How a bond works
A bond is a loan in tradeable form. The issuer borrows a defined amount for a defined period, pays interest — the coupon — at stated intervals, and repays the face value on the maturity date.
Because the coupon is fixed, the market price of a bond moves inversely to interest rates. If rates rise after you buy, the price of your bond falls; if rates fall, it rises. Hold to maturity and this movement does not affect what you receive, provided the issuer pays.
The main varieties
- Government securities — issued by the Government of India, carrying sovereign credit and available across a wide range of maturities.
- State development loans — issued by state governments, usually at a small spread over central government paper.
- PSU bonds — issued by public sector undertakings, with quasi-sovereign standing depending on the issuer.
- Corporate bonds — issued by companies, paying more to compensate for credit risk. Ratings run from AAA downwards and matter a great deal.
- Tax-free bonds — older issues from specified institutions whose interest is exempt from income tax, generally available now only in the secondary market.
What to look at
- Yield to maturity, not the coupon. YTM accounts for the price you actually pay.
- Credit rating, and the direction it has been moving. A downgrade hurts before a default ever happens.
- Liquidity. Many corporate bonds trade thinly; exiting before maturity may mean accepting a poor price.
- Interest treatment. Coupon income is generally added to your income and taxed at your slab rate, which materially changes the comparison against other instruments.
Where bonds fit
Bonds are the ballast of a portfolio rather than its engine. They serve goals with a known date, provide income, and steady the overall portfolio when equity markets fall. They are not risk-free — credit risk and interest-rate risk are both real — but the risks are of a different character from equity.