BONDS

INTRODUCTION

• Bonds refer to debt instruments bearing interest on maturity.

• In simple terms, organizations may borrow funds by issuing debt securities named bonds, having a fixed
maturity period (more than one year) and pay a specified rate of interest (coupon rate) on the principal
amount to the holders.
• Bonds have a maturity period of more than one year which differentiates it from other debt securities
like commercial papers, treasury bills and other money market instruments.
• Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the
coupon is the interest.
• Bonds provide the borrower with external funds to finance long-term investments, or, in the case of
government bonds, to finance current expenditure .
FEATURES OF BONDS
The most important features of a bond are:
• Nominal, Principal or Face Amount - The amount over which the issuer pays interest, and which has to
be repaid at the end.
• Issue price - The price at which investors buy the bonds when they are first issued.
• Maturity date - The date on which the issuer has to repay the nominal amount. As long as all payments
have been made, the issuer has no more obligations to the bond holders after the maturity date. The
length of time until the maturity date is often referred to as the term or maturity of a bond.
• Coupon - The interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout
the life of the bond. The name coupon originates from the fact that in the past, physical bonds were
issued which had coupons attached to them. On coupon dates the bond holder would give the coupon
to a bank in exchange for the interest payment.
• Coupon dates - The dates on which the issuer pays the coupon to the bond holders. It can be paid
quarterly, semi-annually or annually.
TYPES OF BONDS

• Municipal Bonds:
Municipal bonds are debt obligations issued by states, cities, countries and other governmental entities,
which use the money to build schools, highways, hospitals, sewer systems, and many other projects for the
public good.
When you purchase a municipal bond, you are lending money to a state or local government entity, which
in turn promises to pay you a specified amount of interest (usually paid semiannually) and return the
principal to you on a specific maturity date.
Not all municipal bonds offer income exempt from both federal and state taxes.
• Government Bonds :
Government Bonds are securities issued by the Government for raising a public loan or as notified in the
official Gazette.
Government Securities are mostly interest bearing dated securities issued by RBI on behalf of the
Government of India. GOI uses these funds to meet its expenditure commitments. These securities are
generally fixed maturity and fixed coupon securities carrying semi-annual coupon and are known as dated
Government Securities.
Features of Government Securities
• Issued at face value
• No default risk as the securities carry sovereign guarantee.
• Ample liquidity as the investor can sell the security in the secondary market
• Interest payment on a half yearly basis on face value
• No tax deducted at source
• Can be held in D-mat form.
• Rate of interest and tenor of the security is fixed at the time of issuance and is not subject to change.
• Redeemed at face value on maturity
• Maturity ranges from of 2-30 years.
• Mortgage and Asset Backed Bonds:
Mortgage-backed securities (MBS) and asset-backed securities (ABS) represent the largest segment of the
global bond market today. In simple terms, investing in MBS means lending your money to hundreds of
individual mortgage borrowers across the country. In return for a higher yield than Treasury notes,
investors are subject to added “prepayment” risk, meaning money invested may be repaid much sooner
than maturity.
1. Agency MBS
Mortgage bonds which are guaranteed by a government agency or government-sponsored enterprise.
2. Non Agency MBS
Mortgage bonds which are issued by banks and financial companies not associated with a government
agency. These securities have no credit guarantee other than the quality of the loans behind them, and any
other structural credit protection provided by the terms of the bond deal they belong to.
• Asset Backed Securities
Bonds that represent an investment in a pool of consumer or commercial loans. For example, auto loans or
credit card loans are commonly pooled to make asset backed securities. For unknown historical reasons,
bonds backed by high quality mortgage loans are considered Mortgage Backed Securities (MBS) despite the
fact that technically they fall into the broader definition of Asset Backed Securities (ABS). Bonds backed by
home equity loans and other home loans less than high quality are considered Asset Backed Securities.
• Corporate Bonds
Corporate bonds are debt obligations issued by private and public corporations. They are typically issued in
multiples of 1,000 and/or 5,000. Companies use the funds they raise from selling bonds for a variety of
purposes, from building facilities to purchasing equipment to expanding their business. When you buy a
bond, you are lending money to the corporation that issued it. The corporation promises to return your
money (also called principal) on a specified maturity date. Until that time, it also pays you a stated rate of
interest, usually semiannually. The interest payments you receive from corporate bonds are taxable. Unlike
stocks, bonds do not give you an ownership interest in the issuing corporation.
ZERO COUPON BONDS

