What are bonds and how to evaluate them?

Bonds are usually debt instruments that are being issued by companies, governments and municipalities to raise funds for financing their capital expenditure. 

Bond issues are considered fixed income securities because they impose fixed financial obligations on the issuer. The issuer agrees to following terms :


(1) Pay a fixed amount of interest periodically to the holder of the bond
(2) Repay a fixed amount of principal at the date of maturity 


So essentially, in bonds, an investor loans money for a fixed period of time at a predetermined interest rate.While the interest is paid to the bond holder at regular intervals, the principal amount is repaid at a later date, known as the maturity date. While both bonds and stocks are securities, but the important difference between the two is that bond holders are lenders, while stockholders are the owners of that organization whose stock they hold.


Different types of Bonds


(a) Government Bonds : Governments need funds for various developmental projects. Further, the government also needs to raise money to finance the fiscal deficit. In order to achieve the above goals, government usually issue bonds, so called  government bonds. The government bonds can further be classified into 3 types based on their maturity period. Bonds having maturity period less than 1 Year are called Government Bills. Bonds which have maturity period up to ten years are called Government Notes, while those bonds whose maturity period exceeds 10 years are called Government bonds.


(b) Municipal Bonds : These are debt securities usually issued by the state government and their agencies. 


(c) Corporate Bonds : When companies need to raise funds, they issue debt instrument, what is known as corporate bond.



Bonds have a fixed face value, which is the amount to be returned to the investor upon maturity of the bond. During this period, the investors receive a regular payment of interest, semi-annually or annually, which is calculated as a certain percentage of the face value and know as a 'coupon payment.'



Evaluating Bonds


While evaluating bonds, people must understand the term ‘coupon rates’ – which denotes the percentage of interest that the bond will earn for its holder. You can compare coupon rates of various Bonds, certainly the bonds that fetch the highest returns can give you good returns over a period of time. While 
evaluating bonds, the investor must consider the maturity date by when the bond can be redeemed.


Each Bond has its own call provisions and it is necessary to study them as an early pay-off on the Bond may entail loss of interest. The investor should also consider the reliability & reputation of the issuer of the bond as the investor may loose the entire investment if the issuing company files for bankruptcy.


A prudent invest will always diversify his/her investment in bonds by not placing all eggs in one basket. Buying bonds from different issuers may also be a great idea which will not only reduce the risk factor, but also fetch handsome profits.

In short, the prospective investor must thoroughly evaluate the schemes to derive optimum benefits.