
What is A Bond?
A bond is said to be a debt instrument in which the issuer company borrows money from the lender (bondholder) and, in return, is obliged to pay interest on the principal amount. The interest is called the coupon. The holder enters a formal contract where the issuer decides to repay borrowed money along with interest at fixed intervals, such as on a semi-annual, annual, or monthly basis.
Types Of Bonds:
1) 54EC Bonds
Section 54EC bonds, also known as Capital Gains Bonds, are a specific type of investment instrument available in India. These bonds are issued by specified entities, typically Rural Electrification Corporation (REC) and National Highways Authority of India (NHAI), as authorized by the Indian government under Section 54EC of the Income Tax Act, 1961.
Investors in India can avail themselves of the benefits of Section 54EC bonds when they have earned long-term capital gains from the sale of certain assets, such as real estate or equity shares. By investing the capital gains amount into these bonds within a specified period, typically 6 months from the date of sale of the asset, investors can defer the payment of capital gains tax.
Features of Section 54EC bonds
- Tax Exemption: By investing in these bonds, investors can defer paying tax on their long-term capital gains. The amount invested in these bonds is deducted from the total capital gains, thereby reducing the taxable capital gains amount.
- Lock-in Period: The investment in Section 54EC bonds comes with a lock-in period of 5 years. Investors cannot redeem or sell these bonds before the completion of the lock-in period.
- Interest Rate and Maturity: The interest rate offered on Section 54EC bonds may vary and is usually lower than market rates. These bonds have a fixed maturity period of 5 years.
- Limited Investment Amount: There is a cap on the maximum amount that can be invested in Section 54EC bonds in a financial year. As of the latest information available, this limit is ₹50 lakhs per individual.
- Tax Implications on Redemption: While the investment in Section 54EC bonds helps defer capital gains tax liability, the interest earned on these bonds is taxable. However, the principal amount invested is not taxable upon redemption after the lock-in period.
Section 54EC bonds provide investors with an avenue to defer capital gains tax liability while also earning a fixed return on their investment. However, investors should carefully evaluate their tax planning needs and consider factors such as liquidity, interest rates, and tax implications before investing in these bonds.
2) Perpetual bonds
Perpetual bonds, also known as perpetuities or perpetual securities, are a type of fixed-income investment instrument with no maturity date. Unlike conventional bonds that have a fixed maturity period, perpetual bonds have no specific redemption date, meaning they can technically remain outstanding indefinitely.
Features of Perpetual bonds
- No Maturity Date: Perpetual bonds have no fixed maturity date, meaning the issuer is not obligated to repay the principal amount to investors. Instead, the issuer makes periodic interest payments to bondholders indefinitely.
- Fixed or Floating Interest Payments: Perpetual bonds typically pay fixed interest payments to investors at regular intervals, similar to traditional bonds. However, some perpetual bonds may have floating interest rates that adjust periodically based on a predetermined benchmark.
- Callable Option: While perpetual bonds do not have a maturity date, issuers may include a callable option in the bond contract, allowing them to redeem the bonds at a predetermined price after a specified period. This gives the issuer flexibility to call back the bonds if market conditions become favorable for refinancing.
- Risk and Return: Perpetual bonds often carry higher risk compared to traditional bonds due to their indefinite maturity and lack of principal repayment obligation. However, they typically offer higher coupon payments to compensate investors for the added risk.
- Investor Considerations: Investors in perpetual bonds should carefully assess the creditworthiness of the issuer, as well as the terms and conditions of the bond contract. Since perpetual bonds do not mature, investors rely solely on interest payments for returns, making issuer credit quality crucial.
- Market Value Sensitivity: The market value of perpetual bonds is sensitive to changes in interest rates and investor sentiment. In periods of rising interest rates or deteriorating credit conditions, the market value of perpetual bonds may decline, leading to capital losses for investors who sell before maturity.
Perpetual bonds are commonly issued by financial institutions, utility companies, and other corporations seeking long-term financing. While they offer the advantage of indefinite tenure and stable interest income, investors should carefully evaluate their risk tolerance and investment objectives before investing in perpetual bonds. Additionally, thorough due diligence on the issuer’s financial health and creditworthiness is essential to mitigate investment risks.
3) Floating rate bonds
Floating rate bonds are debt securities where the interest rate fluctuates periodically based on a reference rate or benchmark, such as the prevailing market interest rate or an inflation index. These bonds offer investors protection against interest rate risk as the coupon payments adjust according to changes in the reference rate.
Features of Floating rate bonds
- Interest Rate Determination: The interest rate on floating rate bonds is typically tied to a benchmark rate, such as the RBI’s repo rate, government bond yields, or any other market-determined interest rate index. The coupon rate of the bond is set as a spread or margin over the benchmark rate.
