Let us understand the fundamentals of bonds and debentures in this blog. So, what is a bond? A bond is basically a long-term debt instrument or security. (Debt is the loan that the borrower gets from the lender.) There are many instruments where a borrower gets a loan from the lender, and a bond is one such instrument. 

Let us understand how bonds work. Let’s say there are two entities. Entity 1 represents the government, PSUs, and corporations, and entity 2 represents investors (individual or bond funds). In the case of a bond, entity 1 becomes a borrower and entity 2 becomes a lender. 

In India, when companies issue private sector bonds, they are also known as debentures. The difference between bonds and debentures is that debentures are not backed by any security, but the credit rating of the company that is issuing the bond is the security. CARE and ICRA rate the companies that are issuing the debentures. Depending on the credibility of companies, investors have to buy debentures. 

There are different types of bonds and debentures, but let’s try to understand the basic concepts behind them. Let’s say entity 1 decides that they want some funds in order to finance some long-term investments that are going to give them good returns. In order to get the funds, they release the bonds and debentures. Now these bonds have a fixed face value, which is typically 1,000 Rupees. Let’s say the borrowers have issued the bonds and the lender is interested in them. So the lender gives this amount to the borrower (say, 1000 rupees). So this 1,000 is the face value of the bond. This value is also known as the par value. 

Now there are three cases:

  1. Issued at par: The price at which 1 unit of bond is being sold is the same as the face value.
  2. Issued at a discount: less than the face value.
  3. Issued at a premium: more than the face value. 

So basically, when a bond is issued at a discount, the face value is 1000, but the lender has to pay only 950 Rupees. Face value is the amount that the borrower will be returning to the lender at maturity. The investor or lender will receive a regular payment of interest, which can be paid semi-annually or annually and is calculated as a certain percentage of the face value. This rate is also known as the coupon rate. 

The bonds are issued and the lender buys them in the primary market. After the bonds are issued and sold to the investor, he may in turn sell these bonds to other investors. In a secondary market transaction, the bond doesn’t have to be traded at its original issue price.

There are three factors that affect the resale value of a bond:

  1. The relative change in the market interest rate: If, after a bond is issued, the interest rate is higher, then the market value of the bond falls. Consider that ABC Corp. issues an A-rated, 1000 rupee, 30-year, 8% bond. Let’s say investor A buys a bond. Five years later, he wished to sell the bond, which has 25 years left to maturity. But there is a newly issued 25-year bond. After 5 years, there is a bond available in the market that is A-rated for 25 years with 10% interest, and its face value is the same, i.e., 1000. So if someone buys the new bond, he will get 10% on it for the remaining 25 years. So the question is, why would anyone buy this bond if the investor tries to sell it in the secondary market? They will obviously go for the latter. Hence, in order to make the bond attractive to investors, our investor friend must price it so that it offers a competitive return. (Fluctuations in the market interest rate are the most important factor in determining the market value of a bond.).

  2. Credit rating: As we have mentioned above, both companies are A-rated. If, after a bond is issued, the quality improves or declines, The market value of the bond will be adjusted accordingly. Let’s consider company A with a face value of 1,000 and a coupon rate of 12.25%. This bond was trading at 960 in the secondary market. Whereas another bond of company B with a face value of 1000 and a coupon rate of 8.2% was trading at 1040. Now this price difference was because of the risk perception of the market about these bonds. So a person who bought bonds of company A in the primary market will make a loss if he sells them in the secondary market. While the buyer of company B will make gains if he sells at this rate in the secondary market.

  3. Supply and demand: When bonds are in relative short supply, investors wishing to sell get a better price than when there is a surplus of bonds in the market.