Zero coupon bonds are bonds that do not pay interest during the life of the bonds.
Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a
bond will be worth when it “matures”; or comes due.
When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment
plus the imputed interest, which is discussed below. The maturity dates on zero coupon bonds are usually
long-term.
These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a child’s
college education.
With the deep discount, an investor can put up a small amount of money that can grow over many years.
RISKS OF INVESTING IN BONDS

Interest rate risk - When interest rates rise, bond prices fall; conversely, when rates decline, bond prices
rise. The longer the time to a bond’s maturity, the greater its interest rate risk.
Reinvestment risk - When interest rates are declining, investors have to reinvest their interest income and
any return of principal, whether scheduled or unscheduled, at lower prevailing rates.
Inflation risk - Inflation causes tomorrow’s rupee to be worth less than today’s; in other words, it reduces
the purchasing power of a bond investor’s future interest payments and principal, collectively known as
“cash flows.” Inflation also leads to higher interest rates, which in turn leads to lower bond prices.
Market risk - The risk that the bond market as a whole would decline, bringing the value of individual
securities down with it regardless of their fundamental characteristics.
Default risk - The possibility that a bond issuer will be unable to make interest or principal payments when
they are due. If these payments are not made according to the agreements in the bond documentation,
the issuer can default
• Call risk - Some corporate, municipal and agency bonds have a “call provision” entitling their issuers to
redeem them at a specified price on a date prior to maturity. Declining interest rates may accelerate the
redemption of a callable bond, causing an investor’s principal to be returned sooner than expected. In that
scenario, investors have to reinvest the principal at the lower interest rates. If the bond is called at or close
to par value, as is usually the case, investors who paid a premium for their bond also risk a loss of principal.
In reality, prices of callable bonds are unlikely to move much above the call price if lower interest rates
make the bond likely to be called.
• Liquidity risk - The risk that investors may have difficulty finding a buyer when they want to sell and may be
forced to sell at a significant discount to market value. they are due and therefore default.
• Event risk - The risk that a bond’s issuer undertakes a leveraged buyout, debt restructuring, merger or
recapitalization that increases its debt load, causing its bonds’ values to fall, or interferes with its ability to
make timely payments of interest and principal. Event risk can also occur due to natural or industrial
accidents or regulatory change. (This risk applies more to corporate bonds than municipal bonds.)
CREDIT RATING AGENCIES
• Credit Rating Agencies rate the debt instruments of companies. They do not rate the companies, but their
individual debt securities. Rating is an opinion regarding the timely repayment of principal and interest
thereon; It is expressed by assigning symbols, which have definite meaning. A rating reflects default risk.
Ratings are not a guarantee against loss. They are simply opinions based on analysis of the risk of default.
They are helpful in making decisions based on particular preference of risk and return. A company, desirous
of rating its debt instrument, needs to approach a credit rating agency and pay a fee for this service.
• The determinants of ratings The default-risk assessment and quality rating assigned to an issue are primarily
determined by three factors –
• i) The issuer's ability to pay: Ratio analysis is used to analyse the present and future earning power of the
issuing corporation and to get insight into the strengths and weaknesses of the firm.
• ii) The strength of the security owner's claim on the issue: To assess the strength of security owner's claim,
the protective provisions in the indenture (legal instrument specifying bond owners' rights), designed to
ensure the safety of bondholder's investment, are considered in detail.
• iii) The economic significance of the industry and market place of the issuer: The factors considered in regard
to the economic significance and size of issuer includes: nature of industry in which issuer is, operating
(specifically issues like position in the economy, life cycle of the industry, labour situation, supply factors,
volatility etc.), and the competition faced by the issuer (market share, technological leadership, production
efficiency, financial structure, etc.)
RATING METHODOLOGY
• Key areas considered in a rating include the following:
i) Business Risk : To ascertain business risk, the rating agency considers Industry's characteristics,
performance and outlook, operating position (capacity, market share, distribution system, marketing
network, etc.), technological aspects, business cycles, size and capital intensity.
ii) Financial Risk : To assess financial risk, the rating agency takes into account various aspects of its Financial
Management (e.g. capital structure, liquidity position, financial flexibility and cash flow adequacy,
profitability, leverage, interest coverage), projections with particular emphasis on the components of
cash flow and claims thereon, accounting policies and practices with particular reference to practices of
providing depreciation, income recognition, inventory valuation, off-balance sheet claims and liabilities,
amortization of intangible assets, foreign currency transactions, etc.
iii) Management Evaluation : Management evaluation includes consideration of the background and history
of the issuer, corporate strategy and philosophy, organizational structure, quality of management and
management capabilities under stress, personnel policies etc.
iv) Business Environmental Analysis : This includes regulatory environment, operating environment, national
economic outlook, areas of special significance to the company, pending litigation, tax status, possibility
of default risk under a variety of scenarios.
CREDIT RATING AGENCIES IN INDIA

