Basics of Bonds

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BASICS
OF
BONDS

₹ ₹

For RBI Grade B & SEBI Grade A Exams


Bonds Free Finance e-book

Bonds
Being one of the most important topics of Finance from the syllabus of RBI Grade B & SEBI
Grade A, it becomes extremely important to study this topic. Let us know all the important
aspects of Bonds in this eBook.

What are Bonds?


A bond is a loan. When a company needs funds for any number of reasons, they may issue a
bond to finance that loan. Much like a home mortgage, they ask for a certain amount of
money for a fixed period of time. When that time is up, the company repays the bond in full.
During that time, the company pays the investor a set amount of interest, called the coupon,
on set dates, often quarterly.
(From Investopedia)

Bond is a financial instrument whereby the issuer of the bond raises (borrows) capital or funds
at a certain cost for certain time period and pays back the principal amount on maturity of
the bond. Interest paid on bonds is usually referred to as coupon. In simple words, a bond is
a loan taken at a certain rate of interest for a definite time period and repaid on maturity.
(From efinancemanagement)

From a company’s point of view, the bond or debenture falls under the liabilities section of
the balance sheet under the heading of Debt. A bond is similar to the loan in many aspects
however it differs mainly with respect to its tradability. A bond is usually tradable and can
change many hands before it matures; while a loan usually is not traded or transferred freely.

In a nutshell:

• Bonds are debt securities issued by corporations, governments, or other organizations


and sold to investors.
• Backing for bonds is typically the payment ability of the issuer to generate revenue,
although physical assets may also be used as collateral.
• Because corporate bonds are typically seen as riskier than government bonds, they
usually have higher interest rates.
• Bonds have different features than stocks and their prices tend to be less correlated,
making bonds a good diversifier for investment portfolios.
• Bonds also tend to pay regular and stable interest, making them well-suited for those
on a fixed income.
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Features of a Bond
Let us have a look at the common features of bonds and the financial terms related to bonds.

1. Issuer
The entities that borrow money by issuing bonds are called as issuers. There are mainly 4
major issuers of bonds which include the government, government agencies, municipal
bodies, and corporates.

2. Face value
Every bond that is issued has a face value, which is usually the principal amount that is
borrowed and returned on maturity. In layman’s term, it is the value of the bond on its
maturity.

3. Coupon
The rate of interest paid on the bond is called as a coupon.

4. Rating
Every bond is usually rated by credit rating agencies; higher the credit rating lower will be the
coupon required to pay by the issuer and vice versa.

5. Coupon payment frequency


The coupon payments on the bond usually have a payment frequency. The coupons are
usually paid annually or semi-annually; however, they may be paid quarterly or monthly as
well.

6. Yield
The effective return that the investor makes on the bond is called a return.
Assuming a bond was issued for a face value of Rs 1000 and a coupon rate of 10% on initiation.
The Price at a later date may rise or fall and hence the investor who invests at a rate other
than Rs 1000 will still receive a coupon payment of Rs 100 (1000 * 10%) but the effective
earning shall be different since investment amount is not Rs 1000.
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That effective return in layman’s term is called as the yield. If the holding period is
considered for a year this is referred to as current yield and if it is held to maturity it is
referred to as yield to maturity (YTM).

Types of Bonds
There are many types of bonds issued that differ from each other in respect of their features.
These features vary depending upon the requirement of the issuer.
Let us have a look at some of the major types of bonds issued.

1. Plain vanilla bonds


• A plain vanilla bond is a bond without any unusual features.
• It is one of the simplest forms of bond with a fixed coupon and a defined maturity and
is usually issued and redeemed at the face value.
• It is also known as a straight bond or a bullet bond.

2. Zero coupon bonds


• A zero-coupon bond is a type of bond where there are no coupon payments made.
• It is not that there is no yield.
• Zero-coupon bonds are issued at a price lower than the face value (say Rs 950) and
then pay the face value on maturity (Rs 1000). The difference will be the yield for the
investor. These are also called as discount bonds or deep discount bonds if they are
for longer tenor.

