Bond Basics
All You Wanted to Know About Bonds
INTRODUCTION OF BONDS
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Bonds form a major part of treasuries. They are vital to the
functioning of a treasury. Debt market in India India
In this
article, the fundamentals of bonds, ranging from bond features, factors
influencing bond prices, bond risks to bond yields are analyzed. After reading
this, readers will be in a better position to appreciate how bonds are valued,
what causes the bond prices to move on a daily basis in the market and how to
mitigate risks involved in bond prices.
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DEFINITION OF BONDS
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There are a whole host
asset classes that are available for investors. A bond is one of them to meet
the financial goals of the respective investors. A bond is a debt security or
an obligation to repay money. Bonds are usually considered as fixed-income
securities because they carry a fixed rate of interest. Bonds provide a steady
stream of cash flows to the bondholders. Typically, interest is paid by the
issuer at half-yearly intervals. Governments issue bonds to raise money for
spending on infrastructure projects or for their day-to-day expenditure.
Likewise, companies also raise money through bonds to meet their capital
expenditure or working capital needs. In the Indian Securities Market, the term
‘bonds’ is generally used for debt instruments issued by the Central and State
Governments and public sector organizations; and the term ‘debentures’ is used
for debt instruments issued by the private corporate sector. However, the terms
bonds, debentures, and debt instruments are used by the general public
inter-changeably.
BOND FEATURES
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The leading attributes of a bond are:
- The face value of the
bond-face
value or par value or principal refers to the amount that will be paid to
the bondholder at the time of maturity
- The coupon rate or
interest rate-the
coupon is the amount the bondholder will receive as interest payments and
it is expressed as a percentage of the face value
- The maturity date-the date on which the issuer
of the bond has to return the principal to the investor
- The name of the
issuer-the
borrower who receives the money at the time the bond is issued
Government bonds provide
high safety as they carry sovereign guarantee. They offer sufficient liquidity,
so that they can be encashed easily. The returns from the Government bonds are
moderate. However, corporate bonds carry higher returns, as investors expect
higher interest rates to offset the lower safety. Investors demand much higher
interest rates from companies which entail higher risk of default.
There are various financial
investments, like, bonds, equity shares and bank deposits (including term
deposits and savings accounts). Bonds are typically used to rebalance risks in
a portfolio of investments, especially when expectations from equities are low.
Corporate bonds are usually rated by credit rating agencies to determine the
aspects of safety of principal and interest payments. Bonds in India
BOND RISKS
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A bond by and large carries the following risks:
- Interest rate risk-if interest rates rise, the
bond prices will fall. Similarly, if interest rates fall, the bond prices
will go up
- Credit risk-if there is any change in the issuer/debtor’s credit rating due to
any deterioration in the fundamentals of the issuer
- Default risk-refers to the possibility that the bondholder will not be able to
receive either the principal or interest payments from the issuer, and
- Liquidity risk-the possibility that the bondholder will not be able to encash the
bond due to non-marketability of a particular bond
The above risks are explained in detail below:
Interest Rate risk: Interest rates are
defined in nominal terms. However, what really matters is the real interest
rates, which take into account the rise/fall in prices of future goods and
services. If nominal interest rate is eight per cent and the inflation rate is
five per cent, the real interest rate will be approximately three per cent
(8%-5%). The purchasing power of money decreases with every percentage rise in
inflation, hence the real return for the investor will come down. As
experienced between the periods of 2000 to 2004 in India
Default Risk: It refers to the risk
accruing from the fact that a borrower may not pay interest and/or principal on
time. It is involved when a party to a financial transaction is unable or
unwilling to meet the obligation under the contract.
Liquidity Risk: Barring some of the
popular Government of India securities which are traded actively, most debt
instruments do not seem to have a very liquid market. (An active debt market is
under development-the Government and the RBI have of late been taking various
measures to deepen and widen the bond markets in India
VALUATION OF BONDS
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The value of a bond is
the present value of the promised cash flows on the bonds, discounted at an
interest rate that reflects the default risk in these cash flows. Since the
cash flows on a straight bond are fixed at issue, the value of a bond is
inversely related to the interest rate that investors demand for that bond. The
straight bond, also called a plain vanilla bond, is the most popular type of
bond. It pays a fixed periodic (usually semi-annual) coupon over its life and
returns the principal on the maturity date. The interest rate charged on a bond
is determined by both the general level of interest rates and the default
premium specific to the entity issuing the bond.
There are two features
that set bonds apart from equity investments. First, the promised cash flows on
a bond (that is, the coupon payments and the face value of the bond) are
usually set at issue and do not change during the life of the bond. Even when
they do change, as in floating rate bonds, the changes are generally linked to
changes in interest rates. Second, bonds usually have fixed lifetimes, unlike stocks;
since most bonds specify a maturity date (perpetual bonds are exception since
they do not carry any maturity date).
The effect of interest
rate changes on bond prices will vary from bond to bond and will depend on a
number of characteristics of the bond:
- Maturity of a bond: Holding coupon rates and
default risk constant, increasing the maturity of a straight bond will
increase its sensitivity to interest rate changes. The present value of
cash flows changes much more for cash flows further in the future, as
interest rate changes, than for cash flows that are nearer in time. The
longer-term bonds are much more sensitive to interest rate changes than
the shorter-term bonds.
- Coupon rate of the bond: Holding maturity and default
risk constant, increasing the coupon rate of a straight bond will decrease
its sensitivity to interest rate changes. Since higher coupons result in
more cash flows earlier in the bond’s life, the present value will change
less as interest rates change. At the extreme, if the bond is a zero
coupon bond, the only cash flow is the face value at maturity, and the
present value is likely to vary much more as a function of interest rate
changes. The bonds with the lower coupons are much more sensitive, in
percentage terms, to interest rate changes than those with higher coupons.
