Bond Market: Introduction and types, Indian Bond Market

Bond concepts: Yield, Interest rate, Maturity

Bond Valuation
 Introduction

What are bonds?

Bonds are fixed-income instruments that signify a loan forwarded by an investor to a borrower.
The issuer promises to pay a specific interest for the life of the bond and the principal amount or
the face value at maturity. Governments, corporations, municipalities, and other sovereign bodies
generally issue bonds. Bonds can be traded, just like securities.

What is the bond market?

The market for trading debt securities like government, corporate, and tax-free bonds is known
as a bond market. A bond market is generally less volatile than an equity market and is more
suitable for investors with lower risk tolerance. Investing in bond markets is an efficient way to
diversify your portfolio. The primary role of a bond market is to help the government and large
private entities access long-term capital.
 Types of Bonds

GOVERNMENT BONDS
The Indian government, either the central or state governments, may require funds for their
operations, such as infrastructure, public projects, etc. Thus, they issue bonds known
as government bonds
The government (issuer) guarantees principal repayment as well as interest payments. The
government (central or state) backs them, so they are considered the safest.
Government bonds have a long maturity, usually between 5 and 40 years.
These bonds pay a fixed/floating interest rate but provide lower returns as they carry less
risk.
Investors who avoid taking risks, sometimes known as risk-averse investors, and who want
to ensure the highest protection for their money might invest in government bonds.
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CORPORATE BONDS
Companies issue corporate bonds to fund their needs, such as expansion, equipment
purchases, land purchases, construction of a new factory, etc. These bonds are often
medium to long-term investments with more than one year of maturity. Companies pay
investors monthly interest payments at predetermined intervals and their principal amount
when the bonds mature. Companies issue debt because it allows them to raise funds at a
reduced cost and without diluting their stock. Corporate bonds have a larger default risk
than government bonds and provide a higher yield.
PSU BONDS
PSU bonds are issued by public-sector companies, such as PSU banks, power sector
companies, railways, etc., with a government stake of more than 51%. As the government
backs these bonds, they carry less risk, thus lower returns than corporate bonds. They come
with medium to long-term obligations.
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TAX-FREE BONDS
Tax-free bonds are precisely what their name implies: they are tax-free. As a result, the interest
investors generate on these securities will be tax-free under section 10 of the Income Tax Act.
The government issues these bonds for a specified purpose, such as infrastructure or housing
projects. Municipal bonds are an example of this type of bond. Tax-free bonds have a 10-year or
longer maturity and have very low default risk. Thus, they provide a lower rate of return than
corporate bonds.
ZERO-COUPON BONDS
Bonds that pay no interest to the investor are known as zero-coupon bonds. Zero-coupon bonds
(deep discount bonds) are issued at a discount to their fair value but are redeemed at par.
CONVERTIBLE BOND
A convertible bond is a good source of fixed income. The investors get interest payments until
the bonds are converted into equity shares. It is comparatively safe and provides higher yields
than common stock. Examples: Vanilla Convertible, Embedded options etc,.
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SOVEREIGN GOLD BONDS

SGBs are government securities denominated in grams of gold. They are substitutes for holding physical gold.
Investors have to pay the issue price in cash and the bonds will be redeemed in cash on maturity.

• Reserve Bank issues the Bond on behalf of the Government of India. The quantity of gold the investor pays
is protected, since he receives the ongoing market price at the time of redemption/ premature redemption.

• The SGB offers a superior alternative to holding gold in physical form. The risks and costs of storage are
eliminated. Investors are assured of the market value of gold at the time of maturity and periodical interest.

• SGB is free from issues like making charges and purity in the case of gold in jewellery form. The bonds are
held in the books of the RBI or demat form eliminating the risk of loss of script etc.

• There may be a risk of capital loss if the market price of gold declines. However, the investor does not lose
in terms of the units of gold which he has paid for.
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PERPETUAL BONDS
It can go on for as long as the issuer is a going concern. In practice, though, these bonds have a “call” option,
which enables the issuer to redeem the bond at the call date. Perpetual Bonds do not have any maturity date.
They pay regular interest in the form of coupon payments till the call date.

GREEN BOND

It is a debt instrument designed to support specific climate-related or environmental projects. Investing in

Green Bonds is a good choice also for retail investors. They are used to finance projects aimed at sustainable
agriculture, pollution prevention, fishery and forestry, clean water and transportation, and environment-
friendly water management projects.
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COVERED BONDS
It represents a type of debt securities issued by banks or Non-Banking Financial Companies
(NBFCs), backed by a pool of assets. These bonds assure investors that the funds can be
recovered from the collateralized pool of assets if the issuer defaults.

The structure of a covered bond is as follows:

• The bank or NBFC issues bonds to investors.
• A cover pool of secured loans is established as a precautionary measure.
• At the bond's maturity, the bank or NBFC repays the principal amount plus interest to the
investors.
• If the issuer fails to pay, the cover pool can recover the amount.
• The cover pool typically comprises various secured loans such as housing, vehicle, gold,
and others.
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STATE DEVELOPMENT LOAN BONDS

It is commonly known as an SDL bonds issued by the government of several states to fund their fiscal deficit.
State Governments in India have their financial budgets. And when the budget sometimes exceeds the
available revenue resulting in a fiscal deficit. In such situations, state governments issue SDL Bonds to fulfill
their need for additional funds.

CAPITAL INDEXED BOND (CIB)

CIBs are bonds whose base payment rises and falls with the Consumer Price Index (CPI). CIBs have their
capital, or the principal amount of the bond, indexed (usually quarterly) with the revised capital amount due
for repayment at maturity. As indexation increases the principal value of the security over time, the amount
due at maturity becomes greater so your capital is protected against the perils of inflation.
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INFLATION-INDEXED BONDS (IIBS)
It was issued in the name of Capital Indexed Bonds (CIBs) in 1997. The CIBs issued in 1997 provided inflation
protection only to principal and not to interest payment. New product of IIBs provide inflation protection to both
principal and interest payments. Inflation component on principal will not be paid with interest but the same would
be adjusted in the principal by multiplying principal with index ratio (IR). At the time of redemption, adjusted
principal or the face, whichever is higher, would be paid. Interest rates will be protected against inflation by paying a
fixed coupon rate on the principal adjusted against inflation.
Separate Trading of Registered Interest and Principal Securities (STRIPS)
Stripping separates a standard coupon-bearing bond into its individual coupon and principal components. For
example, a 5-year coupon-bearing bond can be stripped into 10 coupons and one principal instrument, which would
then become zero coupon bonds.
In an official STRIPS market for the Government securities, these stripped securities i.e., the newly created zero
coupon bonds remain the direct obligations of the Government. They are registered in the books of the agent meant
for this purpose. Thus the mechanics of stripping neither impact the direct cost of borrowing nor change the timing or
quantum of the underlying cash flows; stripping only facilitates transferring the right to ownership of individual cash
flows.
https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?ID=250
 Types of Bond Market

There are two types of markets in the Indian bond market.

1. PRIMARY MARKET
The primary bond market is a segment where new and seasoned issuers, including
corporations, municipalities, and governments, sell securities to investors.

2. SECONDARY MARKET
The secondary bond market includes bonds that have already been issued. These bonds can
be traded between investors on exchanges or over the counter. Investors use secondary bond
markets to trade existing bonds, instead of purchasing newly issued bonds. These bonds can
be purchased through a broker, who acts as a middleman between the purchasing and
selling parties.
The Indian bond market includes government and private-sector bonds, but government
bonds dominate the Indian bond market.