Bonds
Content
DEBT MARKET
BONDS- TYPES AND CHARACTERISTICS
DEBT MARKET
The environment in which the issuance and trading of debt securities occurs. The bond market primarily includes government-issued securities and corporate debt securities. It facilitates the transfer of capital from savers to the issuers or organizations requiring capital for government projects, business expansions and ongoing operations.
Most trading in the bond market occurs over-thecounter, through organized electronic trading networks. It is composed of the primary market (through which debt securities are issued and sold by borrowers to lenders) and the secondary market (through which investors buy and sell previously issued debt securities amongst themselves).
DEBT INSTRUMENTS
Debt instruments are a way for markets and participants to easily transfer the ownership of debt obligations from one party to another. Debt obligation transferability increases liquidity and gives creditors a means of trading debt obligations on the market.
BONDS
A bond is a debt-security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation or other entity known as the issuer.
Bonds issued by State Governments or Municipalities are usually exempt from tax.
COMPONENTS
TERMS Bonds Issuer of Bonds Bond Holder Principal Amount Issue Price Maturity Date Coupon MEANINGS Loans (in the form of a security) Borrower Lender Amount at which issuer pays interest and which is repaid on the maturity date Price at which bonds are offered to investors Length of time (More than one year) Rate of interest paid by the issuer on the par/face value of the bond The date on which interest is paid to investors
Coupon Date
TYPES OF BONDS & CHARACTERISTICS
GOVERNMENT SECURITIES
It is the Reserve Bank of India that issues Government Securities or G-Secs on behalf of Government of India. Maturity period is of 1 to 30 years. Offer fixed interest rate; interest rate paid semiannually. For shorter term, there are Treasury Bills or TBills which are issued by RBI for 91 days, 182 days and 364 days.
CORPORATE BONDS
These bonds come from PSU’s or Private Corporations. Offer extensive range of tenure up to 15 years.
Compared to G-Secs, corporate bonds carry higher risks which depend upon the corporation, the industry where the corporation is currently operating, current market conditions and the rating of the corporation.
CORPORATE BONDS
Straight Bonds- Plain Vanilla Bond. Pays fixed periodic (usually semi-annual) coupon over life and returns principal on maturity date. Floating Rate Bonds- Pay an interest rate that is linked to a benchmark rate. Convertible Bonds- Give the bond holder the right (option) to convert them to equity shares on certain terms Callable Bonds- Give the issuer the right (option) to redeem them prematurely on certain terms.
Puttable Bonds- Give the investor the right to prematurely sell them back to issuer on certain terms. Commodity Linked Bonds- The pay off from these bonds depends to a certain extent on the price of a certain commodity. Zero Coupon Bonds- Does not carry any regular interest payment. Issued at deep discount over its face value and redeemed at face value on maturity. P= M/ (1+ r)^n
EXAMPLE- ZERO COUPON BOND
Suppose that a one-year, risk-free, zero-coupon bond with a $100,000 face value has an initial price of $97,323.60. Although the bond pays no “coupon,” your compensation is the difference between the initial price and the face value. The difference between the price and the face value (here $2,676.40) is the compensation you receive for buying and holding the bond for a year. The compensation is commonly talked about as a return on the initial investment: R= (100,000- 97,323.60)= 2,676.40 = 2.75% 97,323.60 97,323.60 This is the return you would receive from investing in (buying) the bond and holding it till maturity.
CERTIFICATE OF DEPOSITS
Certificate of Deposits (CDs), which usually offer higher returns than Bank Term deposits, are issued in demat form. Banks can offer CDs which have maturity between 7 days and 1 year. CDs from Financial Institutions have maturity between 1 and 3 years.
COMMERCIAL PAPERS
Commercial paper is a money market security issued (sold) by large corporations to get money to meet short term debt obligations (for example, payroll), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. These are short term securities with maturity of 7 to 365 days.
How does a Bond work?
• If you buy a bond with a face value of Rs1,000, a coupon
of 8%, and a maturity of 10 years. • This means you'll receive a total of Rs80 (Rs1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you'll receive two payments of Rs40 a year for 10 years. When the bond matures after a decade, you'll get your Rs1,000 back
Bond Price
• The bond price is the price at which an investor is willing
to buy a bond, keeping in mind the value to be received in terms of payments of coupon and principal until maturity. • Thus, the expected cash flows are discounted at a discount rate.