3. Deferred coupon bonds


• This type of bond is a blend of a coupon-bearing bond and a zero-coupon bond.
• These bonds do not pay any coupon in the initial years and thereafter pay a higher
coupon to compensate for no coupon in the initial years.
• Such bonds are issued by corporates whose business model has a gestation period
before the actual revenues start.
• Examples of a company which may issue such type of bonds include construction
companies.
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4. Step-up bonds
• These are bonds where the coupon usually steps up after a certain period.
• They may also be designed to step up not once but in a series too.
• Such bonds are usually issued by companies where revenues/ profits are expected to
grow in a phased manner.
• These are also called as a dual coupon or multiple coupon bonds.

5. Step down bonds


• These are just the opposite of Step-Up Bonds.
• These are bonds where the coupon usually steps down after a certain period.
• They may also be designed to step down not once but in a series too.
• Such bonds are usually issued by companies where revenues/ profits are expected to
decline in a phased manner; this may be due to wear and tear of the assets or
machinery as in the case of leasing.

6. Floating rate bonds


• Floating rate bonds are so called because they have a coupon which is not fixed but
rather linked to a benchmark.
• For example, a company may issue a floating-rate bond as Treasury bond rate + 50 bps
(100 bps = 1%),
• In such cases on every interest payment date, the payment will be made 0.50% more
than the treasury bill rate prevailing on the fixing date.

7. Inverse floaters
• These types of bonds are similar to the floating rate bond in that the coupon is not
fixed and is linked to a benchmark.
• However, the differentiating thing is that the rate is inversely related to the
benchmark. In simple words, if the benchmark rate goes up; the coupon rate comes
down and vice versa.

8. Participatory bonds
• A participatory bond is a bond whereby the issuer promises a fixed rate but the coupon
cash flow may increase if the profit/ income levels of the company rise to a pre-
specified level and may reduce when income falls below a pre-specified level; thereby
the investor participates in the return enjoyed based on company revenues/ income.
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9. Income bonds
Income bonds are similar to participatory bonds however these types of bonds do not have a
reduction in interest payments if income/ revenue reduces.

10. Payment in kind bonds


These types of bonds pay interest/coupon, not in terms of cash pay-outs but in the form of
additional bonds.

11. Extendable bonds


• Extendable bonds are bonds that allow the holder to enjoy the right to extend the
maturity if required.
• The holder has an additional benefit in this case because if the rate of interest in the
market reduces, the holder may choose to extend the tenor and enjoy the higher rate
of interest in terms of coupon payment.
• For this benefit, the holder may enjoy the coupon rates that are usually lower than a
plain vanilla bond.

12. Extendable reset bonds


• These are types of bonds which allow the issuer and the bondholders to reset the
coupon rate based on the then prevailing market scenario.
• This is not linked to any benchmark but on the basis of renegotiation between the
issuer and the bondholders.
• This is usually the case where the bond tenor is very long.

13. Perpetual bonds


These types of bonds pay a coupon rate on the face value till the life of the company. Though
Perpetuity means forever, bonds with maturity above 100 years are also considered to
be perpetual bonds.

14. Convertible bonds


Convertible bonds are a special variety of bonds which have an inbuilt feature of being
converted to equity shares at a specified time at a pre-set conversion price.
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15. Foreign currency convertible bonds


• Foreign currency convertible bond is a special type of bond issued in the currency
other than the home currency.
• In other words, companies issue foreign currency convertible bonds to raise money in
foreign currency.

16. Exchangeable bonds


• These bonds are similar to the convertible bonds but differ in one aspect that they can
be exchanged for equity shares but not of the issuer.
• These can be exchanged for equity shares of another company which the issuer may
have stake holding.

17. Callable bonds


• Bonds that are issued with a specific feature where the issuer has the right to call back
the bonds at a pre-agreed price and a pre-fixed date are called as callable bonds.
• Since these bonds allow a benefit to the issuer to repay off the liability before
maturity, these bonds usually offer a coupon rate higher than a normal straight
coupon-bearing bond.

