Tuesday, June 28, 2005

All you want to know about bonds

June 28, 2005, www.rediff.com, Co-author-Vivek Kaul

Individuals have surplus funds in the form of savings which they want to invest. Companies need funds to undertake good projects with high returns. Companies provide individuals with instruments to invest their savings in.
One such instrument is corporate bonds. Similarly, governments also need funds for various developmental projects. Further, the government also needs to raise money to finance the fiscal deficit. They too tap the savings by issuing various kinds of bonds.
Characteristics of a bond
A bond, whether issued by a government or a corporation, has a specific maturity date, which can range from a few days to 20-30 years or even more. Based on the maturity period, bonds are referred to as bills or short-term bonds and long-term bonds.
Bonds have a fixed face value, which is the amount to be returned to the investor upon maturity of the bond. During this period, the investors receive a regular payment of interest, semi-annually or annually, which is calculated as a certain percentage of the face value and know as a 'coupon payment.'
A story goes that in the old days, bond certificates used to come with coupons to claim interest from the issuer of the bond; hence, the name coupon payments. However, nowadays, with paperless issues of scrips (demat), coupons are no longer in use, but the name has stuck and the interest payments are still known as coupon payments.
Issuing a bond
The government, public sector units and corporates are the dominant issuers in the bond market. The central government raises funds through the issue of dated securities (securities with maturity period ranging from two years to 30 years, long-term) and treasury bills (securities with maturity periods of 91 or 364 days, short-term).
The central government securities are issued for a minimum amount of Rs 10, 000 (face value). Thereafter they are issued in multiples of Rs 10,000. They are issued through an auction carried out by the Reserve Bank of India.
State governments go about raising money through state development loans. Local bodies of various states like municipalities also tap the bond market from time to time. Bonds are also issued by public sector banks and PSUs. Corporates on the other hands raise funds by issuing commercial paper (short-term) and bonds (long-term).
Bonds can be issued at par, which means that the price at which one unit of the bond is being sold is same as the face value. Alternatively, they can be issued at a discount (less than the face value) or a premium (more than the face value).
For example, a bond with a face value of Rs 100, if issued at Rs 100, is said to be issued at par. If it is issued at, say, Rs 95, it will be said to have been issued at a discount and conversely, if issued for, say, Rs 110, at a premium.
Investors
Banks are the largest investors in the bond market. In the low-interest scenario that prevailed, it made more sense for banks to invest in government bonds than to give out loans. Mutual funds, in order capitalise on low interest rates, started a good number of debt funds that mobilised a significant amount of money from the investors.
Thus, mutual funds emerged as important players in the bond markets. However, in the recent past with the interest rates on their way up, the performance of debt funds has not been good and so the presence of mutual funds in the bond market has been limited.
Foreign institutional investors are also allowed to invest in the bond market, though within certain limits. Also, regulations mandate provident funds and pension funds to invest a significant proportion of their funds mobilised in government securities and PSU bonds.
Hence, they continue to remain large investors in the bond market in India. The same holds true for charitable institutions, societies and trusts.
Since January 2002, individuals categorised by RBI as retail investors can participate in the auction carried out by RBI. They can submit bids through banks or primary dealers to invest in these securities on a non-competitive basis.
The minimum bid has to be for an amount of Rs 10,000 (and there on in multiples of Rs 10,000) and a single bid cannot exceed Rs 1 crore (Rs 10 million).
Secondary market
Bonds issued by corporates and the Government of India can be traded in the secondary market. Most of the secondary market trading in government bonds happens on the negotiated dealing system (an electronic platform provided by the RBI for facilitating trading in government securities) and the wholesale debt market (WDM) segment of the National Stock Exchange.
Corporate bonds and PSU bonds can also be traded on the WDM. The secondary market transactions in the bond market for the year 2003-04 was Rs 27,21,470.6 crore (Rs 272,147.06 billion), an increase of 36.6 per cent over the previous year.
Of this, government securities accounted for 98.4 per cent of the total turnover. The number of retail trades in the year 2003-04 formed an insignificant 73 per cent of the total number of trades (189,518) in the secondary market.
Returns from the bond
The return on investment into bonds is in the form of coupon payments, as already mentioned before, and through capital gains. Capital gain occurs when the bond is bought at a discount. Bonds bought at a premium would result in capital loss.
And bonds bought at par would have no capital gain or loss. Together, the total return is known as the Yield from the bond. Let us explain this with the help of an example. Let's say, that an investor buys one unit of a Long-term bond issued by a Company X Ltd for Rs 95 (i.e at a discount).
The face value of the bond is Rs 100. The coupon is 5 per cent per annum, paid annually, and the maturity period of the bond is two years.
This means, that the investor will get a payment of Rs 5 every year (calculated as 5 per cent of the face value) and at the end of the second year, he will receive Rs 100, the face value. The yield on this long-term bond can be calculated by solving for r in the equation below.
95 = 5/(1 + r) + 5/(1 + r)2 + 100/(1 + r)2
We get r=7.8%
If we notice, in the above equation, the coupon payments are fixed, the face value is fixed; the maturity of the bond is fixed. Hence the yield from the bond effectively depends on the price of the bond.
The price of the bond is determined by the issuer, by taking the market forces into account. For example, if the price of a similar bond is Rs 94 in the market (all other characteristics being same) no one will be willing to pay Rs 95 for the bond being issued by company X (assuming similar risk as well).
Hence, company X must ensure that the price, at which they are offering their Bond, is competitive with similar bonds in the market, and should provide similar yield to the investors.
Interest rate risk
Price and Yield share an inverse relationship. When price is high, yield is lower and when price is low, yield is higher (As can be seen in the way equation 1 would work). This brings us to the problem of Interest rate risk faced by bonds.
If the government suddenly decides to raise the prevailing interest rates, the expected yield from bonds held by the investors would go up. This would result in a drop in the price of the bonds. And if the investor wants to sell the bond for some reason, instead of holding it till maturity, he will have to suffer a capital loss.
On the contrary, if the interest rates are falling, the price of the bonds will rise and the investors can sell their bonds at higher prices in the secondary market than the price at which they bought the bond initially.
The reason for this inverse relationship is that, when interest rates are raised, the newer bonds issued by the government and the corporates, other investments like fixed deposits, post office savings schemes, et cetera offer greater return, with more or less the same kind of risk.
So an existing bond becomes less attractive. Investors want to sell off their existing investment in bonds and switch to other more attractive investments. The selling pressure in the bond market causes the prices of the bonds to drop. Similarly, when interest rates are dropped, price of bonds increases due to increase in demand.
Over the last few years the treasury departments of banks in India have been responsible for a substantial part of profits made by banks. Between July 1997 and Oct 2003, as interest rates fell, the yield on 10-year government bonds fell, from 13 per cent to 4.9 per cent. With yields falling, the banks made huge profits on their bond portfolios.
Conclusion
As the reader must have realised by now, bonds are not really a retail investor friendly type of investment. In our next article we will take a look at what is probably the friendliest form of investment for the retail investor, the mutual fund.
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