•
C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value
• At 10% coupon rate, 30 year maturity bond with par value
Rs1000, paying 60 semi-annual coupon payments of Rs40 each; what is the price of the bond?
• Answer •Ʃ
40 + 1000 (1.05)60 (1.05)60 = 40*annuity factor(5%,60) + 1000* PV factor(5%,60) = 757.17 + 53.54 = Rs 810.71
Bond price and interest rate
• There is an INVERSE RELATION between the bond price
and bond interest rate.
Bond yields
• The YIELD is the return on investment made by buying of the
bond. • Current Yield of the bond measures only the percentage return that the annual coupon payment provides to the investor. eg: if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of 5%, this is how you'd calculate its current yield:
($100*0.05) *100% = 5.21% 95.92
Yield To Maturity
• Yield To Maturity (YTM), helps one to calculate the bond
price based on the rate of return anticipated on a bond if it is held until the maturity date. Thus it can also be explained as~The compound rate of return over the life of bond under the assumption that all bond coupons can be reinvested at that yield.
Question on YTM
• You hold a bond whose par value is $100 but has a
current yield of 5.21% because the bond is priced at $95.92. The bond matures in 30 months and pays a semiannual coupon of 5%. Calculate the YTM.
• Answer: 6.8%
Yield to Call
• Yield to Call is the interest rate that investors would
receive if they held the bond until the call date. • The YTC is calculated same way that YTM is calculated. The only changes are:
Risk In Bonds
• Bond default risk is usually termed as Credit Risk.
• Many rating agencies like CRISIL, ICRA and CARE
provide with financial information on firms and quality ratings of bond houses. • JUNK BONDS are bonds with high default risk and are poorly rated, but these investors demand such bonds as in lieu of high risk; they offer a better yields.
Yield curve
• Yield curve is the graph that shows the interest rates, at a
set point in time, of bonds having equal credit quality, but differing maturity dates. • The yield curve of the Treasury bond is used as a benchmark for other debt in the market.
•
BONDS- TYPES AND CHARACTERISTICS
DEBT MARKET
The environment in which the issuance and trading of debt securities occurs. The bond market primarily includes government-issued securities and corporate debt securities. It facilitates the transfer of capital from savers to the issuers or organizations requiring capital for government projects, business expansions and ongoing operations.
Most trading in the bond market occurs over-thecounter, through organized electronic trading networks. It is composed of the primary market (through which debt securities are issued and sold by borrowers to lenders) and the secondary market (through which investors buy and sell previously issued debt securities amongst themselves).
DEBT INSTRUMENTS
Debt instruments are a way for markets and participants to easily transfer the ownership of debt obligations from one party to another. Debt obligation transferability increases liquidity and gives creditors a means of trading debt obligations on the market.
BONDS
A bond is a debt-security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation or other entity known as the issuer.
Bonds issued by State Governments or Municipalities are usually exempt from tax.
COMPONENTS
TERMS Bonds Issuer of Bonds Bond Holder Principal Amount Issue Price Maturity Date Coupon MEANINGS Loans (in the form of a security) Borrower Lender Amount at which issuer pays interest and which is repaid on the maturity date Price at which bonds are offered to investors Length of time (More than one year) Rate of interest paid by the issuer on the par/face value of the bond The date on which interest is paid to investors
Coupon Date
TYPES OF BONDS & CHARACTERISTICS
GOVERNMENT SECURITIES
It is the Reserve Bank of India that issues Government Securities or G-Secs on behalf of Government of India. Maturity period is of 1 to 30 years. Offer fixed interest rate; interest rate paid semiannually. For shorter term, there are Treasury Bills or TBills which are issued by RBI for 91 days, 182 days and 364 days.
CORPORATE BONDS
These bonds come from PSU’s or Private Corporations. Offer extensive range of tenure up to 15 years.
Compared to G-Secs, corporate bonds carry higher risks which depend upon the corporation, the industry where the corporation is currently operating, current market conditions and the rating of the corporation.