18. Puttable bonds


• Bonds that are issued with a specific feature where the bondholder has the right to
return back the bonds at a pre-fixed date before maturity are called as puttable bonds.
• Since these bonds allow a benefit to the bondholders to ask for the principal
repayment before maturity, these bonds usually offer a coupon rate lower than a
normal straight coupon-bearing bond.

19. Treasury strips


• In the US, Government dealer firms usually break down a coupon-bearing bond into a
series of zero-coupon bonds by considering each cash flow as a separate bond.
• For example, a 5-year semi-annual coupon-bearing bond can be split into 10 zero
coupon bonds with coupon amount as face value and 1 zero coupon bond with
principal amount as the face value.
• Bond stripping usually is done to increase liquidity and facilitate easy tradability.
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20. Yankee bonds


A dollar-denominated bond issued in the US by an issuer who is outside the US is called as
Yankee bond.

21. Samurai bonds


A yen-denominated bond issued in Japan by an issuer who is outside Japan is called as Samurai
bond.

22. Shogun Bonds


A non-Yen denominated bond issued in Japan by an issuer who is outside Japan is called as
Shogun bond.

Issuers of Bonds
1. Corporate bonds are issued by companies.
Companies issue bonds rather than seek bank loans for debt financing in many cases because
bond markets offer more favourable terms and lower interest rates. Firms issue bonds when
they require funds to finance projects or working capital.

2. Municipal bonds
These are issued by states and municipalities. Some municipal bonds offer tax-free coupon
income for investors. While the bonds themselves are not issued by the government, they are
typically backed by the full faith of that government.

3. Government (sovereign) bonds


• These are issued by the Government of the nation.
• Bonds (T-bonds) issued by the Treasury with a year or less to maturity are called
“Bills”.
• Bonds issued with 1–10 years to maturity are called “notes”.
• Bonds issued with more than 10 years to maturity are called “bonds”.
• The entire category of bonds issued by a government treasury is often collectively
referred to as "treasuries."
• Government bonds issued by national governments may be referred to as sovereign
debt.
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• Governments may also offer inflation-protected bonds (e.g. TIPS) as well as small
denomination savings bonds for ordinary investors,

4. Agency bonds
These are those issued by government-affiliated organizations

5. Special Projects and SPVs


• Firms or governments may issue bonds for special projects or through special purpose
vehicles.
• These bonds are tied to a specific project, such as an infrastructure build.
• The bond proceeds are then used to finance that project, and the coupon payments
and principal are paid out through the project’s revenue.

6. Supranational Entities
• Supranational entities refer to global entities that are not based in a specific nation.
• More specifically, a supranational entity has members that exist in multiple countries.
• Examples of supranational entities that issue bonds are the World Bank or the
European Investment Bank.
• Like government bonds, these bonds are typically quite highly rated.
• A supranational entity may issue bonds to fund its operations and pay out coupon
payments through operational revenue.

What is Bond Pricing?


The price of a bond depends on several characteristics inherent in every bond issued.
These characteristics are:

• Coupon
• Principal/Par value/Face value
• Yield to maturity
• Periods to maturity
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1. Coupons
• A bond may or may not come with attached coupons.
• A coupon is stated as a nominal percentage of the par value (principal amount) of the
bond. Each coupon is redeemable per period for that percentage. For example, a 10%
coupon on a Rs 1000 par bond is redeemable each period.
• A bond may also come with no coupon. In this case, the bond is known as a zero-
coupon bond. Zero-coupon bonds are typically priced lower than bonds with coupons.

2. Principal/Par Value
• Each bond must come with a par value that is repaid at maturity.
• Without the principal value, a bond would have no use.
• The principal value is to be repaid to the lender (the bond purchaser) by the borrower
(the bond issuer).
• A zero-coupon bond pays no coupons but will guarantee the principal at maturity.
Purchasers of zero-coupon bonds earn interest by the bond being sold at a discount
to its par value.
• A coupon-bearing bond pays coupons each period, and a coupon plus principal at
maturity. The price of a bond comprises all these payments discounted at the yield to
maturity.

