The Bond Market Part I: Understanding Bonds

When you buy a bond, you are lending to the issuer, which may be a government, municipality or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it matures or comes due after a set period of time.” – U.S. Securities and Exchange Commission.

What is a Bond?

A bond is an instrument representing the purchase of debt of an entity, such entity can be Government (Government Bonds) or a Corporation (Corporate Bonds). Corporate bonds can be either convertible (where the investor has the option to convert it into a predetermined number of stocks at any later point) or non-convertible. The U.S. Securities and Exchange Commission explains it to be a debt security, similar to an IOU.

A bond is a debt instrument in which an investor loans money to an entity (typically corporate or government) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money to finance a variety of projects and activities. Owners of bonds are debt holders, or creditors, of the issue.” – Reserve Bank of India.

Participants

Like all other financial markets, a bond market involves buyers and sellers of funds. Market participants include institutional investors, traders, government etc. It has been perceived that issuers issue bonds to fund capital investment in new and ongoing operations and to finance debts whereas investors purchase these instruments as firstly, they provide a predictable income stream, secondly, the entire principal is paid back if the bonds are held for maturity and finally bonds help preserve capital while investing and help offset exposure to the investor’s more volatile stock holding.

Characteristics of a Bond

Bonds are issued directly to the investors when issuing entities need to raise money to finance new or to maintain ongoing operations. Bonds typically carry Face Value (the bond’s worth at maturity), Coupon rate (the rate of interest issuer plans to pay on the face value of the bond expressed as a percentage), Coupon dates (the dates on which interest payments would be due), the Maturity Date and the Issue Price (the price at which the bond is originally sold).

Though bonds are considered conservative investments and are not tied to the stock market, bond performance may vary and the principal determinants of a bond’s coupon rate are thus its Credit Quality (typically coupon rate increases with riskiness) and its time to maturity (longer the period, higher the coupon rate).

Types of Bonds

Fixed Rate Bonds are bonds on which the coupon rate is fixed for till maturity of the bond. Most government bonds in India are of this kind.

Floating Rate Bonds are bonds which do not have a fixed coupon rate. The Coupon is re-set at pre-announced intervals by adding a spread over a base rate.

Zero Coupon Bonds are bonds with no coupon payments, these are issued at discount and redeemed at face value.

Capital Indexed bonds are bonds, the principal of which is linked to an accepted index of inflation with a view to protecting the principal amount from inflation.

Inflation Indexed Bonds are bonds wherein both coupon flows and principal amounts are protected against inflation with Whole Sale Price Index or Consumer Price index used as the inflation index.

Callable/ Puttable Bonds are bonds that can be issued with features of optionality wherein the issuer can have the opportunity to buy-back (call option) or the investor can have the option to sell the bond (put option) to the issuer during the currency of the bond. It may be noted that such bond may have put only or call only or both options.

Besides these, there are securities issued by the government to entities such as Oil Marketing Companies, Fertilizer Companies, the Food Corporation of India etc (popularly called oil bonds, fertilizer bonds, food bonds etc.),  Sovereign Gold Bond and ‘Separate Trading of Registered Interest and Principal of Securities’ (STRIPS).

Time Value of Money

The Time value of money [TVM] functions related to Calculation of Present Value [PV], Future Value [FV] etc are important mathematical concepts that assist in bond price calculation. Bond price is nothing but the sum of PV of all future cash flows of the bond. The Interest rate used for discounting cash flows is Yield to Maturity of the bond. Price can be very easily calculated using excel function price.

The yield-price relationship w.r.t. a Bond is inverse.

Duration and Convexity

Duration is a measure of a bond’s price sensitivity. Duration (also known as Macaulay Duration) of a bond is a measure of the time taken to recover the initial investment in present value terms. In the simplest form, duration refers to the payback period of a bond to break even, i.e., the time taken for a bond to repay its own purchase price. Duration is expressed in ‘number of years’.

Convexity is a measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes. It is often used as a risk management tool, which helps measure and manage the amount of market risk. Duration (also known as Macaulay Duration) of a bond is a measure of the time taken to recover the initial investment in present value terms. In the simplest form, duration refers to the payback period of a bond to break even, i.e., the time taken for a bond to repay its own purchase price. Duration is expressed in ‘number of years’.

Manal Shah


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