CORPORATE BONDS
Straight Bonds- Plain Vanilla Bond. Pays fixed periodic (usually semi-annual) coupon over life and returns principal on maturity date. Floating Rate Bonds- Pay an interest rate that is linked to a benchmark rate. Convertible Bonds- Give the bond holder the right (option) to convert them to equity shares on certain terms Callable Bonds- Give the issuer the right (option) to redeem them prematurely on certain terms.
Puttable Bonds- Give the investor the right to prematurely sell them back to issuer on certain terms. Commodity Linked Bonds- The pay off from these bonds depends to a certain extent on the price of a certain commodity. Zero Coupon Bonds- Does not carry any regular interest payment. Issued at deep discount over its face value and redeemed at face value on maturity. P= M/ (1+ r)^n
EXAMPLE- ZERO COUPON BOND
Suppose that a one-year, risk-free, zero-coupon bond with a $100,000 face value has an initial price of $97,323.60. Although the bond pays no “coupon,” your compensation is the difference between the initial price and the face value. The difference between the price and the face value (here $2,676.40) is the compensation you receive for buying and holding the bond for a year. The compensation is commonly talked about as a return on the initial investment: R= (100,000- 97,323.60)= 2,676.40 = 2.75% 97,323.60 97,323.60 This is the return you would receive from investing in (buying) the bond and holding it till maturity.
CERTIFICATE OF DEPOSITS
Certificate of Deposits (CDs), which usually offer higher returns than Bank Term deposits, are issued in demat form. Banks can offer CDs which have maturity between 7 days and 1 year. CDs from Financial Institutions have maturity between 1 and 3 years.
COMMERCIAL PAPERS
Commercial paper is a money market security issued (sold) by large corporations to get money to meet short term debt obligations (for example, payroll), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. These are short term securities with maturity of 7 to 365 days.
How does a Bond work?
• If you buy a bond with a face value of Rs1,000, a coupon
of 8%, and a maturity of 10 years. • This means you'll receive a total of Rs80 (Rs1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you'll receive two payments of Rs40 a year for 10 years. When the bond matures after a decade, you'll get your Rs1,000 back
Bond Price
• The bond price is the price at which an investor is willing
to buy a bond, keeping in mind the value to be received in terms of payments of coupon and principal until maturity. • Thus, the expected cash flows are discounted at a discount rate.
•
C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value
• At 10% coupon rate, 30 year maturity bond with par value
Rs1000, paying 60 semi-annual coupon payments of Rs40 each; what is the price of the bond?
• Answer •Ʃ
40 + 1000 (1.05)60 (1.05)60 = 40*annuity factor(5%,60) + 1000* PV factor(5%,60) = 757.17 + 53.54 = Rs 810.71
Bond price and interest rate
• There is an INVERSE RELATION between the bond price
and bond interest rate.
Bond yields
• The YIELD is the return on investment made by buying of the
bond. • Current Yield of the bond measures only the percentage return that the annual coupon payment provides to the investor. eg: if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of 5%, this is how you'd calculate its current yield:
($100*0.05) *100% = 5.21% 95.92
Yield To Maturity
• Yield To Maturity (YTM), helps one to calculate the bond
price based on the rate of return anticipated on a bond if it is held until the maturity date. Thus it can also be explained as~The compound rate of return over the life of bond under the assumption that all bond coupons can be reinvested at that yield.
Question on YTM
• You hold a bond whose par value is $100 but has a
current yield of 5.21% because the bond is priced at $95.92. The bond matures in 30 months and pays a semiannual coupon of 5%. Calculate the YTM.
• Answer: 6.8%
Yield to Call
• Yield to Call is the interest rate that investors would
receive if they held the bond until the call date. • The YTC is calculated same way that YTM is calculated. The only changes are:
Risk In Bonds
• Bond default risk is usually termed as Credit Risk.
• Many rating agencies like CRISIL, ICRA and CARE
provide with financial information on firms and quality ratings of bond houses. • JUNK BONDS are bonds with high default risk and are poorly rated, but these investors demand such bonds as in lieu of high risk; they offer a better yields.
Yield curve
• Yield curve is the graph that shows the interest rates, at a
set point in time, of bonds having equal credit quality, but differing maturity dates. • The yield curve of the Treasury bond is used as a benchmark for other debt in the market.
•