3. Yield to Maturity
• Bonds are priced to yield a certain return to investors.
• A bond that sells at a premium (where price is above par value) will have a yield to
maturity that is lower than the coupon rate.
• Alternatively, the causality of the relationship between yield to maturity and price
may be reversed.
• A bond could be sold at a higher price if the intended yield (market interest rate) is
lower than the coupon rate. This is because the bondholder will receive coupon
payments that are higher than the market interest rate, and will, therefore, pay a
premium for the difference.

4. Periods to Maturity
• Bonds will have a number of periods to maturity.
• These are typically annual periods but may also be semi-annual or quarterly.
• The number of periods will equal the number of coupon payments.
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The Time Value of Money


Bonds are priced based on the time value of money. Each payment is discounted to the
current time based on the yield to maturity (market interest rate). The price of a bond is
usually found by:

Formula to Calculate Bond Price


The formula for bond pricing is basically the calculation of the present value of the probable
future cash flows which comprises of the coupon payments and the par value which is the
redemption amount on maturity.
The rate of interest which is used to discount the future cash flows is known as the yield to
maturity (YTM.)

or

where
C = Periodic coupon payment,
F = Face / Par value of bond,
r = Yield to maturity (YTM) and
n = No. of periods till maturity

On the other, the bond valuation formula for deep discount bonds or zero-coupon bonds can
be computed simply by discounting the par value to present value, which is mathematically
represented as,
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Zero-Coupon Bond Price


• Zero-Coupon Bond (Also known as Pure Discount Bond or Accrual Bond) refers to
those bonds which are issued at a discount to its par value and makes no periodic
interest payment, unlike a normal coupon-bearing bond. In other words, its annual
implied interest payment is included in its face value which is paid at the maturity of
such bond.
• Therefore, this bond is the one where the sole return is the payment of the nominal
value on maturity.

Bond Pricing Calculation (Step by Step)


The formula for Bond Pricing calculation by using the following steps:
Step 1: Firstly, the face value or par value of the bond issuance is determined as per the
funding requirement of the company. The par value is denoted by F.

Step 2: Now, the coupon rate, which is analogous to interest rate, of the bond and the
frequency of the coupon payment is determined. The coupon payment during a period is
calculated by multiplying coupon rate and the par value and then dividing the result by the
frequency of the coupon payments in a year. The coupon payment is denoted by C.
C = Coupon rate * F / No. of coupon payments in a year

Step 3: Now, the total number of periods till maturity is computed by multiplying the number
of years till maturity and the frequency of the coupon payments in a year. The number of
periods till maturity is denoted by n.
n = No. of years till maturity * No. of coupon payments in a year
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Step 4: Now, the YTM is the discounting factor and it is determined based on the current
market return from an investment with a similar risk profile. The YTM is denoted by r.
Step 5: Now, the present value of the first, second, third coupon payment and so on so forth
along with the present value of the par value to be redeemed after n periods is derived as,

Step 6: Finally, adding together the present value of all the coupon payments and the par
value gives the bond price as below,

Bond Pricing: Main Characteristics


• A bond with a higher coupon rate will be priced higher
• A bond with a higher par value will be priced higher
• A bond with a higher number of periods to maturity will be priced higher
• A bond with a higher yield to maturity or market rates will be priced lower
• An easier way to remember this is that bonds will be priced higher for all
characteristics, except for yield to maturity. A higher yield to maturity results in lower
bond pricing.

Difference Between Coupon and Yield


Coupon refers to the amount which is paid as the return on the investment to the holder of
the bond by bond issuer which remains unaffected by the fluctuations in purchase price
whereas, yield refers to the interest rate on bond that is calculated on basis of the coupon
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payment of the bond as well as it current market price assuming bond is held till maturity and
thus changes with the change in the bond’s market price.
A bond has face value which is the amount the bondholder will receive at the time of maturity
from the issuer of the bond. The coupon rate on the bond is calculated on the basis of the
face value of the bond.

