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2/18/2015 PTeducationEverythingAboutBonds

Everything
AboutBonds

The need for money | Bonds | Bonds vs. Shares | Face Value/Par Value | Coupon / Interest Rate | Maturity | Issuer and quality of bond
Rating systems | Bond Prices | Concept of Bond Yield | Yield To Maturity (YTM) | Price Yield relationship | Policy interest rates and Bond Yields
Calculating the Yield of a Bond | Bonds issued by Governments in India | Government Security | Treasury Bills (Tbills) | Cash Management Bills
(CMBs) Dated Government Securities | Types of Instruments | Open Market Operations (OMOs) | Liquidity Adjustment Facility (LAF)
Major players in the Government Securities market | Repo / Reverse Repo | Repo Rate | Yield | Yield Curve
Indian bond markets 2014 current update (Dec 2014)

EverythingAboutBonds

1.0 The need for money


Individuals need to borrow money from time to time, to meet various needs. And that is precisely the case with companies and governments also.
Companies need funds to create new products, conduct R & D, expand into new markets, and governments need money for large scale projects like
infrastructure (for ex. Golden Quadrilateral road project) to subsidies for various types of social programs (for ex. MGNREGA).

2.0 Bonds
The problem starts when large companies have to execute projects whose size is far more than the amount of funds their lead banker or even a
syndicate of banks can provide. Then the only way out is to reach the general public through a public market by issuing Bonds. Thousands or lacs of
investors then lend a small amount of money (the Bond Face Value) that is part of the capital needed by the company (or the government). Thus, a
bond is a creditorship security. It is a loan for which you are the lender (creditor). The company that sells the bond is known as the bond issuer and
becomes the borrower.

Bonds pay interest to the lenders, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon (or coupon
rate). The date on which the issuer has to repay the amount borrowed (known as Face Value) is called the Maturity Date. Thus, bonds are known as
fixedincome securities because you know the exact amount of cash you'll get back if you hold the security until maturity.

For example, say you buy a bond with a face value of Rs.1,000, a coupon of 8%, and a maturity of 10 years. This means you'll receive a total of Rs.80
(Rs.1,000 x 8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semiannually, you'll receive two payments of
Rs.40 a year for 10 years. When the bond matures after a decade, you'll get your Rs.1,000 back.

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3.0 Bonds vs. Shares
Thus, bonds are debt instruments, whereas stocks are equity instruments. This is the important distinction between the two. By purchasing equity
(stock) an investor becomes a partowner in a corporation. Ownership comes with voting rights and the right to share in any future profits (through
dividends). By purchasing debt (bonds) an investor becomes a creditor to the company (or the government). The primary advantage of being a creditor
is that you have a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder.
However, the bondholder does not share in the profits (through dividends) if a company does well he or she is entitled only to the principal plus
interest.Hence, there is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.

It has been observed that stocks (shares) earn more for an investor than do bonds. In the past, this has generally been true for time periods of at least
10 years or more. Legends like Warren Buffett have only reinforced the story. However, this doesn't mean people do not invest in bonds. Bonds are
appropriate when you cannot tolerate the shortterm swings of the stock markets. Thus, for your retirement, when you wish to live off a fixed income,
bonds are best. A retiree cannot afford to lose his/her principal as income for it is required to pay the bills.

4.0 Face Value / Par Value


The face value (also known as thepar value or the principal) is the amount of money a holder will get back once a bond matures. A newly issued bond
usually sells at the par value. Corporate bonds normally have a par value of Rs.1,000, but this amount can be much greater for government bonds.

What confuses many people is that the par value is not the price of the bond. A bond's price fluctuates throughout its life in response to a number of
variables (more on this later). When a bond trades at a price above the face value, it is said to be selling at a premium. When a bond sells below face
value, it is said to be selling at a discount.

4.1 Coupon / Interest Rate


The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon" because sometimes there used to be physical coupons
on the bond that you tear off and redeem for interest. However, this was more common in the past. Nowadays, records are more likely to be kept
electronically.

Most bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of
the par value. If a bond pays a coupon of 10% and its par value is, say, Rs.1,000, then it'll pay Rs.100 of interest a year. A rate that stays as a fixed
percentage of the par value like this is a fixedrate bond. Another possibility is an adjustable interest payment, known as a floatingrate bond. In this
case the interest rate is tied to market rates through an index, such as the rate on Treasury bills.

You might think investors will pay more for a high coupon than for a low coupon. All things being equal, a lower coupon means that the price of the
bond will fluctuate more.

