Different Types of Bonds and Understand How to invest in Bonds and Debentures

Bonds are a way for governments and corporations to raise funds worldwide. They are very similar to loans, in the sense that investors earn a rate of interest by investing in bonds. Usually, bonds are secured, which means they are backed by collateral.

If an issuer fails to pay the interest or principal of a bond, then the collateral can be utilised to pay the dues to the bondholders. In essence, bonds work like secured debt. If you have a demat and trading account and you want to invest in debt instruments, it is worthwhile knowing about different types of bonds.

Types of bonds in finance

There are several types of bonds in finance, the most prominent ones are explained below.

Fixed-rate bonds: These bonds offer a fixed rate of interest to bondholders until the bonds mature. By investing in such bonds, you are guaranteed to earn a fixed interest every year, no matter what the prevailing interest rates in the market are.

1. Floating-rate bonds

These kinds of bonds do not offer fixed interest to investors. Instead, interest on such bonds varies based on a benchmark rate. Issuers mostly issue such bonds to protect themselves against the variations in interest rate levels.

2. Convertible bonds

These bonds provide a right to investors to convert them into a pre-determined number of equity shares of the issuing company at a certain point in time. 

If the investors choose to convert such bonds into equity, they will become owners of the issuing company. Bear in mind that the investors have a right to do so, not an obligation. If they do not want to convert the bonds, they can even receive the principal amount when these bonds fall due.

3. Zero-coupon bonds

This variety of bonds does not pay interest to bondholders at regular intervals. Rather, issuers issue them at a discount and repay them at par value. Let us take an example. 

Think of a 10-year zero-coupon bond that has a face value of Rs. 100 but is issued at Rs. 80. In this case, the investors will pay Rs. 80 to get the bond and at the end of 10 years, they will get Rs. 100. The difference of Rs. 20 is the interest income for bondholders.

4. Inflation-protected bonds

Such bonds are typically issued by governments. By issuing these bonds, governments try to protect investors against inflation. Investors earn a fixed interest on them. However, the interest rate is tweaked at periodic intervals in accordance with the changes in the inflation rate in the economy.

How to invest in bonds and debentures?

Investors can invest in a number of debenture bond in India, like government bonds, corporate bonds, sovereign gold bonds (these bonds are an alternative to investing in gold and are issued by the central government in India), and RBI bonds (issued by the Reserve Bank of India).

Investors can invest in these debenture bonds through their online demat account. That is one way to invest. However, at times, investors may not be keen to invest in a specific issue of bond. It could be that they think investing in only one variety of bonds is risky; it is like putting all their eggs in one basket.

In that case, investors can consider investing in fixed-income mutual funds, which invest in a bouquet of fixed-income investment options, such as debentures, government securities, corporate bonds, etc. They are commonly known as ‘debt funds’.

Such mutual funds help investors diversify their fixed-income portfolio by investing in several debt instruments, rather than investing in one bond issue. Besides, they are managed by professional fund managers, who have expertise in managing bond investments.

As such funds invest in fixed-income instruments, they offer lower volatility than other investment options. All in all, investing in bonds is quite easy. If you have made up your mind to do so, the only thing you have to do is use your demat account.

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