Bonds can be a great investment option, especially for those seeking stable interest income and relatively lower risk. In India, there are several types of bonds to suit differing investor requirements. With so many options available, it is essential to know and understand about the different types to make informed decisions.
Classification of Bonds in India
In India, there are different types of bonds, which can be classified on the basis of their issuing entities, interest rate types, convertibility, attached collaterals, buy back options, etc. Some of these bond classifications are discussed below:
Types of Bonds in Terms of the Issuing Entity
Central Government Bonds – Central government bonds, also known as governments or dated securities, are issued by the Central Government. These bonds are usually issued for the tenures of 5 to 40 years and the interest payments are made at half yearly intervals.
Corporate Bonds – Corporate bonds are issued by public and private sector companies to raise funds for financing their expansion, operations, etc. Compared to government bonds, corporate bonds carry higher credit risk but also offer higher coupon (interest) rates. Hence, investors should check the credit ratings assigned to these bonds to evaluate their creditworthiness. Usually, corporate bonds having lower credit ratings offer higher coupon rates to compensate their investors for the higher credit risk.
Municipal Bonds – Municipal bonds are issued by the urban local bodies, as defined under the Article 243Q of the Indian Constitution, for financing various development projects.
State Development Loans (SDLs) – Government bonds issued by the State Governments are known as SDLs. In this type of bond, the interest payments are made every six months and the principal amount is repaid at maturity. SDLs have almost similar credit risk profile as the Central Government bonds as the RBI directly monitors maturity and interest payments of these bonds. RBI also has the power to make the interest and maturity pay-outs for these bonds from the Central Government’s budgetary allocation.
Types of Bonds in Terms of the Interest Type
Fixed Rate Bonds – The interest rates (coupon rate) of these bonds remain the same till their maturity dates. Most government and corporate bonds are issued with fixed coupon rates.
Floating Rate Bond (FRB) – Unlike the fixed rate bonds, the interest rates of floating rate bonds are reset at pre-announced intervals, for instance half-yearly or annual intervals, on the basis of predetermined external benchmarks. In case of FRBs issued by the Central Government, averages of the 182 days T-bills are used as external benchmarks. Some Central Government FRBs may also offer floating coupon rates wherein the base rate is linked to the predetermined external benchmarks and a fixed spread over the base rate is arrived at through the auction process.
Zero Coupon Bonds – This type of government bond does not offer any coupon (interest) payments. Instead, they are issued at a discount and redeemed at face value. Thus, the difference between the purchase price of the bond and its face value is the return earned by the investor. Thus, the returns generated by these bonds consist only of the capital gains component and not the interest income component. These bonds would suit investors seeking higher tax efficiency as the long-term capital gains derived from listed bonds are taxed @12.5% whereas the interest income from bonds is taxed as per the tax slab of the investor.
Types of Bonds in Terms of Inflation Indexation
Capital Indexed Bonds – The principal amount of capital indexation bonds is linked to pre-determined inflation indices. The primary aim of linking them to inflation rates is to provide higher inflation-adjusted returns to bond investors.
Inflation Indexed Bond (IIB) – Like capital indexed bonds, inflation indexed bonds also protects the government bondholders from the impact of inflation. However, in this case, both the interest (coupon) receipts and the principal amount are linked to a pre-determined inflation index.
Types of Bonds in Terms of Buy-back Options
Callable Bonds – Bonds with ‘call option’ are known as callable bonds wherein the issuer has the right to buy back the bond before their maturity dates. Governments and corporates insert the call option in callable bonds to reduce their borrowing cost during a falling interest rate regime. However, the exercise of this option works against the bondholders as they are deprived from the potential benefit of rising bond prices during easing rate cycles. The risk arising from call option to the bondholders is also known as call risk or prepayment risk. Bondholders seeking to avoid this risk should carefully read the prospectus (issued at the time of bond issuance) or bond terms sheet to check if the bond(s) have any call option related condition.
Puttable Bonds – Bonds with a ‘put option’ are known as puttable bonds wherein the bondholder has the right to sell bonds back to the issuer before their maturity dates. Note that some bonds may have both call and put options for bond issuers and bondholders respectively.
Types of Bonds in Terms of Collateral
Secured Bonds – These bonds are backed by specific asset(s) of the bond issuing entity as collateral/security. So, if the bond issuer defaults on its repayment obligations, the pledged assets can be liquidated to repay the bondholders. This makes secured bonds less risky as compared to unsecured bonds. Secured bonds can be further categorised into senior and junior or subordinated bonds. Investors holding senior secured bonds receive higher priority in terms of claim on the issuing company’s assets during its liquidation or repayment defaults.
Unsecured Bonds – Unlike secured bonds, the unsecured bonds are not backed by any specific collateral or security of the bond issuing company. The lack of collateral leads their issuers to offer higher coupon rates on unsecured bonds than their secured counterparts.
Types of Bonds in Terms of Convertibility
Convertible Bonds – Investors of convertible bonds are offered the option to convert them into equity shares of the issuing company. The conversion to equity can either take at a pre-determined price set at the time of the bond issuance or at the prevailing stock price at the time of conversion. The interest rates offered on convertible corporate bonds are usually lower than their non-convertible bonds. Also, the bondholders stop receiving interest payments after the conversion of their bonds into equities.
Non Convertible Bonds – Investors of non-convertible bonds are not allowed the option to convert these bonds into equity shares of the issuing company.
Types of Bonds in Terms of the Periodicity of Interest Payments
Cumulative Bonds – Cumulative bonds allow their issuers to make accrued interest income on their maturity dates, instead of the pre-determined intervals. These bonds are ideal for those investors who prefer growth over having regular income.
Non-Cumulative Bonds – In these bonds, the accrued interest income is paid out at regular intervals, (monthly, quarterly, semi-annually or annually), depending on the interest payment frequency set at the time of bond issuance. These bonds are suitable for investors requiring a steady income stream throughout the bond tenure.
Other Types of Bonds
Special Securities – These bonds are issued by the Government of India to entities such as Oil Marketing Companies and Fertilizer Companies on an ad hoc basis. These bonds are used as an alternative means for compensating these entities, for their subsidies, in lieu of cash payments. The interest rates offered on these bonds are higher than the yield of the government bonds of similar maturities.
Sovereign Gold Bond (SGB) – SGB bonds were launched by the Government under the Gold Monetization Scheme for enabling investors to invest in gold without purchasing physical gold. Their value and units are directly linked to gold prices. These bonds offer a fixed interest rate of 2.5% p.a., paid semi-annually while the maturity amount would depend on the gold prices as published by Indian Bullion and Jewellers Association (IBJA). While the maturity period is 8 years, bondholders have the option to redeem them prematurely after 5 years. Being listed in the stock exchanges, bondholders can also sell these bonds in the secondary market. Similarly, investors who missed the chance of purchasing SGBs at the time of their issuance can purchase them through the secondary market.