Basics of Bonds
Basics of Bonds
Basics of Bonds
BASICS
OF
BONDS
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₹ ₹
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.
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:
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.
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.
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.
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.
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.
• 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
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.
• 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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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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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,
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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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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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.
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:
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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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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