Bond

Bond is a long term debt instrument that promises to pay a fixed annual sum as interest for a specified period of time. The basic features of bonds are given below:

1. Bonds have face value. The face value is called Par value. The bonds may be issued at par or at discount.

2. The interest rate is fixed. Sometimes it may be variable as in the case of floating rate bond. Interest is paid semi-annually or annually. The interest rate is known as coupon rate. The interest rate is specified in the certificate. 

3. The maturity date of the bond is usually specified at the issue time except in the case of perpetual bonds.

4. The redemption value is also stated in the bonds. The redemption value may be at par value or at premium.

5. Bonds are traded in the stock market. When they are traded the market value may be at premium or at discount. The market value and redemption value need not be the same.

Types of bonds 

1. Secured bonds and unsecured bonds: The secured bond is secured by the real assets of the issuer. In the case of the unsecured bond the name and fame of issuer may be the only security.

2. Perpetual bonds and redeemable bonds: Bonds that do not make sure on never mature are called perpetual bonds. The interest alone would be paid. In the redeemable Bond, the bond is redeemed after a specific period of time. The redemption value is specified by issuer.

3. Fixed interest rate bonds and floating interest rate bonds: In the fixed Interest rate bonds, the interest rate is fixed at the time of the issue. Whereas in the floating interest rate bonds, the interest rate changes according to the prefixed norms. For example, in December 1993, State Bank of India issued floating interest rate bonds worth off ₹500 Crores packing the interest rate with its own 3 and 5 years fixed deposit rates to provide built in flexibility to investors.

4. Zero coupon Bond: these bonds sell at a discount and the face value is repaid at maturity. The origin of this type of Bond can be traced in the US security market. The high value of the US government security prevented the investors from investing their money in the Government Security. Big brokerage companies like Merril Lynch, pierce and others purchased the government securities in large Quantum and resold them in smaller denomination - at a discounted rate. The difference between the purchase cost and face value of the bond is the gain for the investor. Investor does not receive any interest on the bond, conversion price suitably arranged to protect the interest loss to the investor.

The merit of this bond is that the company does not have the burden of servicing the debt during the execution period of the project. The repayment could be adjusted to fall after the completion of a project. This could result in considerable cost savings for the company.

5. Deep discount bonds: deep discount bond is another form of zero coupon Bond. The bonds are sold at large discount on their nominal value; interest is not paid for them and they mature at par value. The difference between the maturity value, MB issue price serves as an interest return. The deep discount bonds maturity period mein winners from 3 years to 25 years or more. IDBI was the first to issue deep discount bonds in India in 1992 with varying maturity period options. ICICI also issued deep discount bonds with four optional maturity period in 1997. Early redemption option is provided at the end of the 6th, 12th and 18th year.

6. Capital indexed bonds: in the capital index bond, principal amount of the bond is adjusted for inflation for every year. For example, an investment of ₹1000 in the inflation indexed bonds on the investors a semi annual interest income for the five years period. The reselling of the principal amount is done semi-annually based on the WPI movements. The the principal amount of the bond is adjusted for inflation for each of the years. On the inflation adjusted principal, the coupon rate of 6% is worked.

The benefit of the bond is that it gives the investor an increase in return by taking inflation into account. The investor enjoys the benefit of a return on his principal, which is equal to the average inflation between the issue (purchase) and maturity period of the instrument. To avail the benefit of inflated principal, investor needs to hold be instrument for the entire five year period. 

If the investor wants to exit early, he can do it through the secondary market. The value of the principal repayment will be adjusted by me index rate, which will be announced by the RBI 2 weeks prior to the repayment of the principal. The IR is worked out as follows = Reference WPI as in August 2002/ Base WPI (as in August 1997).

In the Indian situation indexed bonds offer more scope since the economy is highly sensitive to the inflation. According to the study conducted by the Development Research Group (DRG) of the RBI, during the period 1972-93, the real rate of interest was negative for most of the years. Average value over the period is -1.84 %.

This situation warrants and inflation hedge. The inflation protection provided by the bond guarantees real rate of return which means that with the rise in inflation, the returned from the inflation-protected bond will rise. In 1997 capital indexed bond is introduced.