What is a Bond?
Bond is a financial instrument used by governments or corporates to raise money. The entity issuing a bond is borrowing money from the purchaser of the bond, with a promise to return the original amount (principal) along with interest. Since borrowing money implies that it is a ‘Debt’, bond markets are called as ‘Debt Markets’.
Interest payments are given out by the borrower at regular intervals, through out the life of the bond. Life of a bond is also called its ‘Maturity Period’. Once the maturity period is over, the borrower also returns back the principal amount borrowed, along with the last interest instalment.
Bonds could be issued by central or state government, companies, or municipalities to finance their projects or activities. For instance, the central government might issue bonds to finance a large infrastructure project. Similarly, a company might issue bonds, to finance construction of their new office.
What are Government Bonds?
Government Bonds are specifically issued by the government, central or state in order to raise money. Bonds recognise the fact that the government is the borrower and promises to pay back the amount borrowed, along with the interest. Hence Government Bonds are also called as ‘Sovereign Debt’. Since the risk of default by any government is low, government bonds are considered as safe investment options and carry minimal risk of default.
Apart from government bonds, Treasury Bills (T-Bills) too are a part of Government securities. T-bills, unlike government bonds, are issued for a shorter period of time. Government of India, currently issues them for 3 time periods, 91 days, 182 days and 364 days. While there is no interest rate associated with T-bills, they are issued at a price lesser than their face value but can be redeemed at the full face value. For example, a 182-day T-bill of face value Rs. 1000, might be issued for Rs. 997 – price at which the holder buys, but the holder at the time of maturity can redeem it for Rs. 1000.
Main Components of a Government Bond
The main components of a government bond, that also form its nomenclature are:
- Face Value – this is the price of the bond when it is first issued. Note that the face value of a bond might differ from its current market value. This is because face value is the cost of the bond at the time it is issued and market value of the bond is its current worth. The latter might differ from face value as a result of various factors that impact the demand and supply in the bond market like prevailing interest rate, bond’s rating, inflation, economic growth etc.
- Coupon Rate – This is the interest rate that the bond holder will get from the bond issuer. It is calculated as a percentage of the face value and paid out at regular intervals which might be half-yearly or annually
- Maturity Date – This is the date at which the liability of the bond issuer is expected to end. On this date, the issuer will pay the holder the face value or the principal amount, along with the last interest instalment
For example, the government might issue bonds on 13 April 2022, of face value INR 10,000 at a coupon rate of 7.25% for a 10-year maturity period. In this case, an interest payment @ 7.25% on the face value that is INR 10,000 would be made by the Government of India to the holder of the bond. That payment schedule might be such that the interest payments are made half-yearly, every year for the 10-year period. The issuer will repay the face value after 10-years are over on 13 April 2032.
How are Government Bonds Traded?
To start with, in India, the Reserve Bank of India (RBI), issues Government Bonds by conducting an auction electronically. The main participants in these auctions are entities that maintain a funds account (current account) and securities accounts (Subsidiary General Ledger (SGL) account) with RBI. These include commercial banks, scheduled Urban Cooperative Banks (UCBs), Primary Dealers (like ICICI Securities, Morgan Stanley, Nomura, Punjab National Bank, State Bank of India etc), insurance companies and provident funds. These transactions take place in the ‘Primary Market’. Primary Market is the place where new bonds are issued that have not been in the market previously.
Retail holding of government bonds takes place mostly in the ‘Secondary Market’. This is where bonds that were originally launched in the primary market are traded with the help of brokers. Here the proceeds from selling of a bond go to seller, who could be anyone – investor or dealer. In the primary market, however, the proceeds from selling a bond go directly to the issuer, which in case of Government Bonds, is the Government itself.
Government Securities Market in India – A Primer, Reserve Bank of India