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The bond market, often known as the debt market or the credit market, allows investors to buy and sell debt instruments as well as issue new debt. Government bonds are a significant component of the bond market due to their size and liquidity.
What is the Bond Market?
The term “bond market” refers to a market where debt securities, such as corporate, government, and tax-free bonds, are traded. Bond markets primarily help private entities and governments access long term capital efficiently. Bonds may offer lesser returns as they are less volatile.
How Does the Bond Market Work?
Corporations or governments issue bonds whenever they need to raise funds for operating expenses, funding for strategic projects and refinance bonds that are about to mature. Investors that purchase bonds are essentially making debt to the business or government that issued them. Each bond has a maturity date and interest payment terms.
The term “coupon” is frequently used to refer to interest payment. Longer-term bonds often pay greater coupons due to the longer length of the lending commitment. Bonds often trade over-the-counter (OTC) and they have a face value, also known as par value.
In most cases, the price of bonds is set at par value when they are issued. A bond is selling at a discount if it is trading at a price less than its face value. A bond is trading at a premium when it is selling for more than its face value.
Changes in interest rates are the main factor influencing price changes. Bond prices and interest rate changes have an inverse correlation. Bond prices often decrease as interest rates rise and vice-versa.
Types of Bond Market
- Primary Market: It is the primary marketplace where the bonds are issued directly to the investors. When a company or government entity decides to seek money for new initiatives and expansions, they issue bonds with the help of organisations like investment banks. Investment banks facilitate bond issuance by locating investors and serving as a bridge between issuers and investors.
- Secondary Market: A secondary market is where an investor who owns the instrument sells it to other interested investors, usually through brokers as intermediaries. The secondary market is where the majority of transactions take place because investors who purchase debt instruments on the main market also trade them on the secondary market.
Ways to Invest in the Bond Market?
1. Invest in Bond Market Through Bond Platforms
Bond platforms act as a broker between the company and the investor. After completing the necessary KYC procedures, one must open a trading account on these platforms to invest. Different platforms have different minimum ticket sizes. One can purchase corporate bonds, perpetual bonds, government bonds, and more through these platforms. These platforms provide a safe environment from which one may conduct the necessary transactions. However, one should research and use caution before selecting a platform.
2. Buy Bond ETFs to Invest in Bond Market
Bond ETFs are passive investments that trade on exchanges similar to stock ETFs. As passive investments, these ETFs involve lower costs than active funds and invest in bonds similar to traditional bond mutual funds. They have set maturation times, which can be anywhere between three and ten years. One should consider investing in bond ETFs if one wants to avoid taking more risks.
3. Open RBI Retail Direct Account to Invest in Bond Market
RBI retail direct gives investors yet another way to purchase bonds and makes it easier for investors to invest directly in government bonds. One should possess a direct gilt account to invest. No fees are to be paid for opening and maintaining an account on RBI direct.
Advantages & Disadvantages of Investing in the Bond Market
Advantages
- Diversification of Portfolio: Because of the diverse variety of bonds available to invest in the market, investors have a great opportunity to diversify their portfolios. Equity investors can also diversify their portfolio by investing in bonds so as to protect them from market volatility.
- Predictability: Bond investments offer an easily predictable income stream, and in many cases, they pay interest twice a year.
- Consistent Income: Bond investments can provide a consistent income stream in the form of interest until the bonds mature.
- Security: Bonds are observed as safe financial instruments since they consistently provide investors with a guaranteed return. This helps investors in securing their investment portfolio against market volatility.
Disadvantages
- Interest Rate Risk: Most bonds are fixed-income securities, offering a constant interest rate throughout their tenure. Interest rate risk is the risk of a bond’s price dropping after one buys it as a result of an increase in interest rates on the market.
- Reinvestment Risk: Reinvestment risk refers to the possibility of being unable to utilise bond proceeds to purchase another bond with a similar or higher interest rate.
- Default Risk: The probability that the bond issuer may file for bankruptcy and be unable to make debt payments on time refers to as default risk. If the bond issuer defaults, investors risk losing all or a portion of their initial investment, as well as any interest payment.
Frequently Asked Questions
Bonds are generally safe, low-risk investments that offer the chance for both interest income and price growth. It is advised that a diversified portfolio include some bonds, with bonds receiving more weight as the investment tenure is coming to an end.
Companies and other organisations may offer bonds directly to investors when they need to raise funds to support ongoing operations, fund new initiatives, or restructure existing debt. The bond that the borrower (issuer) issues specify the loan’s terms, the interest payments that will be made, and the deadline by which the borrowed funds (the bond principal) must be repaid (maturity date). The interest payment (the coupon) is a component of the return that bondholders receive for lending money to the issuer.
The rise in bond yield leads to a significant impact on equity. Equity investments become less attractive as bond yields rise due to the increased opportunity cost. Equity investors anticipate being able to purchase the shares at cheaper P/E ratios if bond yields increase. The cost of capital rises when bond yields do.
Therefore, future cash flows are discounted rapidly. The valuations of these equities are lowered as a result. An increase in bond yield indicates that interest rates on debt for corporations will increase. The danger of bankruptcy and default rise along with the cost of debt servicing, which often leaves mid-cap and heavily leveraged enterprises vulnerable.
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