1. What is a bond?

In its most basic form, a bond acts as a debt instrument. Its kind of like an IOU or a
pledge to repay. When a company issues bonds (or a city, state, municipality etc.)
that company basically says, if you buy our bonds (loan us money) we promise to
pay you interest (coupon rate) over the life of the bond and when the full payment
is due (maturity date) we will pay you back the original investment. When you
purchase a bond, you buy it at one of three price points: at par, at a premium or at
a discount. A bond bought at par means the coupon rate equals the current interest
rate. A bond bought at a premium means the coupon rate is higher than the existing
interest rate and a discounted bond means the coupon rate is lower than the
existing interest rate. Bonds pay coupon payments semiannually. For example, a
two-year $1,000 bond with a 5 percent coupon would pay you two payments of $25
the first year, one $25 payment the first part of the second year and one final
payment of $1,025 the second half of the second year.
Par Value
Think of par value as par in golf. You made the hole in the required amount of
strokes, not too many and not too few. The price you pay for a bond centers on its
par value of 100 because when the bond matures you receive 100 percent of its
value.
Yield to Maturity
Yield to maturity, sometimes called YTM, really refers to the anticipated rate of
return of a bond if you hold it until it matures and if you reinvest all of your coupon
payments at a fixed interest rate. This represents the return you receive from your
entire investment, not just your initial bond investment.
Putting It Together
If you buy a $1,000 bond at par value and a coupon rate of 5 percent you will
receive interest payments of 5 percent each year until the bond matures. But what
if the current interest rate goes up to 6 percent? Well, you would still receive
payments of 5 percent interest on your bond because you have a locked-in rate. But
what if want to sell your bond? To make your 5 percent interest-bearing bond
attractive to buyers that can receive 6 percent interest on new bonds, you would
have to sell your bond at a discounted price. This discounted price has to make up
for the fact that the buyer receives a lower rate of return (yield to maturity) over the
life of your bond than from bonds currently in the market. So, as the interest rate
rose, the price of your bond dropped to compensate for the lower return rate (yield
to maturity) a buyer would receive from your bond vs. a newer bond at a higher
rate. The exact opposite happens if current interest rates drop and your bond has a
higher interest rate. The price of your bond would increase to offset the loss of
return a buyer would receive from new bonds at the lower interest rate.

2. What is the relation between price and yield to maturity of a

bond?
Yield is a figure that shows the return you get on a bond. The simplest version of
yield is calculated using the following formula: yield = coupon amount/price.
When you buy a bond at par, yield is equal to the interest rate. When the price
changes, so does the yield.
Let's demonstrate this with an example. If you buy a bond with a 10% coupon at
its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if
the price goes down to $800, then the yield goes up to 12.5%. This happens
because you are getting the same guaranteed $100 on an asset that is worth
$800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield
shrinks to 8.33% ($100/$1,200).

3. Increase in FII investment limit in debt market is a step in right

direction

Foreign institutional investors (FIIs) have invested $6.85 billion in bonds versus
$5.90 billion investment in equities so far this year. Last year, FIIs invested
$26.24 billion in bonds compared to $16.11 billion in equities. "We have seen
increased demand from FIIs for Indian debt securities," said Shashikant Rathi,
head of investments and capital markets, Axis Bank. "They are coming in a big
way with mixed objectives: To make trading gains in a falling interest rate
scenario, while earning relatively higher yield over a long period."
The 10-year benchmark government bonds are now yielding about 7.74%. Debt
market participants expect the yield on the 10-year bond to fall to 7%-7.25%
over the next 15 months led by interest rates cuts, helping them make trading
gains. Bond prices and yields move in opposite directions. "India is a heaven on
earth because you get about 7-8% returns on government bonds," said Hans
Rademaker, global chief investment officer at Robeco Group. "The yield gap with
other countries is quite big. Hence global asset allocators have put part of their
investments into India debt."
"There are many countries where you do not get any interest or they are at low
levels," he added. The 10-year US Treasury yields are at around 1.86%. The
higher rate in India comes at a higher risk as India's sovereign credit rating is at
the lowest of the investment grade --- BBB- (negative). US rating is at least fivesix notches higher at AA+. In Europe and Japan, rates are at around zero
percent. Till 2013-end, FIIs preferred equities over debt because stock valuations
were cheaper then. But after the yearlong rally since February 2014, valuations
have become rich. The 30-share BSE Sensex is now trading at 15.6 times oneyear forward price-toearnings multiple, which is relatively expensive compared
to MSCI Emerging Market Index which is trading at 10.8 times. "Indian bonds
look more preferred by FIIs over equities," said Ashish Vaidya, executive director
and head of trading and asset liability management at DBS Bank. "The real

interest rate is now at about 2.25% in India, which is attractive when compared
to other emerging nations." The real interest rate is derived by subtracting retail
inflation rate from the RBI's benchmark policy rate, now at 7.50%.

