Hope you had read the 1st Part of Basics, if not, to click here read it. Basics of Stock Market – Part I
Today, we will discuss about the types of Financial Instruments:
As already mentioned in the previous part, the financial instruments are categorized into 2 parts:
Let’s come to Debt based instruments:
Read carefully otherwise it may slip and go above your head.
Now, understand one thing that Debt is a class of asset which is further classified on the basis of following:
Let’s discuss each of the above in detail:
Long term debt in the form of Securities
Meaning of securities:
These are the investments that can easily be bought or sold on the open market. The high liquidity of marketable securities makes them very popular among individual and institutional investors.
Type of securities in long term debt asset class:
For example: If you want to invest in Long term debt securities then that means you are investing in Bonds or you can invest in Bonds.
Meaning of Bonds:
A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debt-holders, or creditors, of the issuer.
For example: ABC Pvt. Ltd. Company need some funds for the completion of his project but it don’t want to take loan from Bank because of xyz reasons. In that case it can issue Bonds to the public who will purchase the bond of the company after paying g the specified amount. The purchaser will become the debt-holder or creditor of the company.
Benefit of purchasing Bonds:
The purchaser gets the Coupon along with the bond, according to which the purchaser gets the interest amount on the date of that maturity along with the principle amount. The interest rate is mentioned in the coupon.
Types of Bonds:
The classification of bonds depends upon various factors like issuer, priority, redemption features and coupon rates. Let us take a look at the various types of bonds:
A. Government Bonds:
A government bond is a bond issued by a national government, generally with a promise to pay periodic interest payments and to repay the face value on the maturity date. Government bonds are usually denominated in the country’s own currency.
In India, the government bonds are classified as tax free bonds which include some of the famous tax free bonds trending in the markets such as:
Working of Tax free/Govt. Bonds:
Tax free bonds are usually issued for a period of 10 – 20 years or even more than that. They are also listed on stock exchanges to offer an exit route to investors. The bonds are tax-free, secured, redeemable and non-convertible in nature. Trading in these bonds can be only done through Demat accounts.
Taxability of Tax Free Bonds:
You might be wondering after reading the above heading that why taxability when the bonds are tax free. Try to understand this with the help of an example:
Suppose one of your friends lend you 500 rupees without any interest for meeting your household expenses but instead of using that money for bearing your expenses, you further lend that money to some other person @10% interest rate. After 1 month you got the money back with interest. Subsequently, you visited your friend’s home for returning the money back and then you also told him regarding interest income. After listening to your words, your friend asked for the share in the interest income and that was absolutely right because he gave you the money for fulfilling your need and that too without any interest.
Same has happened in this case, Govt. has issued bonds for investment but if some people start selling it to others for profit then definitely govt. will ask for his share in that profit (capital gain) from that sale of bonds.
Therefore, If there is any capital gain on transferring them on exchanges, that will be taxed. If the holding period is less than 12 months, capital gains on sale of tax-free bonds on stock exchanges are taxed as per the tax rate of the investor. If bonds are held for more than 12 months, the gains are taxed at the rate specified by Income Tax Act, 1961. There will not be any benefit of indexation in them.
Why to invest in these bonds?
No Risk: These bonds are issued by the govt. ,That’s why these are called risk free bonds and people feels it safe to invest in these securities.
Tax Exemption: As these are Tax free bonds, there is no taxability on interest income earned from these bonds. However, capital gains will be taxed if any (explained above)
Effective Pre-tax yield: Pre tax yield is the rate of return on an investment before taxes have been considered. As with other measures of yield, pretax yield is usually stated on an annual basis.
Be careful before investing in tax free bonds…..
There are some factors which must be considered once before investing in these bonds:
Long Tenure: The tenure of these bonds are very long ranging from 10 years to even more than 20 years. So, one must obtain the complete information regarding the tenure of bonds in which he is investing.
Low Liquidity: These securities do not offer good liquidity feature that means it is not easily convertible into cash. Usually, they are listed on stock exchanges to provide an exit route to investors.
Annual Interest: The frequency of interest rate in these bonds is generally annual. Usually other bonds pay interest on bi-monthly basis.
B. Corporate Bonds
Corporate bonds are debt securities issued by private and public corporations. Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business. When one buys a corporate bond, one lends money to the “issuer,” the company that issued the bond. In exchange, the company promises to return the money, also known as “principal,” on a specified maturity date. Until that date, the company usually pays you a stated rate of interest, generally semiannually.
Investment in these bonds are more riskier than investing in govt. bonds but on the other side, these bonds offers high rate of return to its investors which attracts them to invest in these bonds.
Reason for issuing there bonds
Corporate bonds are a form of debt financing. They can be a major source of capital for many businesses, along with equity, bank loans and lines of credit.
Working of Corporate Bonds:
Corporate bonds are issued in blocks at par value, and almost all have a standard coupon payment structure. As the investor owns the bond, he receives interest from the issuer until the bond matures. At that point, the investor can reclaim the face value of the bond.
Investors may also opt to sell bonds before they mature.
Yield is a critical concept in bond investing, because it is the tool used to measure the return of the bond. It enables one to make informed decisions about which bond to buy. In simple words, yield is the rate of return on bond investment.
However, it is not fixed, like a bond’s stated interest rate. It changes to reflect the price movements in a bond caused by fluctuating interest rates.
Example of Yield working:
You buy a bond, hold it for a year while interest rates are rising and then sell it.
You receive a lower price for the bond than you paid for it because, no one would otherwise accept your bond’s now lower-than-market interest rate.
Although the buyer will receive the same amount of interest as you did and will also have the same amount of principal returned at maturity, the buyer’s yield, or rate of return, will be higher than yours, because the buyer paid less for the bond.
Yield is commonly measured in two ways, current yield and yield to maturity.
The current yield is the annual return on the amount paid for a bond, regardless of its maturity. If you buy a bond at par, the current yield equals its stated interest rate.
However, if the market price of the bond is more or less than par, the current yield will be different. For example, if you buy a Rs. 1,000 bond with a 6% stated interest rate at Rs. 900, your current yield would be 6.67% (Rs. 1,000 x .06/Rs.900).
Yield to maturity
It tells the total return you will receive if you hold a bond until maturity. It also enables you to compare bonds with different maturities and coupons. Yield to maturity includes all your interest plus any capital gain you will realize.
Valuation of Corporate Bonds:
There is inverse relationship between bonds and interest rates—bonds are worth less when interest rates rise and vice versa.
Why inverse relationship?
As a result, if one sells a bond before maturity, it may be worth more or less than it was paid for.
By holding a bond until maturity, one may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because one will receive the par, or face, value of the bond at maturity.
Some Popular Corporate Bonds:
This much for today.
In the next part we will discuss about Zero Coupon Bonds, Tax Saving Bonds & Junk Bonds.
Kindly Note: The author’s intention is only confined to create awareness about the stock market. Do not take anything as any investment advice as the author do not deals in investment advisory services.