When the government, corporate or public sector undertakings want to raise the capital they launch Bonds, which are essentially loan instruments. Ipso facto, these are financial instruments that the issuer (government, corporate, or public sector undertakings) uses to borrow money from the market (retail or institutional investors) by promising to pay them fixed annual/semi-annual interest and return the principal at the time of maturity of the bond. The government usually floats these bonds for infrastructure projects, welfare schemes, or during emergency situations like war. On the other hand, corporates, and public sector undertakings (PSUs) float such bonds for business expansion, incur capital expenditure or undertake research and development.
Bond Jargon – you may come across various terms while dealing with bonds and it is important to understand their meaning. These are as follows:
- Face Value – it is the amount of money that the bond is worth at maturity. Financial experts also call it as the par value, stated value, maturity value, principal amount, and legal amount. Cash interest payments during the life of the bond are based on the face value, and it also indicates the cash amount that the issuer must pay the lender at the maturity date. To clarify this further, let us assume that A buys the bond on its issue date for ₹ 1,000, B buys it at a premium after 2 years for ₹ 1,080, and C buys it at a discount for ₹ 960 after 4 years. However, when the bond matures, all three investors will receive ₹ 1,000 as the principal amount.
- Issue Price– isthe price at which the bond issuer originally sells the bonds. Normally, government and corporates issue bonds in the denomination of ₹ 100 or 1000.
- Coupon Rate– is the rate of interest the bond issuer will pay on the face value of the bond periodically in percentage terms. The issuer calculates the coupon rate on the bond’s face value and not on the issue price or market value. Going ahead with the example given for face value above, we assume the maturity date of the bond is 10 years from its launch date and it pays a coupon rate of 6% annually. Then, A will get ₹ 60 (1000*6%) annually on the coupon date (dates on which the bond issuer will make interest payments) for 10 years. Whereas, both B and C will also receive ₹ 60 annually on the coupon date for 8 and 6 years respectively since they had purchased the bond after 2 and 4 years from the issue date. A simple formula to calculate the coupon rate is Coupon Rate = (Annual Coupon Payment/Bond Face Value) *100.
- Market Price– This is important when an investor wants to trade bonds with other investors in the secondary markets. A bond’s market price is what investors are willing to pay for an existing bond. The market price of a bond is determined using the current interest rate compared to the interest rate stated on the bond. Depending on the level of interest rate in the environment, the investor may purchase a bond at par, below par, or above par. For example,if interest rates increase, the value of a bond will decrease since the coupon rate will be lower than the interest rate in the economy. When this occurs, the bond will trade at a discount, that is, below par. However, the bondholder will be paid the full face value of the bond at maturity even though he purchased it for less than the par value. Conversely, if interest rates decrease, the value of a bond will increase since the coupon rate will be higher than the interest rate in the economy. When this occurs, the bond will trade at a premium, that is, above par. The market price of the bond comprises two parts – the present value of the bond’s face value and the present value of the bond’s interest payments.
- Current Yield– a bond’s yield is the return to an investor from the bond’s coupon and maturity cash flows. The current yield compares the coupon rate to the current market price of the bond. It is calculated by the formula Current Yield = (Annual Coupon Payment/Bond Price) *100. Therefore, if a ₹1,000 bond with a 6% coupon rate sells for ₹1,000, then the current yield is also 6%. However, because the market price of bonds can fluctuate, it may be possible to purchase this bond for a price that is above or below ₹ 1,000. If this same bond is purchased for ₹800, then the current yield becomes 7.5% because the ₹60 annual coupon payments represent a larger share of the purchase price. Similarly, if the bond was purchased for ₹ 1,100 then the current yield becomes 5.45% because annual coupon payments represent a smaller share of the purchase price. Therefore, a bond’s coupon rate is the rate of interest it pays annually, while its yield is the rate of return it generates. While calculating the coupon rate, the annual coupon payment is divided by the bond’s face value, whereas, for calculating yield we divide the annual coupon payment by the bond’s market price. An inverse relationship exists between the bond’s price and the prevailing yield environment. If the prevailing yield environment declines, prices on those bonds generally rise. The opposite is true in a rising yield environment – in short, prices generally decline.
