What are Bonds?
Bonds are fixed income instruments, which are issued by government and private sector entities to raise finances. When investors purchase bonds, they are basically lending money to the bond-issuing entity in return of interest (coupon) payments. The principal amount of the bonds, i.e. their face values, are returned on their maturity dates. Thus, bondholders can be considered as creditors for the bond issuers.
Features/Characteristics of Bonds
Face value: The face value or par value of a bond is the amount that its investors will receive at the time of its maturity. The interest payments, also known as coupon payments, are calculated on the basis of a bond’s face value.
Coupon rate: The interest rate promised by a bond issuer to pay on the face value of the bond is called the coupon rate. While the coupon rates of most bonds are fixed at the time of issue, some bonds also pay coupons at floating rates wherein their coupon rates are benchmarked to government bonds, MIBOR, etc.
Coupon dates: The dates on which a bond issuer promises to make coupon (interest) payments to its bondholders.
Issue Price: The price at which the bond issuer sells a bond to the investor (in the primary markets) at the time of bond issue. When the issue price of a bond is the same as its face value, it is said to be issued at par. When the issue price is higher than the face value, then the bond is said to be issued at premium. In case the issue price is lower than the face value, then the bond is said to be issued at discount.
Maturity date: The date on which the bond issuer promises to repay the face value of a bond to its investors.
What is Bond Yield?
Bond yield term refers to the rate of returns that an investor realises or expects to realise from his investment in a bond. The coupon payments made by the bond issuer and the capital gains or losses, if any, realised on the date of bond sale or maturity are factored in while calculating bond yields.
There are three yield measures that investors commonly use to calculate the rate of returns from their bond investments.
Coupon Yield
Coupon yield refers to the annual coupon payment expressed as a percentage of the face value of a bond.
Coupon Yield = Annual Coupon Payment / Face value of bond x 100
Example:
If a bond having a face value of Rs 100 pays a coupon of Rs 9 to its investors per year, then the coupon yield of that bond would be 9%.
Current Yield
Current Yield refers to the annual coupon payment expressed as a percentage of the purchase price of a bond.
Current Yield = Annual Coupon Payment / Purchase Price of the bond * 100
Example:
Assume that an investor purchases a bond having a face value of Rs 100 for Rs 102 and that bond pays an annual coupon of Rs 9. Then, the current yield of that bond would be as follows.
Current Yield = 9/103 x 100 = 8.73%
Yield to Maturity (YTM)
YTM is the annualised rate of return for an investor if he or she decides to hold the bond till its maturity date. If expressed in technical terms, YTM is the discount rate that makes the present value of all future cash flows from a bond (i.e. its remaining coupon payments and maturity value) equal to its current market price.
Which entities can issue bonds in India?
In India, central and state governments, municipal bodies, banks, financial institutions, public sector units, public/private limited companies and any other entities meeting the eligibility conditions laid down by the SEBI for bond issuances can issue bonds to raise funds.
Types of Bonds
Fixed Rate Bonds: These bonds pay fixed interest amount or coupon to their investors till their maturity, irrespective of the changes in the prevailing economic and market conditions.
Floating Rate Bonds: The interest or coupon payments of these bonds are not fixed but linked to predetermined benchmark rates. Thus, any changes in the linked benchmark rates can lead to a change in their coupon rates and thereby, their coupon repayments.
Secured Bonds: These bonds are backed by specific collateral/security of the bond issuing entity. In case the issuer defaults on its repayment obligations or winds up, the pledged assets can be liquidated to repay secured bond holders. Within the secured bond holders, investors holding senior secured bonds will receive the higher priority in receiving repayments (right after payment of statutory and tax dues) than sub-ordinated or junior secured bonds.
Convertible Bonds: These bonds can be converted into equities after a specified period as per the prevailing market price or at a price pre-determined at the time of the bond issue. The investor receives coupon payments till the conversion of such bonds into equities.
Bonds that are compulsorily convertible into equities after a particular period or on a particular date are known as compulsorily convertible bonds.
Callable Bonds: In case of callable bonds, issuers have the right to buy back these bonds before their maturity dates.
Puttable Bonds: These bonds offer their investors the right to make bond redemption before their maturity dates.
State Development Loans (SDL): Bonds or dated securities issued by the state governments in India are known as state development loans. In terms of safety of capital, SDLs are similar to G-Secs. SDLs have quasi-sovereign status as the RBI directly monitors interest and maturity payments of these bonds and also has the power to make the pay-outs for these bonds from the budgetary allocation of the Central government for the bond issuing state government.
Risks Involved in Investing in Bonds
Interest Rate Risk: Bonds prices have an inverse relationship with the direction of interest rate changes in the economy. When interest rates rise, bond prices fall as fresh bond issuances will offer higher interest rates than the existing ones, making the existing bonds less attractive for the investors. The opposite happens when interest rates fall. The sensitivity of bond prices to interest rates is the lowest in case of bonds having lower residual maturity while bonds having longer residual maturity carry the highest interest rate risk.
Credit Risk: Credit risk or default risk of a bond refers to the possibility of its issuer defaulting on its future coupon or maturity repayments. Government bonds carry the lowest credit risk while companies having the lowest credit ratings carry the highest credit risk. Those planning to invest in bonds can refer to their credit ratings assigned by SEBI-registered credit rating agencies like CRISIL, ICRA, India Ratings, CARE, etc to evaluate the creditworthiness of those bonds.
Prepayment or Call Risk: Callable bonds allow their issuers to prepay the maturity dues before their maturity dates. Exercise of call option by the bond issuers during a falling interest rate regime may lead bond holders to realise lower amounts than the market value of such bonds. Investors seeking to avoid this risk should ensure to go through the prospectus or other available bond literature to ensure that their bonds do not have the callable option.
Liquidity Risk: This risk refers to the likelihood of failing to find a bond buyer before the maturity date of a bond. Liquidity in bond markets is lower than the equity markets and the lack of liquidity for a particular bond may also affect the price realisation for the bond seller. To minimise this risk, bond investors should check the trading volumes in the secondary market before purchasing any bond.
Market Risk: This risk refers to the fluctuations in bond prices due to changing market conditions, changes in interest rate regimes, credit rating upgrades/downgrades, demand supply factors, etc. Investors can reduce this risk by holding their bonds till their maturity dates.