Can you ever lose your original capital if you put your money in fully secured bonds or such-like instruments? The answer is both yes and no. Yes, if you try to sell the bonds at the wrong time. No, if you wait till the time comes to redeem the bonds and get your capital back.

Before we explain how, let us look at how bonds work. To put it simply, bonds are actually proof of lending. If you buy a bond, you are in effect giving a loan to the issuer who agrees to repay the sum (principal) along with a specified interest (coupon rate) at a specified time (maturity of the bond). Bonds have a face value, usually the issue price. The issuer could be the central government, various state or municipal governments, public or private corporations. The tenure or the maturity of the bond could be any time period fixed by the issuer and the interest is usually paid at pre-determined intervals - quarterly, half-yearly or annually. The coupon rate on the bond is usually based on the creditworthiness of the issuer and the tenure of the bond. Generally speaking, the longer the maturity of the bond, the higher the coupon rate.

Similarly, the bonds with higher risk of default will have higher interest rates to offset the additional risk. Until a bond matures, it can be bought or sold in the open market. In India, bonds are traded on the Wholesale Debt Market (WDM) segment of the National Stock Exchange. The bulk of the trading, however, is done over telephone. The big players in the debt markets are banks, financial institutions and mutual funds. Since bonds are usually tradable, their prices can literally change everyday, depending on the demand and supply, and on other fundamental factors like the expected movement in interest rates and the credit quality of the issuer.

Interest rates and bond prices are inversely related. When interest rates fall, bond prices rise and vice versa. Let’s say you buy a Rs. 1,000 bond earning 7% interest. Three years later, similar new bonds may be issued at, say, 8% interest. No buyer will now pay you Rs. 1,000 for the old bond for which you paid
Rs. 1,000 since it earns only 7%. So it will fetch a price lower than what you bought it for.

However, if new bonds selling for Rs. 1,000 offer only 5% interest, you will be able to sell your 7% bond for more than what you paid since buyers will pay more to get a higher interest rate. But no matter what the rate of interest, if you hold the bond till maturity, you will get your principal back. Apart from, of course, the interest income due during the currency of the bond.

What you ultimately earn on a bond (which is tradable) is the yield or the bond’s interest income divided by its price. One must remember that since the price of a bond can change after it is issued; the yield could change from time to time even though its interest rate stays the same. When you assess the value of your bonds at the end of the day based on the day’s prices - this process is called mark-to-market-your portfolio could show losses if bond prices fall. In the case of traded instruments, mark-to-market losses are evident at the end of the day. However, when an instrument is not traded - like bank deposits and corporate fixed-deposits - the actual price of that instrument is not really known. However, if one were to impute the value of similar instruments (read risk) non-traded instruments could also show potential losses. That is why the net asset value of debt schemes shows losses when interest rates are on the rise. Whichever way debt markets turn, bonds are a staple for any portfolio as they offer a high level of safety and steady income unlike equities.