Types of Bonds in India

The world of bonds is complex. The types of each bond, number of bonds and their many characteristics are more than the average investor can track or even process.

The primary reason being the sheer types of bonds that exist in India. The average investor finds it difficult to navigate through the vast universe of bonds and invest in the right bond.

This article will simplify one aspect of understanding bonds: the types of bonds in India. Let’s quickly look at what bonds are and the different types of bonds present in India.

What are bonds?

Bonds and debentures are fixed income instruments that represent a loan made by the buyer (or investor) of bonds to the issuer (or borrower) of bonds.

Here’s a simple scenario that will help you understand bonds.

A company wants to build a new factory to expand its business. There are three ways in which the company can finance this factory:

1. Generate enough revenue and profits from present scope of business
2. Sell ownership of company to investors by selling shares via an IPO
3. Borrow money from investors and pay them interest for a few years until the money is returned

Option 1 is slow. Option 2 is expensive because the cost of equity is very high. So, many companies prefer option 3 and borrow money to expand their business.

Option 3 is nothing but the process of issuing bonds.

Just like companies, governments also need money to finance infrastructure projects (like highways and railroads) and welfare projects (like free food for the poor). Hence, governments around the world also issue bonds to raise money.

Types of bonds in India

There are several types of bonds in India depending on the classification factor. Broadly, there are 9 classification factors that can help us segregate bonds:

1. Issuer
2. Security
3. Seniority
4. Credit rating (or safety)
5. Interest rate
6. Maturity (or term)
7. Listing
8. Convertibility to stock
9. State guarantee

Types of bonds based on issuer

Bond issuers can be categorized into 2 types.

1. Government
2. Corporations

Government Bonds

Government bonds are issued by the state and central governments.

Government bonds are considered to be extremely safe. In fact, bonds issued by the government are sometimes referred to as ‘risk-free bonds.’ This is because the government can always print money and repay debt obligations and don’t have to rely on anyone else.

Example of a government bond: In Jan 2023, the Govt of India issued 6.89% GS 2025, a 2 year bond with interest rate of 6.89% and maturity date 16th Jan 2025.

Corporate bonds

Bonds issued by corporations or companies are referred to as corporate bonds. Corporate bonds can be issued by public and private sector companies.

As compared to government bonds, corporate bonds are considered to be riskier. This is because the company issuing the bonds has to generate revenue and profit to be able to pay interest to the bondholders. Generation of revenue and profits is subject to many external factors that the company may not have control over.

Even within corporate bonds, PSU bonds are considered to be safer than bonds issued by private companies. This is because PSUs are owned and enjoy support from the government.

Examples of corporate bonds:

Types of bonds based on security

Bonds can be categorized into two types based on security:

1. Secured bonds
2. Unsecured bonds

Secured bonds

Secured bonds are bonds backed by collateral or specific assets that belong to the bond issuer. This collateral provides extra security to the bondholders.

In case of default or bankruptcy, bondholders (assisted by trustees) can go after the collateral and sell it to recover their money.

Majority bonds issued by companies are secured NCDs (or non-convertible debentures). Debentures is just another name for bonds in India.

Unsecured bonds

Unsecured bonds are bonds that are not backed by collateral. Unsecured bonds issued by private companies are considered to be riskier than secured bonds.

Bonds issued by the government are always unsecured. However, they are not considered to be risky like unsecured corporate bonds. As we saw in the last section, government bonds are considered to be risk-free because the government can simply print money and repay debt obligations.

Types of bonds based on seniority

Bond seniority tells us where bonds are stacked in the capital structure of a company. The capital structure determines who gets paid first in case of bankruptcy.

Bonds can be categorized into the following types based on seniority:

1. Senior secured bonds
2. Senior unsecured bonds
3. Subordinated bonds (multiple tiers)

Senior secured bonds

Senior secured bondholders are at the top of the capital structure. This means that if the company goes bankrupt, senior secured bondholders will be paid first.

Senior unsecured bonds

Senior unsecured bonds rank just below senior secured bonds. Senior unsecured bondholders get paid next.

Subordinated bonds

Subordinated bonds rank the lowest among bonds in the capital structure. Subordinated bonds have tiers like tier 1, tier 2, tier 3 etc. The tiers determine the seniority of a given subordinated bond. Tier 1 ranks higher than Tier 2 which in turn ranks higher than tier 3.

Interesting fact: Equity or stocks have the lowest seniority (below all the above bonds) in the capital structure. Hence, it is said that equity investing is riskier than bond investing because in the event of bankruptcy, bondholders are paid first. Equity investors are paid only after all the bondholders are paid in full and there is a good chance that equity investors don’t get paid at all.

Types of bonds based on credit rating (safety)

Credit rating indicates the bond issuer’s ability to repay the bondholders.

Credit rating agencies are responsible for assessing the issuer’s financial strength and awarding a suitable credit rating.

There are as many as 14 levels of credit ratings that start from AAA, AA… and end at D. However, we can group the credit ratings into 4 safety levels: highest, high, adequate and low.

