The Explainer: Bond

It has been many days since I penned The Explainer. Last week, I was at a college where a student asked me about 'bonds'. She told me that she had come across this term while running through the numerous scary stories on the Greek crisis. While I did explain the term to this student, I thought of sharing with you a few ideas on bonds.

So here is The Explainer on Bonds.

What is a Bond?

A bond is a security, just like a fixed deposit. In the case of an FD, you put money in the form of a deposit with a bank and the bank pays a fixed rate of interest on your deposit. 

Let us say, you wish to invest Rs10,000 (this amount is called 'principal') in a five-year FD, which will pay you an annual interest rate of 8%. This means that every year, your FD will yield 8 per cent in interest and at the end of five years, you will get back your principal amount of Rs10,000. 

In other words, you are lending your money to the bank, for which it pays you interest. 

Just like this, in the case of a bond, you keep your money with the government and the government pays a fixed rate of interest. When a government wants to borrow money, it does so by way of issuing bonds. 

Here's a simple example: The Government of India wishes to borrow money to finance its expenditure (or to spend on anything it wishes). To borrow money, it issues bonds.

Let us say, the government prices each bond at Rs1,000, which carries an interest rate of 5% and a tenure of 10 years. This means that if you buy the Rs1,000 bond, you will be paid interest at 5% and at the end of 10 years, the government will return your principal amount of Rs1,000 also. 

What is 'yield' on bond?

The rate of interest generated on your investment when you buy a bond is called yield. Like in the example, the ten-year Rs1000 bond carries an interest rate of 5%. This 5% is called yield. 

Who buys government bonds? Are they safe?

Government bonds carry sovereign guarantee. This means that the government of the country stands 'guarantee' to the repayment of your investment. Such bonds are generally considered very safe for investment and are rated to be risk-free. This attracts a large number of conservative investors (like pension funds and insurance companies), who generally avoid investing in risky securities like shares.

Does a bond market, like a share market, exist? 

Yes. There is a large bond market in our country, and so is the case with most large economies. Generally, in India it is the Reserve Bank of India (RBI) that sells bonds to generate funds for the government. 

Can you buy / sell bonds?

Yes. If you wish to sell your bond, you can do so. However, it depends on the interest rate scenario. For example, if you (as a bond holder) believe that the government will not be able to honour its repayment, i.e. it may default, then you will try to sell the bond in the market. But such a bond will attract a low price, which means that you will lose money on selling it.  

Read The Explainers on Stock Market - Part I; Stock Market - Part II; Stock Market - Part III; 

Foreign Direct Investment; Cash Reserve Ratio; Credit Rating, and GDP - Part I.