This article aims to explain the basic construct of the bond and knowledge of fundamental parameters which you will need to consider bond investments.
What is a Bond?
A bond is a financial instrument whereby you lend to an entity and earn a fixed return for the amount you have lent.
There are some terminologies which you will encounter when you are looking into bond investments.
The easiest way to learn these terminologies is through an example. Consider the ten year Government of India bond. The below is quoted as per RBI NDS OM Platform, which is the official platform of RBI for Gsec bond trade & settlement.
The face value or par value is the amount of money the bondholder will be repaid on the bond’s maturity. A newly issued bond sells typically at face value, and there is no regulation that mandates the face value of any bond.
In the table given above, the face value/par value of the security is Rs. 100 as it is a G Sec (Government Security).
In India, publicly issued corporate bonds generally have a face value of Rs. 1000 while that of the government bond is Rs. 100. However, in the Private Placement market, the Face Value of a corporate bond is usually either Rs 1 lakh or Rs 10 lakhs.
ISIN stands for International Securities Identification Number, and it is a 12 digit unique code to identify specific security. Hence there could be scenarios of a single entity having multiple ISINs as it may have issued various securities.
The coupon is the interest amount the bondholder will receive until its maturity. The coupon of the bond is different from the yield of the bond.
The coupon for the G Sec given in the table above is 5.85%. It means that the bondholder will receive 5.85% of the bond’s face value until its maturity, i.e. Rs 5.85 ( FV of Rs 100 * 5.85%).
Further, the interest can be paid on various frequencies like annually, semi-annually, etc.
The coupon rate can be fixed (as in this specific case of 5.85%) or a floating / variable rate.
The bond price refers to the bond’s market price, which fluctuates throughout its life depending on several factors. It is different from the face value of the bond.
When a bond is trading at a price below the face value, it is trading at a discount. Similarly, if it is trading above the face value, it is trading at a premium.
In the example given above, the price of the bond (last traded price) is Rs. 99.1175, which is less than the bond’s par value. Hence the bond is trading at a discount.
Yield to Maturity:
Yield to maturity (YTM) is the total return anticipated on a bond if held until it matures.
If YTM > coupon rate, the bond would be trading at a discount.
If YTM < coupon rate, then the bond would be trading at a premium.
If YTM = Coupon Rate, then the bond would be trading at par.
How do people calculate YTM? Well, there is a hard way and an easy way. The hard way requires either excel or a financial calculator, and the easy way will give you rough but a close estimate.
Let’s see the hard way first.
Let’s consider the semi-annual bond example above, where the clean price would be calculated as shown below at issuance.
“n” is the tenor
Applying this equation at issuance, let’s say the bond was issued at par. Then if you try to calculate YTM with the above formula, you will get precisely 5.85%, which is equal to the coupon rate.
There is another simpler way to calculate the YTM, you could simply use the below formula:
As you can see, this formula will give approximation and not the exact answer. The answer is close but still 4 bps away from the actual value.
While all these computations appear complex, the inference is that YTM indicates the riskiness of the instrument.
The higher the yield, the risk is perceived to be higher. As the yield falls, the bond price increases; as the risk is reducing, the bond becomes more valuable and the price increases. Similarly, the corollary is, as the yield increases, the bond price decreases.
If you are looking to grow your wealth, you may consider investing in bonds. To know more, contact us today at firstname.lastname@example.org