Coupon vs Yield
Basis Coupon rate Yield
Definition The coupon is similar to interest Yield to maturity of a bond is the
rate, which is paid by the issuer ofinterest rate for a bond which
a bond to the bondholder as a calculated on the basis of coupon
return on his investment. payment and the current market
price of a bond.
Basis of The coupon rate is calculated with The coupon rate is calculated with
calculation numerator as the coupon payment numerator as the coupon
and the denominator as the face payment and the denominator as
value of the bond. the market price of the bond.
Effecting delta The coupon rate remains fixed for Yield changes with the change in
the entire duration a bond as the the market price of a bond.
coupon payment is fixed and also
the face value is fixed.
Effect of Change in the interest rate in the The price of a bond is inversely
interest rate economy by the central bank has proportional to the interest rates.
no effect on the coupon rate of a With the increase of interest rate,
bond. the price of a bond will decrease,
as the investor then will look for
higher yield from a bond. And
with the decrease of interest rate,
the price of a bond will increase
as then the investor will happy
with the lower interest rate.
Example Suppose the face value of an XYZ If the annual coupon of a bond is
bond is Rs1000 and the coupon Rs 40. And the price of the bond is
payment is Rs 40 annually. The Rs 1150 then the yield on the
way the coupon rate is calculated bond will be 3.5%.
is by dividing the annual coupon
payment by the face value of the
bond. In this case, the coupon rate
for the bond will be Rs 40/$1000
that is a 4% annual rate.
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Coupon Rate vs Interest Rate


Let us now look at the head to head difference between Coupon Rate vs Interest Rate

Particulars – Coupon Rate Interest Rate


Coupon Rate vs
Interest Rate
Meaning Coupon rate can be considered as The interest rate is the rate charged
the yield on a fixed-income security by the lender to the borrower for the
borrowed amount
Calculation The coupon rate is calculated on The interest rate is calculated
the face value of the bond which is considering the basis of the riskiness
being invested. of lending the amount to the
borrower.
Decision The coupon rate is decided by the The interest rate is decided by the
issuer of the bonds to the lender.
purchaser.
Effect of interest Coupon rates are largely affected by Interest rates are decided and
rates on the the interest rates decided by the controlled by the government and are
coupon government. If the interest rates dependent on the market conditions
are set to 6% then no investor will
accept the bonds offering coupon
rate lower than this

Relationship Bonds with lower fixed rate coupon Interest rates are not affected by
will have a higher interest rate risk individual coupon rates of the bonds
and higher fixed rate coupon
bonds will have lower interest rate
risk
Example If the investor purchases a bond of If a bank has lent Rs 1000 to a
10 years, of a face value of Rs 1,000 customer and the interest rate is 12
and a coupon rate of 10 percent percent, then the borrower will have
then the bond purchaser gets Rs to pay charges Rs 120 per year.
100 every year as coupon payments
on the bond.
Maturity duration 1. With longer maturity of the 1. Longer maturity duration increases
bond, the coupon rate is higher. the interest rates which affects the
2. Shorter maturity of the bond interest amount.
reduces the coupon rate. 2. Shorter maturity duration reduces
the risk of interest rates.
Types Coupon can be of two types Fixed Interest rate does not have any types
rate and Variable rate. Fixed rate and is fixed until the regulatory body
does not change and fixed till decides to change it.
maturity while the variable rate
changes every period.
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Formula to Calculate Current Yield of a Bond


The current yield formula of a bond essentially calculates the yield on a bond based on the
Market price, instead of face value. The formula for calculating the current yield is as follows:
Current Yield of Bond = Annual coupon payment/ Current Market price

The current yield is an accurate measure of calculating the yield on a bond as it reflects the
market sentiment and investor expectations from the bond in terms of return.
Current yield, when used with other measures such as YTM, Yield to the first call, etc. helps
the investor in making the well-informed investment decision. Moreover, it is a reliable
measure given its sensitivity to inflation expectations of the bond market investors.