4. How Interest rate is likely to move in India? What kind of

investment strategy is most suitable in this condition?

Markets have previously been rattled by speculation that the US Federal Reserve
might look to adopt a tighter monetary policy. Investors fear another taper
tantrum - the name given to the market's reaction in 2013 to then Fed boss Ben
Bernanke's suggestions of QE being reined in.
In the end, after much to-ing and fro-ing, when the end of QE did actually arrive,
markets took it in their stride. This time round, potential interest rate moves are
being very clearly and carefully signposted. There were expectations earlier this
year that the Fed would raise US rates this summer - now a September rise is
widely predicted. If this comes it won't be a surprise.
The consensus among UK economists is that the Bank of England wont raise
rates until early to mid-2016 - money markets agree - but these forecasts in the
past have often proved notoriously wide of the mark. Last week, Bank of England
governor Mark Carney sparked a rate rush with comments that the Bank Rate
may rise at around the turn of the year. In reality, this was little different to
previous guidance but is did bring the subject into sharp focus. It is worth
bearing in mind that interest rate rises normally spell losses for bonds and many
parts of the equity market. The fear is that this time round a bull market founded
on ultra-low interest rates could come unstuck. Many suggest the risk is not that
rates rise at the gentle path mapped out but that they have to rise much faster
due to a sudden return of inflation - this could trigger a major deterioration in
sentiment and send bond and bond-like blue chip share prices tumbling.
5. What are the possibility of fed rate hike and its likely impact on Indian
Capital market?
Investors in the US reacted favorably on Wednesday as the Federal Reserve
moved a step closer to its first rate hike since 2006. As the central banks
outlook pointed to a hike in June or later in the year, Indian markets, too, may
not be impacted much for now. However, a sooner-than-expected hike would
impact markets and also lead to volatility in the rupee. Sandeep Singh explains
the issues around India and the US Fed decision.
1. Why is a rate hike anticipated?
The US economy grew at 5 per cent in the quarter ended September 2014. The
data came in December 2014, and on January 28, the Federal Open Market
Committee (FOMC) the policy-setting body of the Federal Reserve System
said faster progress towards the committees employment and inflation
objectives may result in a hike in rates sooner than anticipated. Markets have
speculated ever since on a rate hike announcement. Following FOMC January,
the BSE Sensex fell for seven trading sessions, losing over 1,400 points. Over the
last two trading sessions FIIs have pulled out a net Rs 1,154 Crores.

2. What is the likely impact of a US Fed rate hike on the Indian markets?
Indian markets anticipate a rate hike, and as the Fed has indicated to do so in
June or later, markets may not be impacted much. If, however, the hike comes
earlier, or if the quantum of hike is more than expected, markets may react
sharply. Funds may flow out of both debt and equity markets, and put under
pressure the rupee, which over the last couple of weeks has inched towards 63
against the dollar.
3. Why will a hike in interest rates in US result in outflows?
The differential between interest rates in the US and India is big, and a small
hike in the US may not be attractive enough. However, a signal from the US Fed
will ultimately lead to subsequent rate hikes. A series of hikes in interest rates in
the US over a period of time will raise the borrowing cost for carry trade (borrow
from US and invest in India), and thereby reduce their risk-adjusted return in
India. On the other hand, the Reserve Bank of India has embarked on cutting
interest rates, and has cut repo rates twice by 25 bps each. A cut in India and a
hike in US further reduces their risk-adjusted return. Experts also say that this
may make US bonds more attractive. The US is in any case considered a safe
haven, and investors looking for stable returns will be more attracted towards US
bonds.
4. How will it impact the equity markets?
The outflow of funds may not be restricted to the debt market, and extend to
equity markets because a higher return from a safer instrument (US bonds) may
be considered a better investment for conservative investors or funds who may
have parked funds in Indian equities. Emerging market equities are anyway
considered a risky asset, and therefore India, along with other emerging
markets, are more vulnerable to outflows when the US raises its federal funds
rate.