• CRISIL : This was set-up by ICICI and UTI in 1988, and rates debt instruments. Nearly half of its ratings on
the instruments are being used.
• CRISIL evaluation is carried out by professionally qualified persons and includes data collection, analysis
and meeting with key personnel in the company to discuss strategies, plans and other issues that may
effect ,evaluation of the company. The rating ,process ensures confidentiality. , Once the company
decides to use rating, CRISIL is obligated to monitor the rating over the life of the debt instrument.
• Symbol (Rating category). Description (with regard to the likelihood of meeting the debt obligations on
time)
AAA - Highest Safety, AA - High Safety, A - Adequate Safety, BBB - Moderate Safety, BB - Inadequate Safety,
B - High Risk, C- Substantial Risk, D - Default
• ICRA : ICRA was promoted by IFCI in 1991.
• The factors that ICRA takes into consideration for rating depend on the nature of borrowing entity. The
inherent protective factors, marketing strategies, competitive edge, competence and effectiveness of
management, human resource development policies and practices, hedging of risks, trends in cash
flows and potential liquidity, financial flexibility, asset quality and past record of servicing of debt as well
as government policies affecting the industry are examined.
• Symbol (Rating category). Description (with regard to the likelihood of meeting the debt obligations on
time)
LAAA - highest-credit-quality & lowest credit risk. LAA - high-credit-quality & low credit risk. LA - adequate-
credit-quality & average credit risk. LBBB - moderate-credit-quality & higher than average credit risk. LBB
- inadequate-credit-quality & high credit risk. LB - risk-prone-credit-quality & very high credit risk. LC -
poor-credit-quality & limited prospect of recovery. LD - lowest-credit-quality & low prospect of recovery.
• CARE : CARE is a credit rating and information services company promoted by IDBI jointly with
investment institutions, banks and finance companies.
• The company commenced its operations in October 1993.In January 1994, CARE commenced
publication of CAREVIEW, a quarterly journal of CARE ratings. In addition to the rationale of all accepted
ratings, CAREVIEW often carries special features of interest to issuers of debt instruments, investors and
other market players.
• Symbol (Rating category). Description (with regard to the likelihood of meeting the debt obligations on
time)
CARE AAA - highest-credit-quality & lowest credit risk. CARE AA - high-credit-quality & low credit risk.
CARE A - adequate-credit-quality & average credit risk. CARE BBB - moderate-credit-quality & moderate
credit risk. CARE BB - moderate credit risk. CARE B - high credit risk. CARE C - Very high credit risk.
CARE D - Default or expected to be default.
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