- Interest Payment: Unlike fixed-rate bonds, where the interest payments remain constant throughout the bond’s tenure, floating rate bonds have variable interest payments. The coupon payments are recalculated periodically (e.g., every six months or annually) based on changes in the reference rate.
- Risk Management: Floating rate bonds provide investors with protection against interest rate risk. If market interest rates rise, the coupon payments on floating rate bonds increase, thereby preserving the bond’s value. Conversely, if interest rates fall, the coupon payments decrease.
- Issuer and Investors: Floating rate bonds can be issued by various entities, including government agencies, corporations, and financial institutions, depending on their financing needs. Investors in floating rate bonds include individuals, institutional investors, banks, and mutual funds seeking exposure to fixed income securities with interest rate risk protection.
- Market Dynamics: The pricing of floating rate bonds in the secondary market is influenced by changes in market interest rates, credit risk perception, and liquidity conditions. Investors may buy and sell floating rate bonds based on their expectations of future interest rate movements and overall market conditions.
While the RBI itself doesn’t issue floating rate bonds directly to the market, it does influence interest rates through its monetary policy decisions, which in turn impact the pricing and performance of floating rate bonds in the Indian debt market. Investors interested in floating rate bonds should consider factors such as credit quality, liquidity, and market dynamics before making investment decisions.
4) Tax-free bonds
Tax-free bonds are a type of debt instrument issued by government-backed entities or infrastructure financing companies in India. These bonds offer investors the benefit of receiving tax-free interest income, meaning the interest earned on these bonds is exempt from income tax under the Income Tax Act, 1961.
Features of Tax-free bonds
- Issuers: Tax-free bonds are typically issued by government-backed entities such as government-owned companies (PSUs), infrastructure financing companies, or other government institutions. These entities issue bonds to raise funds for infrastructure development projects or other capital expenditure requirements.
- Coupon Rate: Tax-free bonds offer a fixed coupon rate of interest, which is predetermined at the time of issuance. The coupon rate is usually higher than the prevailing interest rates on taxable bonds to attract investors. However, the interest earned on tax-free bonds is exempt from income tax, making them attractive to investors seeking tax-efficient investment options.
- Maturity Period: Tax-free bonds have a fixed maturity period, typically ranging from 10 years to 20 years or more, depending on the issuer. Investors receive periodic interest payments throughout the bond’s tenure, and the principal amount is repaid at the end of the maturity period.
- Tax Benefits: One of the main attractions of tax-free bonds is the exemption of interest income from income tax. Unlike interest earned on fixed deposits or other taxable bonds, the interest earned on tax-free bonds is not added to the investor’s taxable income. This makes tax-free bonds particularly attractive for investors in higher tax brackets seeking tax-efficient investment avenues.
- Liquidity: Tax-free bonds are listed on stock exchanges, providing investors with liquidity and the option to buy or sell them on the secondary market before maturity. However, investors should be aware that bond prices in the secondary market may fluctuate based on changes in interest rates, market conditions, and credit risk perception.
- Credit Rating: Before investing in tax-free bonds, investors should assess the creditworthiness of the issuer by considering factors such as the issuer’s financial health, credit rating assigned by credit rating agencies, and the nature of the projects being financed.
- Investor Eligibility: Tax-free bonds are open to both retail and institutional investors, including individuals, Hindu Undivided Families (HUFs), trusts, and corporate entities. Investors can subscribe to tax-free bonds during the initial public offering (IPO) or purchase them from the secondary market.
Overall, tax-free bonds offer investors an attractive combination of fixed income and tax benefits, making them a popular investment choice, especially for conservative investors seeking stable returns with tax efficiency. However, investors should carefully evaluate the credit risk, liquidity, and investment horizon before investing in tax-free bonds.
Important Bond Terminologies:
- Face Value: Face Value is the amount of money the bond will be worth at maturity. The Interest is also paid on the face value of the bond. The face value of the bond is determined by the issuer at the time of the issue. The face value may be as low as Rs.100 or as high as Rs.10 lakhs.
- Coupon Rate: It refers to the rate of interest payable by the bond issuer to the bondholder. The Coupon Rate or interest is paid on the face value of the bond. For example, a 10% coupon rate means that the bondholder will receive 10% interest on the Rs.10,00,000 face value of the bond which is Rs.1,00,000 every year.
- Interest Payment: Different bonds are issued with different conditions. One important thing that a bond investor should know is the way interest will be paid. Bond interests can be paid monthly/ quarterly/ half-yearly and yearly.