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Bonds are securities issued by governments and corporations against money borrowed from other entities. The difference between a bond and a normal loan is that the former can be traded in the market, which means the bond-holder does not need to hold on to it till it matures.
By virtue of being debt instruments, bonds are relatively risk-free instruments, especially when compared to shares. The extent to which they are risk-free is determined by the credit profile of the entity issuing them.
Bonds can be issued for various purposes like funding expansion activities or for meeting day-to-day expenses. Typically, bonds that are issued for purposes like expansion, which are long-term in nature, come with longer tenures and higher rate of interest, while those issued to meet short-term expenses come with a lower rate of interest and a shorter tenure. Bonds issued by corporations sometimes include an option to convert them into shares.
Bond prices and bond yields
When a bond is issued, it bears a specific price and a specific interest or 'coupon' rate for a specified maturity period. Say a company issues a bond at Rs 100 and a coupon rate of 8 percent per annum for 1 year, any holder of the bond is liable to receive the principal amount of Rs 100 at the time of maturity along with an interest of Rs 8 for the 1-year period.
When this bond gets traded in the market, its value -- and by extension, its interest rate -- move according to prevalent demand and supply. The last traded value of the bond is its market price and the effective rate of interest at that price is its yield.
An interesting fact about bonds is that their prices and yields move in opposite directions. If a 1-year bond priced at Rs 100 and bearing a coupon of 8 percent per annum is traded in the market and its price falls to Rs 98, a bond holder is still liable to receive Rs 100 if he holds it to maturity. Because he bought the bond at a Rs 2 discount to the face value, its effective yield will be over 8 percent because he will still be paid interest at 8 percent on Rs 100.
What factors affect bond yields?
Bond yields are a good indicator of the economic situation of a country. They are reflective of numerous macro-economic factors such as inflation, rate of growth of gross domestic product (GDP), interest rates (cost of borrowing).
If the central bank of a country decides to raise its benchmark interest rates, bond yields usually move to mirror the change to an extent. Since interest rates are typically raised when inflation is inching upward, there is also an indirect correlation between inflation and bond yields.
Apart from these factors, short-term movement in bond yields are also caused by changes in investors' sentiment.
What are Masala bonds?
Masala bonds are rupee-denominated bonds issued by Indian entities outside India. They are typically issued by Indian companies who wish to take advantage of the lower cost of borrowing in developed economies.
Since July 2016, masala bonds have been listed on London Stock Exchange (LSE). HDFC, NTPC and Indiabulls Housing are some companies that have raised funds by issuing these bonds.
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