What Are Bonds And What Happens When It Is Traded? – Part 1

Basics of Bonds

In one of our previous articles on How a company raises capital, we discussed raising capital using two methods. One is equity and the other one is debt. Today let us discuss types of debt instruments.

Debt instruments are used to transact money between two people/companies who have surplus money and who are in money deficit. Those who issue debt instruments are called issuers. Issuers issue debt instruments to raise money. There are various types of products in the DEBT market as mentioned below.

  • Government issues T-bills to borrow money for a short term and issues securities to borrow money for a long term.
  • PSU or Private company issues Bonds to raise money.
  • Corporate issues debentures to borrow money for long term and issues commercial papers to borrow money for short term. 
  • If Banks are in need of money, then they issue certificates of deposit. Other banks, Government or other financial institutions invest in these certificates of deposit.

What is Fixed Income ?

The investor is aware of the following details upfront.

  •  Maturity period of the investment –  Tenure 
  •  Returns received on the investment made in a regular interval until maturity – Coupon 
  • Maturity value – Investment amount received at the end of the tenure – Principal

How is the coupon (interest) determined ?

We have to understand “Inflation” before we discuss coupon. The value of Rs.100/- before 10 years is not the same now. The value of money has decreased, this is known as inflation. The buying power of Rs.100 has decreased today as compared to 10 years ago. Similarly the value of Rs.100 will further decrease every year. The average inflation rate in India is around 5-7% per year. 

So, When we invest in an instrument, we will expect the return to be more than inflation. Therefore, the coupon rate (i) should be equal to the sum of inflation rate (I) and the real rate (R) 

i = I + R

i=Coupon 

I = Inflation 

R = Real Return – over and above the inflation

The real return depends on the risk of the bond. The bonds issued by Private companies will give more return  than PSU bonds.  It means that the risks involved in private company bonds are more than the PSU bonds.

If the inflation is high then your fixed return will also be on the higher side, and vice versa.  If inflation and interest rates are always on the higher side then the borrowers will hesitate to borrow at high interest. Similarly at lower inflation and interest rate the lender will be disappointed to lend at very lower rates. So, inflation and interest rates will always fluctuate (and fluctuate in the same direction) within a range depending on demand in the economy.  

Example of a Fixed Bond investment:

Face value of the bond is Rs.100/- – Face value is the original value of the bond.

Tenure – 10 years – The investment duration will be 10 years

Coupon – 10% payable annually.

  • The investor buys the above bond in the primary market at the face value i.e Rs.100/-.
  • He will receive interest of Rs.10/-  every year till 9th year of the investment (Coupon 10% of the face value Rs.100) 
  • At the end of 10th year the investor will receive coupon and the principal amount invested i.e Rs.100 + Rs.10 = Rs.110/-

What if Bond is traded in the market ?

Now let’s look at what happens when the interest rate moves after purchasing the above mentioned bond. Assume that interest rates have been moved to 11% and you  want to sell the bond in the secondary market.

Since similar bonds in the market available for 11% return the purchase of the bond will demand a lesser price than the face value of the bond. If the purchaser buys at face value i.e Rs.100/- then he will receive a coupon of Rs.10/- every year which is a loss for the purchase since the market return is Rs.11/-.  So the price of the bond will be discounted (lesser than the face value) in the market. The loss in interest rate will be compensated with the price of the bond.The discounted price may be say Rs.90/- since Rs.1 loss for the tenure of 10 years. 

Similarly if the interest rates decrease in the market and now if you want to sell your bond then you can demand a Premium (higher price than the face value) since the other bonds in the market are issued at a lower interest rate.The premium price of the bond may be Rs.110/- since Rs.1 profit for the tenure of 10 years.

If the Fixed Income Bond is made to trade in the secondary market then Face value of the bond will be known as Price. Coupon(Rate of Interest) will be known as Yield.  Tenure ( period of the bond) will be known as Maturity.

The source of returns in the Bond Funds are the interest income and mark to market gains/losses.

We will discuss more about bond price changes, bond yields and other features of bonds funds in the next part.

Tc Stay Safe.

2 thoughts on “What Are Bonds And What Happens When It Is Traded? – Part 1”

Leave a Reply