Highest credit rating/safety bonds

AAA is the highest credit rating that can be awarded to bonds. These bonds are considered to be the safest among all corporate bonds.

High credit rating/safety bonds

AA is the second highest credit rating that can be awarded to bonds. AA-rated bonds are considered to be quite safe but not as safe as AAA-rated bonds.

Adequate credit rating/safety bonds

A is the third highest credit rating that can be awarded to bonds and this is where most investors should draw the line. Bonds rated below A are not safe for investment for most investors.

Low credit rating/safety bonds

Low credit rating bonds are bonds that have BBB rating and lower. They are not safe for investment for most investors and anyone who wants to invest in a BBB or lower rated bond must first consult an investment expert.

What is the credit rating of government bonds?

Credit rating agencies award credit ratings to corporate bonds only. This is because government bonds have a default ‘sovereign’ rating which can be considered one notch above the AAA credit rating.

What is the relationship between credit rating and interest rate/yield?

The higher the credit rating, the lower is the interest rate/yield offered by the bond. This is because higher rated bonds have the highest demand and don’t need to attract investors. On the other hand, lower rated bonds need to offer high interest rates to compensate investors for the risk they are taking.

Types of bonds based on interest rate

By now we know that bonds are interest paying instruments. But the interest rate may not be fixed throughout the bond’s life!

Based on the interest rate, we can classify bonds into 2 types:

1. Fixed interest rate bonds
2. Floating interest rate bonds

Fixed interest rate bonds

Fixed interest rate bonds pay a fixed amount of interest throughout their tenure. The interest rate is paid on the face value of the bond.

Most bonds (govt and corporate) have a fixed interest rate.

Floating interest rate bonds

Floating interest rate bonds have an interest rate that may fluctuate over the bond’s life.

The floating interest rate is generally linked to a benchmark interest rate. For example, GOI FRB 2033 has a floating rate interest rate that is linked to the interest rate of 182 day treasury bills. The interest rate of GOI FRB 2033 is 1.22% plus the interest rate of 182 day treasury bills.

Types of bonds based on maturity (term)

Bonds have a defined maturity date. This is the date when the bond issuer returns investors their money and extinguishes the bond. The period from bond’s issuance to bond’s maturity is called the bond’s term.

However, bonds can be traded. So bond’s term for individual investors may be different. For example, if you buy a bond with a 5 year term today but decide to sell it one year later, the bond’s term for the new bondholder will be 4 years.

Bonds can be classified into 5 types based on balance maturity:

1. Ultra Short term bonds
2. Short term bonds
3. Medium term bonds
4. Long term bonds
5. Perpetual bonds

Ultra-short term bonds

Ultra-short term bonds have a balance maturity of less than 1 year. Treasury bills issued by the central government have a term of less than one year.

Short term bonds

Short term bonds have a balance maturity between 1 and 3 years.

Medium term bonds

Medium term bonds have a balance maturity between 3 and 5 years.

Long term bonds

Long term bonds have a balance maturity of 5 years and more.

Perpetual bonds

Perpetual bonds are an interesting category of bonds. They pay interest perpetually or forever and never return your principal.

However, issuers of perpetual bonds generally have the option to extinguish them at specific points in time or when certain conditions are met. This feature is called a ‘call option.’

Types of bonds based on listing

Bonds can also be classified based on whether they are listed on the stock exchange.

1. Listed bonds
2. Unlisted bonds

Listed bonds

Listed bonds are listed and traded on either or both of National Stock Exchange (NSE) and Bombay Stock Exchange (BSE)

Unlisted bonds

Unlisted bonds are not listed and traded on any stock exchange. Bondholders may be able to trade bonds over the counter (OTC) with the help of market makers who can help bondholders find buyers.

Types of bonds based on convertibility into stock

As we saw, bonds are higher in seniority than stocks in a company’s capital structure. However, stocks of a company have the potential to deliver higher returns than the fixed returns offered by bonds.

To give investors that chance to become shareholders, companies may issue convertible bonds. Convertible bonds convert into shares when certain conditions are met or at a fixed point of time in the future.

Based on convertibility feature, bonds can be classified into 3 types:

1. Fully convertible bonds
2. Partially convertible bonds
3. Non convertible bonds

Fully convertible bonds

Fully convertible bonds can be converted into shares of the issuer completely. After the conversion into shares takes place, the bondholder will hold no bonds but only equity of the company.

Partially convertible bonds

Partially convertible bonds can be converted into shares of the issuer but only partially. The bondholder will continue to hold at least some bonds even after the conversion into stocks is complete.

Non convertible bonds

Non convertible bonds are bonds that cannot be converted into shares of the issuer under any circumstances.

Types of bonds based on state guarantee

PSU bonds can sometimes have a special privilege. Since PSUs are owned by the government, certain PSU bonds may be guaranteed by the state government to make them more attractive to investors.

PSU bonds guaranteed by the state are considered to be safer than other corporate bonds.

It is important to note that not all PSU bonds are not guaranteed by the government, only a few specific ones are.