-Bond terminology -Bond types -Indian bond market

Pavneet Khara Subhashni Sharma

What is a bond?
A bond is a long term contract under which a borrower

agrees to make payments of interest and principal, on specific dates to the holders of bonds.
Parties involved: purchaser (creditor) and issuer (debtor) A trustee maybe appointed by a corporate to represent the bondholders.

Who issues bonds?

Govt. bonds: these are issued by the government. They carry no default risk as the securities carry sovereign guarantee. But there prices decline when market rates rise.

Bills - debt securities maturing in less than one year. Notes - debt securities maturing in one to 10 years. Bonds - debt securities maturing in more than 10 years.

 Indian 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. Since the date of maturity is specified in the securities, these are known as dated Government Securities, e.g. 8.24% GOI 2018 is a Central Government Security maturing in 2018, which carries a coupon of 8.24% payable half yearly.

 Corporate Bonds: these are issued by corporate

houses. They are prone to default risk ( also called credit risk). If issuing company gets into trouble, it maybe unable to make promised interest and principal payments. These are generally the riskiest fixed-income securities of all, because companies - even large, stable ones are much more susceptible than the governments to economic problems, mismanagement and competition.

 But these can also be the most lucrative fixed-

income investment, since investors are generally rewarded for the extra risk the take. The higher the company's credit risk , the higher the interest that should be paid. Eg of corporate bonds listed on bse: Dr Reddys Laboratories L&T Finance Holdings Muthoot Finance National Highways Authority of India
Foreign bonds: these are issued by foreign govts or foreign corporations. These are exposed to default risk. There also exists a risk if bonds are denominated in a currency other than investors home currency.

Face value: the amount that will be repaid at the end of the loan. Also called the par value of bond. The bond that sells for its par value is called a par value bond.
Bonds coupons: The regular interest payments that

the issuer has to make . if it is constant and paid every year, type of bond is the level coupon bond.

 Coupon rate: annual coupon / face value.

Thus, if a bond has a par value of $1,000 and a coupon rate of 10%, the person holding the bond will receive $100 a year. The bond will also specify when the interest is to be paid, whether monthly, quarterly, semi-annually, or annually.
Maturity: the specified date on which the principal

amount of a bond is repaid.

Current Yield
It is the coupon payment as a percentage of the bonds

purchase price. Its return holder of bond gets againbst its purchase price which maybe less or more than the par value. Current yield= (annual coupon rate/ purchase price) *100

 Current yield of a 10 year 8.24% coupon bond selling at

rs.103 per rs.100 par value is Annual coupon interest = 8.24% * 100 = 8.24 Current yield = (8.24/103)*100= 8%

Yield to maturity (YTM)

It is the expected rate of return on a bond if it is held

until its maturity. Price of a bond is the sum of present values of all its remaining cash flows. And the present value is found out by discounting each cash flow at a rate which is YTM.

 As time passes, interest rates in the market change but

cash flows from a bond stay the same ( in case of level coupon bond) as a result the value of the bond will fluctuate. When interest rates rise, Present value of bonds remaining cash flows decline, and the bond is worth less. When rates decrease, the bond is worth more.

Interest rate risk

Its The risk that arises for bond owners from

fluctuating interest rates. The risk depends on how sensitive bonds price is to interest rate change. This sensitivity depends upon 2 things: Time to maturity. Coupon rate.

When market interest rates are higher

A bond has face value rs.1000. the coupon rate is 8%

while the market rate is 10%. Because this bond pays less than the market rate, investors are willing to pay something less than 1000 hence the bond will sell for less than its face value, its said to be a discount bond.

 The purchaser will get a gain only if he gets interest

rate up to 10%, but with fixed coupon rate this can happen only if the price of bond is lower than 1000. If this bond sells for 885, which is 115 less than the face value, the investor will get 80 per year and would have a 115 gain at maturity of the bond. This gain compensated the lender for below market coupon rate.

 Now in case interest rate drop by 2%, coupon rate

being 8%, the bond will sell for more than rs.1000. this bond is selling a a premium hence called a premium bond. The investors are willing to pay premium to get this extra coupon amount.
So, bond prices and interest rate always move in

opposite directions. When market rate = coupon rate, bond sells at its par value

The call provision

Call provision: an agreement giving a company the

option to repurchase a bond at a specified price prior to maturity.

Call premium: the amount by which the call price

exceeds the par value of bond. This value keeps decreasing as time to maturity decreases.

 Deferred call provision: a call provision prohibiting

the company from redeeming a bond prior to a certain date. For example for first 10 years of bonds life. During this period of prohibition, the bond is said to be call protected
Call protected bond: which during a certain period,

cannot be v redeemed by the issuer.

Refunding operation
Suppose a company sold bonds when interest rates

were higher. Now if the issue iss callable, the company could sell a new issue of low yielding securities if the interest rates fall. It can use the proceeds of new issue to retire the high rate issue and thus reduce its interest expense.

