When it comes to investment, Bonds is an important asset.
We already saw that in Asset Allocation video.
When compared to Stocks, Bonds are less risky and less volatile.
Thats why all financial advisors recommend to have bonds exposure in our portfolio.
As a common man, we know how James Bond work.
But we don't have much idea about how "Bonds" work.
Because it is a bit complicated subject.
This episode will help to understand Bonds better.
Bond - is called as "Oppantha Pathiram (A Contract) n Tamil.
What do people do at home if they have to lend money to someone?
They give the money only after getting a bond/deed for security.
Its same concept in "Bonds" as well.
By buying a bond from an entity, we are giving loan to that entity.
For that loan, the entity will pay us an interest either once a year or twice a year.
This is the basic concept in Bonds.
So who are these entities? Anyone who issues bond is entities in this context.
If Corporates issues the bonds, we call it "Corporates Bonds".
If local municipality issues the bonds, we call it as "Muni Bonds".
Even State or Central Govt can issue bonds.
So lets see what happens during an issuance of a Corporate Bond.
Lets take Tata Motors.
They want to increase their manufacturing capacity.
For that, they have to build a new manufacturing plant.
But they got no cash in their hand for that.
They decide to borrow thru Bonds.
They work with an investment bank and create a bond structure.
Their need is Rs. 1,000 Crore.
With one bond value as Rs. 10,000, they are creating 10 Lakhs Bonds for issuance.
They decide to return this loan in 10 years.
The date in which the debt is returned is called "Maturity Date".
So the maturity date of this bond is, 10 years from the date of issuance.
No one is going to give cash for free.
The loan definitely needs an interest to be paid.
That interest is called as "Coupon Rate".
How much should Tata give as interest for this bond?
It depends on two important factors.
1. This Bond's maturity date. As the loan period increases, the interest rate increases as well.
2. Credit quality of the company that is issuing the bonds.
that is, measuring the capability of Tata Motors to pay back this debt is the credit quality.
Credit rating agencies like Moody's and S&P analyse the financial situation of Tata Motors and assign credit ratings like AAA, AA to them.
If this credit rating is good, these companies can issue bonds for less interest rate.
If the credit rating is not that good, the companies issuing the bonds would end up paying more interest for the bonds.
Because, by buying the bonds from companies with poor credit quality, investors are taking higher risk.
They expect extra interest for that extra risk.
Bonds with good credit ratings are called as "Investment Grade" Bonds.
If the credit rating is not that good, it is called as "high Yield Bonds" or "Junk Bonds".
So this coupon rate is dependent on the bond's maturity date and the credit quality of the issuer.
Market Interest rate also affects this.
In US, it is called as "Fed Funds Rate", and in India, it is called as "Repo Rate".
If the "Fed Funds Rate" was higher during the issuance of a bond, the coupon rate of the bond will be higher as well.
Ok - Lets get back to our example.
Tata is working with Moody's and S&P - and getting AAA rating for its bond.
With that rating, it is issuing the bond in the market for 5%R Coupon Rate.
Insurance companies, Mutual Funds, Pension Funds buy these bonds for a value of Rs. 10,000 per bond.
Buying a bond directly during the time of issuance is called as buying in "Primary Market".
Like Stock Market IPO.
If all the bonds are sold successfully, the 1,000 Crore required for building the manufacturing plant would have come to Tata Motors.
After that, Tata has to just pay a interest of Rs. 500 per year or Rs. 250 every 6 months to the bond holders.
That is all.
After paying interest for 10 years, Tata will return the money to the bond holders by its maturity date.
That is, for each bond, it returns the face value of the bond - Rs. 10,000.
All these bonds that are issued in primary market, is traded in secondary market.
Whoever holding these bonds, can decide to sell it to any one at any time. Like Stocks.
Just like how stocks are trading in stock market, Bonds are traded in Bond market.
Till now, we were looking from the perspective of the bond issuer - Tata Motors
Lets see from the perspective of bond buyers - Eg. Mutual Funds.
Lets take "Axis Corporate Debt Fund" for example.
They come to know that Tata Motors is planning on issuing a AAA rated bond in the market.
As a good quality bond is coming to the market, they decide to buy this bond for Rs. 1 Crore.
By holding these bonds for 10 yrs till its maturity date, they get the 5% interest from Tata Motors every year a d pay them as dividends to their fund investors.
If we have invested in this Axis Corporate Debt Fund, we would have got the interest from Tata Motors as dividends.
If Axis wants to sell this bonds, they can do this any time in the secondary market.
They bought it for Rs. 10,000 - would they be able to sell it for the same price in the secondary market?
That depends as these bonds trade in the secondary market just like stocks.
Its price keeps changing depending on market conditions.
What are all the market conditions that has an impact on Bond's price,
What are all the risks we are exposed to by buying bonds,
What are all the type of bonds can we buy for our portfolio,
We will cover all those topics in our next episode. Thank You.