- Yield to Maturity (YTM)– it is the total return anticipated on a bond if the investor holds it till maturity. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond till maturity, with all payments made as scheduled and reinvested at the same rate. People also refer to it as book yield or redemption yield. Unlike current yield, YTM is speculative and accounts for the present value of a bond’s future coupon payments. In other words, it factors in the time value of money. It also considers that you can achieve compounding interest by reinvesting the annual coupon payment you receive each year. Since the calculation of YTM is complicated, it is best to use Microsoft Excel formula ‘YIELDMAT’, which returns the annual yield of the bond that pays interest at maturity. Certain factors that have a bearing on YTM are as follows:
- Coupon Rate – higher a bond’s coupon rate, the higher is its yield; because, each year the bond will pay a higher percentage of its face value as interest.
- Price –higher a bond’s price, the lower is its yield; because an investor buying the bond pays more price for the same return.
- Years Remaining until Maturity – YTM factors in the compound interest you can earn on a bond if you reinvest your interest payments.
- Difference between the Face value and Price – if you keep a bond to maturity, you receive the bond’s face value. The actual price you paid for the bond may be more than the face value of the bond or less than it. Yield to maturity factors in this difference.
- Types of Bonds – in India, there are primarily two types of bonds issued by different institutions, viz. Government (also called G-Sec) and Corporate. The government bond market size is much larger than the corporate bond market size. The corporate bonds are either convertible into a pre-defined number of stocks or plain non-convertible bonds. Companies, who are new entrants in the market or those who have not built a strong reputation yet, issue high-yield bonds, which have a lower credit rating than corporate bonds but offer a higher yield. In addition, some other institutions issue Municipal bonds to fund government activities. These institutions are local or state level governments or other agencies of the government like the transportation or healthcare department. Like government bonds, municipal bonds are safe investment options, as the government backs their repayment. Then there are Public Sector Bonds issued by organizations within which the government holds more than 50% ownership. These enjoy quasi-sovereign guarantee because of government implicit guarantee. Perpetual bonds are a viable money-raising solution during troubled economic times. With perpetual bonds, the issuer pays agreed-upon interest forever since they have no maturity date. Investors can get their investment back only by selling them in the secondary debt market unless the issuer calls the bonds back.
- Risk Involved – primarily there are two types of risks involved while investing in bonds, namely, credit risk and interest risk. Credit risk is a default risk when the issuer of the bonds fails to meet his obligation towards investors of periodic interest payment or principal repayment on maturity. Investors must consider ratings assigned by various rating agencies who assess the creditworthiness of issuers and assign a credit rating based on their ability to repay their obligations. Interest risk entails that when the market interest rates rise, the bond prices fall but their yields rise. Conversely, when the interest rates fall, the bond prices rise but their yields go down. Accordingly, the investors must consider the interest rate outlook to assess the bond’s duration (short, medium, and long-term). Additionally, for subsequent transactions in the market, investors may face a liquidity risk, which means difficulty in finding a buyer when they want to sell. This may force them to sell at a significant discount to market value. To mitigate this risk, some bond issuers appoint market makers to provide liquidity on the exchanges. Then there is a reinvestment risk when interest rates are declining and investors must reinvest their coupon income in similar underlying assets as that of the index/portfolio at lower prevalent rates.
- Taxation – returns from investments in bonds come from interest and capital appreciation. The government taxes interest (coupon payment) at the marginal slab rate, which at the higher end is 30% plus surcharge, if applicable, and cess. It taxes price appreciation or cumulative growth payment as capital gains on debt instruments; short-term gains (holding period less than 36 months) as per investor’s applicable tax slab and long-term gains (holding period more than 36 months) at 20% after indexation benefit.