Bond Basics

ICMS presents:

Every one know about the stock market . Stocks look exciting. Buying at low price and sell at high price may be an interesting job. Every day you watch TV and read news paper to get an idea about the bonds

New investors get the help of advisors.

For many others stock market is a scary jungle. They have no idea where to invest and how to start. They follow the stories of windfall profits from market bulls

Diversification - “ Do not put all your eggs in one basket”

Investors need to diversify their investments in various assets classes to reduce risk. In bull market investors are excited by the stock rally and ignore bonds. Only in market crash thinks about the bonds.

In coming chapters we are going to discuss bonds and its relation ship with stock market.

After reading the full chapter you can decide whether you need to include bonds in your portfolio

What are bonds ?

Sure ,everyone borrowed money at least once in their life.Remember you asked pocket money from your parents to buy candy

Like this Companies and Government also need money to run their business

Here we can see one giving ( lending ) money other receiving (borrow ) it .

Assume here you are the lender and Government is the borrower . As you are giving hard earned money to Government you will expect a return. That is called interest or coupon.

Next slide

What is a coupon ?

say you buy a bond with a face value of Rs.1,000, a coupon of 8%, and a maturity of 10 years. This means you'll receive a total of Rs. 80 (Rs. 1,000*8%) of interest per year for the next 10 years.

Actually, because most bonds pay interest semi-annually, you'll receive two payments of Rs. 40 a year for 10 years. When the bond matures after a decade, you'll get your Rs. 1,000 back.

Who should invest in bonds?

1. Retired persons : They are living on fixed income. If he is losing his investment he may not able to pay his bills.

2. Shorter time horizons : Lets say a young executive planning for higher education in next 3 years. His time horizon is low. He cannot afford losing big.

How to deal with bonds ?

We already discussed coupon rate . Now we need comes maturity. The maturity date is the date in the future on which the investor's principal will be repaid. Maturities can range from as little as one day to as long as 30 years

So you decided to buy Rs. 100 bond with a coupon rate of 8% paying semi annually expiring at 2020.

This means you will get Rs.4 every 6 months. And you will get full Rs. 100 in 2020.

How interest rates effect bonds ?

Now you must realize Rs. 100 bond can be traded at Rs. 90 or Rs. 110. How this happens .

Lets check

Think about a situation bank interest rates rises to 10% in the country. Now you don’t buy bond paying Rs. 100 because you will get only 8% in bonds. So you will try to get bonds with lower price

If interest rates comes down demand for bonds will be high and thus price of the bond will rise.

Bond yields

Now lets dog the term bond yield. In our example we are talking about a bond with a face value of Rs.100. This bond price can be Rs. 110 or Rs. 90 depends on interest rate expectation . Those who purchasing bond in above prices will all get same 8% interest rate. But yield will be different . How?

Watch excel sheet for calculations

Bond yields

Those purchasing bonds with lower price will get higher yield

Eg : Person buying bond for Rs.90 will get same coupon rate of Rs.8 . He is effectively getting 8.89% interest.

His yield will be high comparing with those who are purchasing same bond at par or premium rate

Yield to Maturity (YTM)

Yield to maturity accounts for the present value of a bond’s future coupon payments.

YTM is the interest rate an investor would earn by investing every coupon payment from the bond at a constant interest rate until the bond’s maturity date.

The present value of all of these future cash flows equals the bond’s market price.

Calculation

Pricing the bondNow it is very important part

We understood that when bank interest goes up price of the bond will come down and bond yield will rise .

Now we are going to calculate the price of the bond in given interest arte expectation

Assume RBI rises interest rate to 9%Bond coupon is only 8%Of course you and me ask for 9% . Now the demand for the bond will come down and price will fall then yield will rise.

Calculation

Credit/Default Risk

Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required.

Prepayment Risk

Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision. This can be bad news for investors, because the company only has an incentive to repay the obligation early when interest rates have declined substantially. Instead of continuing to hold a high interest investment, investors are left to reinvest funds in a lower interest rate environment.

Interest Rate Risk

Interest rate risk is the risk that interest rates will change significantly from what the investor expected. If interest rates significantly decline, the investor faces the possibility of prepayment. If interest rates increase, the investor will be stuck with an instrument yielding below market rates.

Risk of Bonds

The most commonly cited bond rating agencies are Standard & Poor's, Moody's and Fitch. These agencies rate a company's ability to repay its obligations.

In India CRISIL is the authorized agency for credit rating

Bond Ratings