While the maturity and
the coupon rates are the key determinants of how sensitive the price of a bond
is to interest rate changes, a number of other factors impinge on this
sensitivity. Any special features that the bond has, including convertibility
(as in the case of convertible bonds) and callability (as in the case of
callable bonds), make the maturity of the bond less definite and can therefore
affect the bond price’s sensitivity to interest rate changes.
FACTORS INFLUENCING BOND PRICES
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- Supply
and demand factors for money in the monetary system
(the supply comes from the bank deposits,
household savings, ECBs, FCCBs,
private corporate savings, public sector
investments, etc; and the demand is from
the Governments, the private sector and
the household sector)
- Market
interest rates: any factors like, fluctuations in crude oil prices or
revision in administered fuel prices in India, policy actions from central
bank or governments, inflationary or deflationary pressures and other
factors that influence the market interest rates, will have a huge bearing
on bond prices (if inflation goes up, bond prices will come down and vice
versa)
- Total
borrowing of the Central and State Governments (As the Government
borrowing has reached gargantuan proportions, India’s G-Sec prices have
fallen heavily with the 10-yeach benchmark yield moving up from a level of
6.50 per cent in the first week of June 2009 to a level of 7.50 per cent
in the first week September 2009)
- Market
expectations/sentiments with regard to inflationary pressures
- Inflationary
pressures in the economy and the policy makers’ response or non-response
to them
- Tax
factors
- Bank
credit off-take from the corporate sector
- The
quantum of liquidity situation in the system
- Actions
of the central bank in the country
- Overall
GDP Growth rate and its expectations of the overall economy (As recently
as 2008, Government Bond – G-Secs – prices witnessed unprecedented
volatility driving down the 10-year G-Sec benchmark yield from a high of
9.54 per cent in the last week of July 2008 to a low of 4.86 per cent in
the first week of January 2009. Some of the important factors that caused
such huge increase in bond prices were: 1. the perception that
- The
movements of bond, currency and derivatives markets are closely
inter-linked (well-known phrase used here is ‘BCD’ nexus) and as such the
movements of exchanges rates of the domestic country vis-a-vis other currencies of the competing countries or
trading partners influence the domestic bond prices (After the collapse of
Lehman Brothers in September 2008, the financial markets had experience a
‘flight to safety’ and dollar money has moved from emerging markets to the
US and strengthening the US dollar in the process tremendously and driving
down the US bond yields to one of their lowest in several decades. Since
March 2009, the US dollar has started its decline against major currency
and in its wake the
- Forward
looking or policy-related statements from officials (Governor or Deputy
Governors) of the Reserve Bank of
- Forward
looking or policy-related statements from the Finance Minister or other
officials, like, Finance Secretary in the Ministry of Finance, Government
of India
- Security
provided
- Maturity
period
- Callable
feature of the bond
- Credit
rating of the issuer
BOND YIELDS
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The yield on an
investment is loosely defined as the income one earns on it as a percentage of
what one spent on it. The crucial piece of information to know in order to
compare a bond with other potential investments is its ‘yield’, calculated by
dividing the amount of interest it will pay during a year by its price.
A
bond’s yield need not always be same as its coupon rate. That’s because some bonds
can be bought and sold in the market; their open-market prices may go above or
below the par value as interest rates in the economy change. When bond prices
rise, the yield on them falls and vice versa. The reasons for the rise and fall
in bond prices are mainly due to:
- Changes
in the company’s (that issued the bond) outlook, particularly risk
profile, and interest rate changes. Say a company offers a coupon of 10
per cent on its bonds; if, however, interest rates fall two years later,
the company may be able to raise funds at eight per cent. Here, the older
issue becomes more attractive and an investor would pay more for a bond
that returns 10 per cent.
- If,
however, there are project delays and the company is at risk of not being
able to service the interest, risk-averse investors may sell the bonds at
a discount to face value, pushing up the yield.
There are two important yield measures that are
commonly used: current yield and yield-to-maturity. They are explained below:
CURRENT YIELD
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It is the simplest measure of the return one gets
from a bond. It tells us how much return the investor gets, in percentage
terms, from the coupon rate against the market price of a bond (that is, the
coupon divided by market price). This does not take into account the capital
gain (or loss) that investor will realize if the bond is purchased at a
discount (or premium) and held till maturity. It also ignores the time value of
money. If a bond that cost Rs. 1,000 paid Rs. 80 a year in interest, its yield
is eight per cent.
Current Yield = (Annual
interest received / market price of bond) x 100
YIELD-TO-MATURITY (YTM)
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It takes into account a lot more than the current
coupon payment. Keep in mind bonds make several coupon payments over a period
of time. Towards maturity, we get only the face value of the bond. As the date
of maturity approaches for the bond, the market price moves closer to the face
value. The YTM takes into account all the coupon payments, gains or losses on
the price of the bond as it approaches maturity. The YTM of a bond is the
interest rate that makes the present value of the cash flows receivable from
owing the bond equal to the price of the bond.
If the bond is traded,
and a market price is therefore available for it, the internal rate of return
can be computed for the bond (that is, the discount rate at which the present
value of the coupons and the bond’s face value is equal to the market price).
This internal rate of return is called the yield to maturity on the bond.
PRICE-YIELD RELATIONSHIP
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A basic property of a bond is that its price varies inversely
with yield. The reason is simple. As the required yield increases, the present
value of the cash flow decreases; hence the price decreases. Conversely, when
the required yield decreases, the present value of the cash flow increase;
hence the price increases.
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