Bonds are tricky investment instruments. 

But no portfolio is truly diversified without bonds in some form—direct bonds, sovereign gold bonds, debt mutual funds etc. So, it is important to understand them well in all forms.

However, unlike stocks, bonds work differently.

In fact, while stocks with good underlying businesses are expected to generate good returns, bonds are more complex.

For bonds, good (or high) returns are expected from the worst bonds, whereas the best bonds actually deliver bad (or low) returns.

Interesting, isn’t it?

In this article, we will answer the question: Why do some bonds generate higher returns than others?

But first, let’s understand the very basics of bonds that will help us set up the discussion.

Understanding bonds

Bonds represent loans made by the buyer of a bond (bondholder or debt holder) to the institution borrowing the money (bond issuer).

Bond issuers borrow money for various reasons. However, bondholders buy the bonds for only one reason—to generate returns on their money or savings.

Let’s understand bonds better by defining a few terms:

Interest rate: This is the percentage figure that indicates how much interest the bondholder will pay as long as they hold the bond. The interest rate is calculated using the face value of the bond and not the bond price.

Yield to maturity: This is the gross return the bondholder is expected to generate if they hold the bond until maturity. It is different from the interest rate.

Face value: This is the amount that the bondholders are returned at the maturity of the bond (excluding the interest payments)

Bond price: This is the price at which bondholders purchase the bond. It is beneficial for the bondholder if the bond price is lower than the face value because the bondholder will register a profit or capital gains at the bond’s maturity.

Types of bonds

Note: While bonds can be categorised based on different factors, for this article, we will keep it simple.

Bonds are of two types: government bonds and corporate bonds.

The central and state governments issue government bonds primarily to be able to spend on welfare schemes and public infrastructure projects.

Corporate bonds, on the other hand, are issued by private and public sector companies primarily for business purposes like starting a new line of products or building a factory.

This is the first point where the returns of bonds start diverging.

Why do some bonds generate higher returns than others?

Government vs corporate bonds

Government bonds have lower returns than corporate bonds for similar tenures. But why?

The reason is simple: Governments can print money and repay their bondholders regularly without defaulting. But companies who issue corporate bonds don’t have this luxury.

Companies need to generate revenues to pay interest and principal to their bondholders. And this is easier said than done.

Macro challenges, regulatory changes, and other special situations may restrict a company’s ability to generate regular revenues and pay bondholders. This is an element of risk from the bondholder's perspective.

Now, let’s think of a situation where government and corporate bonds offer an identical interest rate and tenure. Say 10 per cent interest rate for five-year bonds.

In such a situation, no rational investor would buy the corporate bond. This is because government bonds offer the same interest rate as the corporate bond but at a significantly lower interest rate.

Hence, corporate bonds offer higher interest rates to investors to be able to compensate investors for the risk.

Now, let’s look at another point of divergence in bond returns.

Credit ratings of corporate bond issuers

All governments are the same (when it comes to obliging interest and principal payments) but not all companies are the same. 

Simply put, if a state government is about to default, the central government can instruct the country's central bank to print money and pay the debt obligations of the state government.

But all debt-issuing companies need to be self-reliant when paying off their debts. And every debt-issuing company is different in business models, sector they operate in, their size, regulations they are subject to, but most importantly, their financial position.

A good financial position is difficult to assess—so many factors like the above mentioned, but much more needs to be taken into consideration. And yet, it may be difficult to be certain that a company has a good financial position. And explaining this to investors and portfolio managers is a different challenge altogether.

This is where credit ratings come into the picture.

Credit ratings are quantitative indicators assigned to bond issuers by third-party credit rating agencies (CRAs). CRISIL, CARE, and ICRA are some of the most popular CRAs.

The CRAs holistically analyse the financial position of bond issuers and give their opinion on it through a credit rating.

Credit ratings range from AAA and AA to D, with AAA being the highest (a notch below the sovereign rating). On the other hand, D is the lowest rating and indicates that the issuer has either already defaulted or a default is imminent.

The interest rate a bond issuer offers heavily depends on the issuer's credit rating. Here’s a scenario to understand why:

Two bond issuers, one with a AAA rating and the other with a BBB rating, offer similar tenure bonds at identical interest rates.

A rational investor will always choose the AAA-rated bond over the BBB-rated one since both offer the same interest rate and the AAA-rated issuer is better positioned to repay their debt.

Hence, lower-rated issuers need to offer higher interest rates than higher-rated issuers to compensate the investors for the higher risk involved.

Long story short: Within the corporate bond kingdom, returns are lowest for the highest-rated bonds and increase as the credit rating of the issuer/bond decreases.

Conclusion

Bond expected returns are inversely related to the financial position of the bond issuer.

The government’s financial position is the most favourable; hence, the expected returns on government bonds are the lowest. On the other hand, corporate bonds issued by public and private sector companies offer higher expected returns than government bonds because their financial position is not as favourable.

Within the realm of corporate bonds, some bonds offer higher returns than others. This is generally due to a lower credit rating that requires bond issuers to offer higher returns to compensate their investors for the risks involved.

(This article is part of IndiaDotCom Pvt Ltd’s Consumer Connect Initiative, a paid publication programme. IDPL claims no editorial involvement and assumes no responsibility, liability or claims for any errors or omissions in the content of the article.)