is the secondary market. Primary markets offer new bonds which are sold for the first time here, whereas secondary markets sell previously issued bonds among traders. The liquidity in bond issuance comes from these secondary markets as it enables the exchange of bonds before their maturity periods. Let's understand this market in a little detail now.

A. Primary Market

In the primary market, new bonds are sold for the first time, you can directly buy the bonds you want from here. The issuing party which is offering bonds writes down the bonds and later determines the price to offer to investors. After this process, the bonds become public and you can purchase these newly issued bonds directly from the issuing party or some intermediaries in between.

B. Secondary Market

If you want to buy previously issued bonds then you need to search the secondary markets. Here investors sell and purchase bonds from other investors and intermediaries. This choice to buy and sell bonds provides liquidity to the bondholders. An interesting phenomenon happens here, you can buy bonds at way higher rates than the initial rates the company issued, and the prices fluctuate here in the secondary market. It depends on various factors like supply and demand dynamics and the changes in interest rates per year.

Bond Pricing and Yield

Now answering the most important question of how am I going to know when it's the right time to buy a bond and when it's not? Everything depends on the prices of the bonds and how they will affect the ongoing changes in the markets. You need to look for these signs which we will tell you and you can easily predict what's coming. Various factors come into work in case of bond price fluctuations. These include current interest rates of bonds, the credit rating the corporation providing the bond is currently holding and last but not least the current scenario of demand and supply in the markets. Let's understand them in detail.

A. Factors Affecting Bond Prices

   1. Interest Rates

It is a known fact now that bond prices and interest rates work inversely to each other. When the interest rates rise then the prices of bonds fall and when the bond prices rise interest rates fall. This happens because when corporations launch new higher-interest rates bonds then the lower coupon rates of previous bonds become less attractive to investors.

   2. Credit Ratings

Credit ratings are provided by various agencies which assess the creditworthiness of the bond issuers. When an issuer is rated high in credit rating it means that the corporation has lower risks and typically lover yields too. Conversely, lower-rated bonds carry higher yields to compensate for the increased risks.

   3. Supply and Demand

The effects of supply and demand affect everything in this world, they are in play here too. Bond prices get influenced by the balance between supply and demand in the market. If the demand in the market is high for a particular bond then its price may increase and the vice-versa is also true.

B. Bond Yield

In simple words, bond yield is the return an investor will get from a bond he has invested in. For calculating bond yield you should consider the bond's coupon payments with the price and the time it takes to reach maturity. Yield can be expressed as current yield, yield to maturity (YTM), or yield to call (YTC), depending on the characteristics of the bond you are investing in.

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Credit Rating Scales:

Lowest credit risksAAA
Very low credit risksAA
Low credit risksA
Moderate credit risks BBB
High credit risksB
Very high credit risksC
DefaultedD
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Risks and Rewards of Bonds

The balance between the risk factors and the potential rewards a bond is giving is of utmost importance for you to invest in any bond. Investing in bonds carries both risks and potential rewards. A list of the risks which you should check before buying a bond is provided below.

A. Bond Risks

   1. Interest Rate Risk: 

As you have seen above, the fluctuations in interest rates can affect the prices of bonds inversely to a great extent. When interest rates rise, the prices of the bonds fall and this results in great capital losses for the bondholders. Similarly, bondholders gain capital when the rates decline due to a hike in bond prices.

   2. Credit Risk: 

Credit risk refers to the risk that the bond issuer may default on its payment obligations. Lower-rated bonds which are issued by a financially distressed corporation or government results in having a higher probability of default in the bond market.

   3. Call Risk: 

Some bonds have a call feature that allows the issuer to redeem the bond before its maturity date. Call risk arises when an issuer calls back bonds when interest rates have fallen, leading to potential reinvestment risk for bondholders.

B. Potential Rewards

   1. Regular Coupon Payments:

A fixed amount of income can be generated easily through regular coupon payments with the help of bonds. These perks are highly attractive for an income-oriented investor.

   2. Return of Principal: 

The principal amount comes back into your hands after the period of maturity ends. The full principal amount you initially invest comes back to you after the maturity period.

   3. Diversification and Stability: 

Investing in the stock market is very volatile but here investing in bonds is very stable for your investment portfolios. A great tool for diversification, Bonds offset the risk of other investments.

Conclusion

Understanding the fundamentals of bonds is essential to diversify your investment portfolios. All the basics related to bonds are provided above. You can make informed decisions now as you have a clear understanding of these concepts. All your financial goals can easily be achieved by the concept provided above by us. A great resource full of stability is waiting for you to achieve your financial goals. But take care to analyse the risks associated with bonds before making your investments. If you have any other queries, feel free to ask us. We will try our best to boil down difficult concepts into a very easy explanation.

FAQs

Q.1 What are the best bond-giving agencies present in the USA?

There are several reputable agencies present today in the US market.These agencies access the creditworthiness and risks associated with bonds of different corporations.Some of them are :
Standard & Poor's (S&P)
Moody's Investors Service
Fitch Ratings

Q.2 Are there any online sites available to check the credit ratings of bond issuing companies in the USA?

Yes, there are several online platforms where you can check the credit ratings of bond issuing companies in the USA.Some of them are:
1. Bloomberg Terminal
2. Morningstar
3. Fitch Ratings
4. Moody's Investors Service
5. Standard & Poor's (S&P)

Q.3 How are bonds different from stocks?

Although both bonds and stocks are used as instruments for investment,both of them are way different than each other.Bond represents a debt that you provide to the borrower whereas stocks represent your own ownership in the assets of the company.In bonds we get fixed returns thus they are somewhat less riskier than investing in stocks.