What are Bonds?
Oftentimes, governments and corporations require funds for incurring capital expenditure, increasing the country’s capital stock (i.e. investment), financing development projects or refinancing existing debts. Of the many financial instruments available in the market, bonds are one of the safest and low-risk assets (for investors). Bonds are fixed-income, debt instruments that represent an agreement between the borrower (government, bank, financial institution, corporate, etc) and the investor for repaying the principal amount of loan at maturity and fixed periodic interest payments till maturity. The instalments can be semi annual, annual or monthly, depending on the discretion of the parties involved.
The issuer of the bond i.e the borrower specifies the terms of agreement of the loan. This includes the interest payments , and the time at which the principal amount must be paid back (maturity date). The interest payment is part of the return that bondholders earn for loaning their funds to the issuer.
Bond market in India- A brief overview
In the past 10 years, the Indian bond market has grown leaps and bounds, registering a compounded annual growth rate of 13.6% from March 2012 to March 2022. In Asia, India ranks third in terms of trading volume, with Japan and Korea occupying the first and second position respectively. As of 2022, the value of the Indian bond market is approximately US$2.29 trillion. The most popular and largely traded bonds are G-Secs (Government Securities/Bonds), State Development Loans (SDL) and Corporate Bonds. Additionally, sovereign gold bonds, RBI bonds and inflation linked bonds are popular debt instruments in the country. However, the bond market has been traditionally skewed towards government securities/bonds(G-secs) with the size of India’s corporate bond market being merely 17% of the GDP.
A recent report by Morgan Stanley has stated that inclusion of India in the global bond indices could “trigger $170 billion in bond flows over the next decade, lifting Indian bond prices while lowering borrowing costs—this milestone could have profound implications for the country’s currency, corporate bonds and equities.” Foreign ownership of central government bonds
Source: CEIC, Bloomberg, Morgan Stanley Research According to the graph,
there is merely a 1.9% foreign ownership in central government bonds. With the inclusion of India in global bond indices, the corporate bond market will be provided a boost to grow at the same pace as government bonds. Foreign investors would be provided an easy access to a larger pool of
Indian corporate issuers bringing domestic corporations out of uncertainty. It is expected to prompt one-off flows of $30 billion to $40 billion which would reduce the funding gap, lower the cost of borrowing for domestic corporations and strengthen the value of rupee.
Popular Bond Categories in India
G-secs are financial debt instruments issued by the central and state governments and comprise mainly of treasury bills and government bonds. Government bonds are issued by governments to fund their developmental projects, meet capital expenditure targets and overcome problems of illiquidity. They are issued for a period of 5-40 years. Government bonds issued by State Governments are called State Development Loans (SDLs).
In a bid to make government bonds more accessible, the RBI, in 2021, launched the Retail direct scheme. The scheme allows investors to open a retail direct guilt account directly with the RBI through which they can buy or sell government securities (G-Secs) directly without the interference of an intermediary like a mutual fund. Government bonds included under this scheme are State Development Loans (SDLs) and Sovereign Gold Bonds (SGB).
Government bonds can prove to be a safe or “risk-free” investment as there is sovereign guarantee offered by the lender i.e. the government. Thus, they are called “risk-free gilt-edged instruments.” As per RBI guidelines, interest earnings accrued on Government Bonds are supposed to be disbursed every six months to debt holders thereby providing them a regular income stream of income.
Yields on government bonds
One of the major setbacks of government bonds is the low interest earning as compared to corporate bonds. Other than the 7.75% GOI Savings Bond launched in 2018, interest earnings on other government bonds remains less than 7% on an average.
A popular type of government bond is the Sovereign Gold Bond which enables investors to invest in electronic gold through bonds. They are issued for a period of 8 years thereby posing problems of illiquidity. Investors must wait for a minimum of five years to the principal amount. However, redemption shall only take place when the next and the most recent interest payment is due.
Lets understand this with the help of an example –
Assuming that Mr X invested in an SGB on 1st April 2023, interest payments are scheduled for 1st May 2023 and every six months from thereon. In case he decides to withdraw it on 1st June 2028 (after five years) , he compulsorily has to wait till 1st November 2028 (interest disbursal due date) to receive the redemption amount.
One of the major advantages of investing in an SGB is that the government offers a fixed annual interest rate, paid every 6 months. Thus, volatilities in gold costs and prices don’t affect the interest payments of investors.
SGB’s also offer attractive tax benefits. First, TDS is not applicable on the interest income received from an SGB investment. Second, if the bond is redeemed after maturity, the capital gains tax will be exempted as well. However, the interest income received is taxable according to the income tax slab.
One of the major concerns that arise when dealing in gold is that international gold prices are volatile and an SGB investment can lead to a capital loss as the value of the bond is linked directly to these prices. If at maturity, you redeem the bond at a price lower than at which you bought the bond you will incur a loss.
A lot of investors are averse to investing in gold bonds because of the long maturity period of 8 years. However, the long period reduces gold price volatility and reduces losses for the investors, as discussed above.
State Development Loans (SDL) is another type of government bond that is issued by state governments to finance their fiscal deficit or borrowing requirements. Interest is paid out every six months and the principal amount is paid on the maturity date. They are issued for a period of ten years.
Corporate bonds are fixed income, debt securities that are issued by private and public corporations to fund their investment and capital expenditures such as setting up a new plant/ factory , purchasing equipment, or growing the business
Corporate bonds have higher coupon rates than G-secs. Normally, corporate bonds offer 7% to 12% interest rates as compared to G-secs which provide less than 7% interest. Thus, investors usually prefer investing in corporate bonds due to attractive yields.
