Bonds and their types

A bond is a loan you make to a government or a company, turned into something you can hold and sell. It pays interest on a schedule and returns your money on a set date. The idea is simple; the one surprise is the way its price moves.

How a bond works

Every bond has three terms:

• a face value, the amount repaid at the end (₹100 for Indian government securities);
• a coupon, the interest it pays as a percentage of face value, usually every six months;
• a maturity, the date the face value is repaid.

A ten-year bond with a 7.25% coupon and a ₹100 face value pays ₹3.625 every six months for ten years, then gives the ₹100 back.

Price and yield

Bonds keep trading after they are issued, and their price moves. The yield is the return you would earn buying a bond at today’s price and holding it to the end, counting both the coupons and any gain or loss on the price.

Price and yield always move in opposite directions. Say you hold that 7.25% bond, and interest rates rise so that new bonds pay 8.25%. Nobody will pay you ₹100 for 7.25% when ₹100 buys 8.25% elsewhere, so your bond’s price falls until its yield matches the new rate: here, to about ₹93.28. When rates fall, the reverse happens. Your higher coupon becomes worth more, and the price rises above face value.

The longer the bond, the bigger the move. A one-point rise in yields cuts a ten-year bond’s price by about 6.7%, but a two-year bond’s by only about 1.8%, because the longer bond has more years of below-market coupons locked in. This sensitivity is called duration.

Hold a bond to maturity and none of this changes what you are paid: the coupons and the ₹100 arrive as promised. Price movements matter if you sell before the end, or if you hold bonds through a fund that values them every day.

Government bonds

Issued for the central government through the Reserve Bank of India, and regarded as the safest rupee bonds there are.

• Treasury bills (T-bills). Short-term, maturing in 91, 182 or 364 days. They pay no coupon: you buy them below face value and receive the full face value at the end.
• Dated government securities (G-secs). Longer-term bonds, running from a couple of years to several decades, with a fixed coupon paid twice a year.
• State development loans (SDLs). Bonds issued by state governments. They usually yield a little more than central government bonds of the same length.
• Floating rate bonds. The coupon resets from time to time in line with a benchmark rate, so the price moves far less when rates change.

Company bonds

Companies borrow the same way. In India their bonds are often called non-convertible debentures (NCDs). They pay more than government bonds of the same length, because a company can fail to pay; the extra yield is the price of that risk.

Credit ratings from agencies such as CRISIL, ICRA, CARE Ratings and India Ratings grade the risk, from AAA at the top down to D, for a borrower that has already defaulted. The lower the rating, the higher the yield a bond has to offer.

Other kinds you will meet

• Tax-free bonds. Issued in the past by government-backed companies. The interest is exempt from income tax, so the coupon is lower than a taxable bond’s. Existing issues still trade on the exchanges.
• Zero-coupon bonds. No interest along the way: bought below face value and repaid at face value, like a long T-bill.
• Convertible bonds. Can be exchanged for the company’s shares on terms set in advance.
• Perpetual bonds. No maturity date at all. Some issued by banks, known as AT1 bonds, can be written down to nothing if the bank runs into trouble, and in India that has happened.

Work it out on your own numbers

• Company deposit and NCD calculatorThe return that reaches you after tax, from the coupon and the dates.
• FD calculatorA fixed deposit’s payout, and what reinvesting the interest adds.
• Real return calculatorThe yearly rate on anything that pays you over time.

This lesson explains ideas. It is not advice about what to buy, sell or hold.