What is Yield to Call?


Yield to call is the return on investment for a fixed income holder if the underlying security
i.e. Callable Bond is held until the pre-determined call date and not the maturity date.
The bond is held until the pre-decided call date and not the maturity date
Bond’s purchase price is assumed to be the current market price instead of the Bond face
value

B = Current Price of the Bonds


C = Coupon payment paid out annually
CP = Call price
T= number of years pending until the call date.
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Yield to Maturity Definition


Yield to maturity (YTM) is the expected return on a bond that an investor will receive if it is
held until the maturity date of the bond. In other words, it refers to the returns that a bond
will fetch considering all payments made on time throughout the life of the bond.
Unlike current yield which measures the present value of the bond whereas the yield to
maturity measures the value of the bond at the end of the term of a bond.

Where,
C = Coupon Payment
F = Face Value
P = Price
n = Years to maturity

Types of Risks
Bonds are subject to various types of risks such as:

1. Inflation Risk/Purchasing Power Risk


Inflation risk refers to the effect of inflation on investments.
When inflation rises, the purchasing power of bond returns (principal plus coupons)
declines.
The same amount of income will buy lesser goods.
For e.g. when the inflation rate is 4%, every Rs 1000 return from the bond investment
will be worth only Rs 960.

2. Interest Rate Risk


Interest rate risk refers to the impact of the movement in interest rates on bond returns. As
rates rise, bond price declines.
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In the event of rising rates, the attractiveness of existing bonds with lower returns declines,
and hence the price of such bond falls.
The reverse is also true.
Short term bonds are less exposed to this risk while long term bonds have a very high
probability of getting affected.

3. Call Risk
Call risk is specifically associated with the bonds that come with an embedded call option.
When market rates decline, callable bond issuers often look to refinance their debt, thus
calling back the bonds at the pre-specified call price.
This often leaves the investors in the lurch who are forced to reinvest the bond proceeds at
lower rates.
Such investors are however compensated by high coupons. The call protection feature also
protects the bond from being called for a particular time period giving investors some relief.

4. Reinvestment Risk
The probability that investors will not be able to reinvest the cash flows at a rate comparable
to the bond’s current return refers to reinvestment risk.
This tends to happen when market rates are lower than the bond’s coupon rate.
Say, a Rs 100 bond’s coupon rate is 8% while the prevailing market rate is 4%. The Rs 8 coupon
earned will then be reinvested at 4%, rather than at 8%. This is called the risk of reinvestment.

5. Credit Risk
Credit risk results from the bond issuer’s inability to make timely payments to the lenders.
This leads to interrupted cash flow for the lender where losses might range from moderate
to severe.
Credit history and capacity to repay are the two most important factors that can determine
credit risk.

6. Liquidity Risk
Liquidity risk arises when bonds become difficult to liquidate in a narrow market with very
few buyers and sellers. Narrow markets are characterized by low liquidity and high volatility.
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7. Market Risk/Systematic Risk


Market risk is the probability of losses due to market reasons like slowdown and changes in
rates.
Market risk affects the entire market together. In a bond market, no matter how good an
investment is, it is bound to lose value when the market declines. Interest rate risk is another
form of market risk.

8. Default Risk
Default risk is defined as the bond issuing company’s inability to make required payments.
Default risk is seen as other variants of credit risk where borrowing company fails to meet the
agreed terms of the issue.

9. Rating Risk
Bond investments can also sometimes suffer from rating risk where a slew of factors specific
to the bond as well as the market environment affect the bond rating, thus decreasing the
value and demand of the bond.

This is all from us in the eBook for Bonds. Hope you like the content presented here. The
sources being referred here are given below.
Sources Referred:

• https://www.investopedia.com/
• https://corporatefinanceinstitute.com/
• https://www.wallstreetmojo.com/bonds/
• https://efinancemanagement.com/sources-of-finance/bonds-and-their-types
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