BOND BASICS

BOND BASICSCEDRIC LAWRENCE AND RENU AJWANI, MEMBERS OF FACULTY

What is a Bond?1. A bond is simply an “I Owe You(IOU)”. When you purchase a bond, you are lending a sum of

amount (the Principal) to the Bond Issuer, who in turn promises to compensate you with contractually agreed upon interest and repayment of the Principal amount on maturity.

2. Bonds are negotiable instruments, i.e. the ownership of the bond can be transferred from one party to another in the secondary market. Compare this property with that of “Term/Fixed Deposits” issued by your bank.

3. In the ensuing slides we will learn some jargon related to bonds

BOND JARGON1. Principal

2. Coupon

3. Price

4. Yield

5. Maturity

PRINCIPAL1. Principal is the amount that the issuer borrows and agrees to repay the bondholder on

maturity date. Market participants may refer to the Principal amount as:1. Par value2. Face value3. Nominal value4. Redemption value5. Maturity value

2. In India dated government securities (Bonds with maturity over one year) are issued with a face value of Rs 100 per Bond.

COUPON1. The rate of interest on the Principal offered by the bond issuer to the bondholder is called

Coupon.

2. Coupon payments are generally made on a semi-annual or annual basis.

3. Most bonds pay a fixed rate of interest throughout their life.

4. Floating Rate Notes (FRNs) are bonds whose coupon fluctuates in line with a predetermined benchmark rate. In India, think of our Inflation linked bonds where the coupon is determined as certain percentage over the Consumer Price Index movement.

5. Zero-coupon bonds do not pay any interest throughout their life. They provide a return to investors by being sold at a discount to the redemption (par) value. At maturity, the holder receives the full redemption amount.

YIELD (1 of ..)1. This is the most confusing jargon in Bonds.

2. What is the difference between Coupon and Yield?

Unless we understand the difference between coupon and yield we cannot proceed further. Let us look at it:

Remember that bonds are negotiable instruments. That means that you need not hold them to maturity. You can sell it at any time before maturity to any other interested market participant. Let us look at a few scenarios:

Yield (2 of..) Scenario I

Let us assume that you have Government of India bond with a par value of Rs 100 and paying a coupon of Rs 4 every six months. You will simply reinvest your coupon proceeds in any new bond issue. In other words, you are have no intention of selling the bond before maturity. In such a scenario, the “Nominal Yield” is calculated by summing the annual coupon payments and dividing it by the par value.

In the above example, “Nominal Yield” would be Rs 4+ Rs 4 divided by Rs 100, i.e. Rs 8/Rs 100, which will give you an yield of 8%. Note that the nominal yield and coupon are the same.

YIELD (3 of..) Scenario II

Let us assume that you have Government of India bond with a par value of Rs 100 and paying a coupon of Rs 4 every six months and a maturity of two years. Let us look at the cash flows(CF) of this bond

Time of the Cash Flow Cash flow Amount

After six months Rs 4

After one year Rs 4

After one and half year Rs 4

After two years (i.e. on maturity) Rs 4 + Rs 100 (Principal) = Rs 104

YIELD (4 of..) Scenario II (cont’d)

Now let us assume that one year has passed since you bought the bond and you are in urgent need of money. So you decide to sell the bond. As one year has passed, your bond now actually has a residual maturity of 1 year. You observe that due to changed interest rate scenarios your bond issuer is now issuing bonds with 1 year maturity at 10% per annum,i.e. a coupon Rs 5 every six months. Now, you have got a prospective buyer, but his return expectations from the bond is 10% per annum, as he can easily buy a 10% bond with the same characteristics of your bond from the market. Let us look at his cash flow expectations in relation to that of your bond.

Time of the cash flow Cash Flow Amount Buyers Cash Flow Expectation

After six months Rs 4 Rs 5

After one year(maturity) Rs 4+ Rs 100 Rs 5+ Rs 100

Yield (5 of..) Scenario II (cont’d)

Now from the previous slides it is clear that our bonds cash flow after six months is short by Re 1/- and the cash flow after one year is also short by Re 1/. What are the value of these cash flows today. For that we use the concept of Present Value of a cash flow (PVCF). PVCF is obtained by dividing the cash flow by (1+the relevant interest rate for that period). Let us assume that the six month interest rate is 9% and that of one year is 10%.

We get Time of the Cash Flow

Cash Flow Interest rate Present Value of Cash Flow

After six months Re 1/ 4.5% (9%/2 ) 1/(1+4.5%)=1/1.045= Rs 0.96

After one year Re 1/ 10% 1/(1+10%)=1/1.10=Rs 0.91

Total Rs 1.87

Yield(6 of..) Scenario II (Cont’d)

Naturally, we have to compensate for this shortfall in expected cash flow, and we will have to sell the bond. The actual price at which the bond will be sold would be around Rs 98.37. For the time being we will not venture into the detailed pricing aspects. As such we observed that as the market yields increased, you have to compensate for the extra expected cash flows by making adjustments in the price at which you have to sell the bond. That is the bond is now selling at a discount to the par value.

Now, the reverse would happen, if market yields are lower than that of your bond’s coupon, i.e., the buyer of your bond would have to compensate you for the extra cashflows that your bond offers compared to his expected cash flows. Why don’t you look compare the cash flows of your bond to that of expected cash flows, if market yields at present are only 6% per annum? You will realize that your bond will fetch more than the par value or a premium.

PRICE In the discussion of yield we observed that bonds have a principal or par value. However, if the bond’s coupon and the current market yields are not in tandem, the amount that you have to pay the bond is either at a premium or discount to the face value.

If market yields are more than the coupon of the bond, the bond sells at a discount

If market yields are less than the coupon of the bond, the bond sells at a premium

The bond sells at par value when the coupon and market yields are in balance

There is an inverse relationship between the Price and market yield.

MATURITY•The maturity of the bond is simply the length of time before it expires.

•Debt securities with a term of less than one year generally classified as money market instruments

• Generally bonds are issued with maturities upto 10 years, however, bonds upto 100 years are their in the market

•When a bond reaches maturity, the borrower must pay back the principal. Bonds are redeemed at par. Therefore, as bond reaches maturity, its price converges to par.

•Maturity of a bond can be altered by inserting call/put options.

CREDIT QUALITY•Bonds are like loans. Its repayment depends on the financial soundness of the bond issuer.

•Professional rating agencies help the market participants in assessing the credit worthiness of the bond issuers.

•Higher (Lower) credit worthiness leads to a lower (higher) credit risk spread

•RBI guidelines require banks to appraise bond investments as if they are loans given to those issuers.