Impact of call provision

If interest rates go up, the company will not call the bonds and the investor will be struck with the original coupon rate. And if interest rates fall, the company will call the bond and pay off the investor, who will then have to invest the proceeds at current market rate, which is lower than the rate he was getting on original bond. Hence investor loses when rates increase cant reap the benefits when rate fall.

Put option
An option contract giving the owner the right, but not

the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy bonds.

 Bonds that are redeemable at par at the holders

option protect investors against a rise in interest rates. if interest rate have risen, holders can put a bond back with the issuer at par and reinvest the proceeds at higher rate.

Sinking funds
Some bonds include a sinking fund provision that

facilitates orderly retirement of bond issue. The firm may deposit money with a trustee which invests the funds and uses accumulated sum to retire the bonds when they mature.a failure to meet this requirement may throw a bond in default.

Administering sinking fund

A company may call in for redemption a certain %age

of bonds each year. The company may buy bond in open market. bonds with sinking funds are safer and hence carry lower coupon rates.

The Indenture
Its a written agreement between the borrower and its

creditors. Its a legal document it includes: Basic terms of bond Total amount of bonds issued Description of property used as security Repayment arrangement Call provisions

Bond types these are bonds on which the coupon Fixed Rate Bonds:
rate is fixed for the entire life of the bond. Most govt. bonds are issued as fixed rate bonds. Eg.The 8.15 per cent government security maturing in 2022
Floating rate bonds: these are debt securities which do

not have a fixed coupon rate. the interest rate is linked to a benchmark rate. (Treasury bill rate, MIBOR are commonly used) If IR rises, investor benefits as he earns higher interest and if IR falls, borrower can raise funds at a low cost. These are vulnerable to IR risk. There is a cap or floor option on certain bonds.

 Zero coupon bonds: these are bonds with no coupon

payments. It is offered at a price which is much lower than its stated face value ( like the treasury bills). Companies with projects having large gestation periods issue these as there is no immediate interest commitment. eg. Mahindra and Mahindra, HB Leasing and Finance.
Deep discount bonds: its a zero coupon bond with very high maturity, greater than 15 years. IDBI introduced them in 1992

 Capital indexed bonds: The rate of interest on CIBs

is calculated as a fixed percentage over the wholesale price index (WPI) or consumer price index (CPI). These securities are issued at face value. The interest rate changes according to the change in the WPI, as the interest rate is fixed as a percentage over the WPI. The maturity of these securities is fixed and the interest is payable on half-yearly basis. The principal redemption is linked to the WPI.

 The inflation indexed bond could have both principal

and coupon linked to the inflation rate or it could have only the principal linked to the inflation rate with the coupon being paid on the nominal amount. In December 1997, the RBI issued capital indexed bonds at a coupon rate of 6% maturing in the year '02. The coupon was not adjusted for inflation and paid at the rate of 6% per annum on the nominal value of the capital indexed bonds.

 Income bond: it is required to pay interest only if

earnings are high enough to cover interest expense. These are riskier than the regular bonds from investors view. If earnings are not sufficient, then company is not required to pay interest and bondholders cannot force the company into bankruptcy.

 Convertible bonds:

these have the option to convert the bonds into a fixed number of shares of common stock at an agreed-upon price. these offer lower interest rate than an identical non convertible bond. It is a hybrid security with debt- and equity-like features. Although it typically has a coupon rate lower than that of similar, non-convertible debt, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company's equity value.

From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.

 The 8.15 per cent government security maturing in 2022

dipped to Rs 99.5625 from 99.7750 yesterday, while its yield rose to 8.21 per cent from 8.18 per cent. The 8.33 per cent government security maturing in 2026 fell to Rs 100.2250 from Rs. 100.54, while its yield surged 8.30 per cent from 8.26 per cent. The 8.19 per cent government security maturing in 2020 plunged to Rs 99.6200 from Rs 99.8250 while its yield gained to 8.26 per cent from 8.22 per cent. The 8.07 per cent government security maturing in 2017, the 7.83 per cent government security maturing in 2018 and the 8.20 per cent government security maturing in 2025 were also quoted lower at Rs 99.5600, Rs 98.11 and Rs 99.48 respectively.

 The dated Government securities market in India has two

segments: Primary Market: The Primary Market consists of the issuers of the securities, viz., Central and Sate Government and buyers include Commercial Banks, Primary Dealers, Financial Institutions, Insurance Companies & Co-operative Banks. RBI also has a scheme of noncompetitive bidding for small investors (see SBI DFHI Invest on our website for further details). Secondary Market: The Secondary Market includes Commercial banks, Financial Institutions, Insurance Companies, Provident Funds, Trusts, Mutual Funds, Primary Dealers and Reserve Bank of India. Even Corporates and Individuals can invest in Government Securities. The eligibility criteria is specified in the relative Government notification.