Short term capital gains tax is paid on bonds held for less than 3 years. If bonds are held for a period of more than 3 years, then according to Section 112 of the Indian Income Tax, a 0% tax on long-term capital gains needs to be paid to the government.
Top Corporate Bond Funds in India
1. ICICI Prudential Corporate Bond Fund
It was launched on 11 Aug 09 and is a moderately low risk bond. It has provided a CAGR/Annualized return of 6.9% since its launch. The return for 2022 was 4.5% , 2021 was 4.1% and 2020 was 10.4% .
2. Nippon India Prime Debt Fund
It was launched on 3 Mar 97. It is a fund with Moderately Low risk and has given a CAGR/Annualized return of 9% since its launch. The return for 2022 was 4.1% , 2021 was 4% and 2020 was 11.9%.
3. HDFC Corporate Bond Fund
It was launched on 29 Jun 10. It is a fund with Moderately Low risk and has given a CAGR/Annualized return of 8.2% since its launch. The return for 2022 was 3.3% , 2021 was 3.9% and 2020 was 11.8%.
One of the major concerns of investing in a corporate bond is that the value of bonds declines with a rise in the interest rate. Holding a bond until maturity ensures that such price fluctuations (known as interest-rate risk, or market risk) are reduced or eliminated because one will receive the par, or face value of the bond at maturity.
Moreover, inflation leads to a reduction in the value of interest payments. Rising inflation has been a major concern for the Indian economy with RBI predicting a 5.2% retail inflation in the first half of the ensuing financial year (2023-24). Thus, investors must tread with caution.
4. Asset-Backed Securities (ABS):
ABS are bonds issued by banks or financial institutions that are backed by underlying assets such as mortgages, auto loans, or credit card receivables. These securities provide a source of financing for the issuing institution and offer investors a potential stream of income through the payment of interest and principal on the underlying assets. ABS can offer diversification and a unique investment opportunity, but they also carry credit and interest rate risk that should be considered before investing.
Different Types of Bonds in India:
Investors have a range of bond options to choose from, which can be classified based on the rate, type of interest, or coupon payment. The following are the most common types:
- Callable Bonds: Bonds that can be redeemed by the issuer prior to maturity.
- Fixed-rate Bonds: Bonds with a constant coupon rate throughout the investment period.
- Floating-rate Bonds: Bonds with a changing coupon rate during the investment period.
- Zero Coupon Bonds: Bonds with a coupon rate of zero, where only the principal is paid to the investor at maturity.
- Puttable Bonds: Bonds that can be sold back to the issuer by the investor before the maturity date.
How do Bonds work?
Bonds are a form of investment in which a borrower raises funds from investors through the issuance of debt securities. The yield of a bond is determined using three key components:
- Principal: This refers to the amount of money that the borrower initially raises from investors through the sale of bonds.
- Coupon rate: This is the interest rate that the borrower promises to pay to the bondholders, usually at set intervals (e.g. semi-annually or annually), for the duration of the bond.
- Maturity date: This is the date when the borrower is expected to repay the bondholders the full amount of the principal that was borrowed.
When a bond is issued, the borrower and the lender enter into a legally binding agreement, where the borrower promises to repay the principal amount at maturity and to pay periodic interest on the borrowed funds (coupon rate) until the bond reaches maturity. This arrangement allows investors to receive a steady stream of income in the form of interest payments, while also providing the borrower with access to much-needed funds.
What to Consider Before Investing in Bonds
Before investing in bonds, investors should take the following factors into consideration:
- Alignment with financial goals: Investors should evaluate if the bonds they are considering fit into their overall financial plan and goals.
- Default risk: It’s important to assess the risk of default associated with the bonds, as this can have a significant impact on the investor’s returns.
- Price risk: Investors should consider the price risk associated with bonds, as bond prices can fluctuate over time.
- Exit option: It’s important to understand what the exit option is for the bonds, as this will affect the investor’s ability to sell the bonds in the future.
Features of a Bond
- Issue Date: The start date of interest accrual on the bond.
- Coupon Rate: The interest rate promised by the company to the bondholders, paid semi-annually or annually.
- Maturity Date: The date when the issuer repays the bond’s face value to the investor.
- Taxation: Some bonds offer tax benefits, while others may be taxed, depending on the type of bond and issuer. Certain government bonds and municipal bonds may not impose taxes on profits earned.
What are Sovereign Green Bonds
Recently, the Indian government also launched another type of bond known as the sovereign green bonds.
Such bonds are issued by any “sovereign entity, inter-governmental groups or alliances and corporations” and ensures that the proceeds of the bonds are utilized for green and sustainable projects, clean transportation, energy efficiency, climate change adaptation,
sustainable water and waste management, pollution and prevention control and green buildings.
RBI has auctioned green bonds with tenures of 5 and 10 years. Each bond is worth Rs.4000 cr. This comprises the Sovereign Green Bond 2028 and Sovereign Green Bond 2033. One of the major advantages of the green bond is that there is no limit on foreign investment in these bonds because they are considered as specified securities. This will surely provide a boost to the Indian market and also help the country in achieving its vision of sustainability, circularity and renewability.
What is YTM?
Yield to Maturity (YTM) is a method of calculating the price of a bond. It is the estimated return that an investor would receive if they held the bond until its maturity date. YTM takes into account the current market price of the bond, the coupon rate, and the time left until maturity and expresses the result as an annual rate.
The Indian bond market is a lucrative investment option that provides safe and timely returns to investors. At the same time, it becomes imperative to choose an investment avenue that best aligns with your financial goals and aspirations. If you prefer returns over risk, then opt for bonds.