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4.2 Maturity
The maturity date is the date in the future on which the investor's principal will be repaid. Maturities can range from as little as one day to as long as
30 years (though terms of 100 years have been issued).A bond that matures in one year is much more predictable and thus less risky than a bond that

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matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term
bond will fluctuate more than a shorter term bond.

4.3 Issuer and quality of bond


The issuer of a bond is a crucial factor to consider, as the issuer's stability is your main assurance of getting paid back. For example, the Indian
government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small so small that
government securities are known as giltedged securities (goldenedged) or riskfree securities. The reason behind this is that a government will
always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is far from
guaranteed. This added risk means corporate bonds must offer a higher yieldin order to entice investors. Why? Because that is the basis for the Risk
Return equation. Higher is the perceived risk, higher has to be return expected.

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4.4 Rating systems
The bond rating system helps investors determine a company's credit risk. There are independent thirdparty credit rating companies that do it for you.
The best companies are called the bluechip firms, which are safer investments, have a high rating, while risky companies have a low rating.

There are various credit rating agencies in India that do it for investors. The table below illustrates the same.

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The global system of credit rating also takes into account Sovereign States, as the following table indicates.

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4.5 Bond Prices
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Many new investors may be surprised to learn that a bond's price changes on a daily basis, just like that of any other publiclytraded security (for ex. a
share). A bond does not have to be held to maturity. You can hold it to maturity, or sell it earlier also.

At any time, a bond can be sold in the open market, where the price can fluctuate sometimes quite a lot.

4.6 Concept of Bond Yield


Yield is a figure that shows the return you get on a bond. Thus, Yield = Interest amount / Bond Price. When you buy a bond at par (face value), yield is
equal to the interest rate. But when the price changes, so does the yield.

An example of fluctuating yields

If you buy a bond with a 10% coupon at its Rs.1,000 par value, the yield is 10% (Rs.100/Rs.1,000).

But if the price goes down to Rs.800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed Rs.100 on an asset
that is worth Rs.800 (Rs.100/Rs.800). Conversely, if the bond goes up in price to Rs.1,200, the yield shrinks to 8.33% (Rs.100/Rs.1,200).

4.7 Yield To Maturity (YTM)


Of course, these matters are always more complicated in real life. When bond investors refer to yield, they are usually referring to YieldToMaturity.
This (YTM) is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest
payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if
you purchased at a discount) or loss (if you purchased at a premium). The whole calculation can be a bit complex!

4.8 Price Yield relationship


Summary of the relationship of yield to price: When price goes up, yield goes down and vice versa. Technically, you'd say the bond's price and its
yield are inversely related.

So, if you are a bond buyer, you want high yields. A buyer wants to pay Rs.800 for the Rs.1,000 bond, which gives the bond a high yield of 12.5%. On
the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by
selling your bond in the future.

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4.9 Policy interest rates and Bond Yields
However, the factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the
prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher
coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with
newer bonds being issued with lower coupons. So, with the RBIs monetary policy review from time to time, bond markets get affected.

The relationship between yield to maturity and coupon rate of bond may be stated as follows:

When the market price of the bond is less than the face value, i.e., the bond sells at a discount, YTM > current yield > coupon yield
When the market price of the bond is more than its face value, i.e., the bond sells at a premium, coupon yield > current yield > YTM
When the market price of the bond is equal to its face value, i.e., the bond sells at par, YTM = current yield = coupon yield.

4.10 Calculating the Yield of a Bond


An investor who purchases a bond can expect to receive a return from one or more of the following sources:

The coupon interest payments made by the issuer


Any capital gain (or capital loss) when the bond is sold
Income from reinvestment of the interest payments that is interestoninterest.

The three yield measures commonly used by investors to measure the potential return from investing in a bond are briefly described below:

(1) Coupon Yield The coupon yield is simply the coupon payment as a percentage of the face value. Coupon yield refers to nominal interest payable
on a fixed income security like Government security. This is the fixed return the Government (i.e., the issuer) commits to pay to the investor. Coupon
yield thus does not reflect the impact of interest rate movement and inflation on the nominal interest that the Government pays.

Coupon yield = Coupon Payment / Face Value

Example:
Coupon: 8.24, Face Value: Rs.100, Market Value: Rs.103.00, Coupon yield = 8.24/100 = 8.24%

(2) Current Yield

The current yield is simply the coupon payment as a percentage of the bonds purchase price; in other words, it is the return a holder of the bond gets
against its purchase price which may be more or less than the face value or the par value. The current yield does not take into account the reinvestment
of the interest income received periodically.

Current yield = (Annual coupon rate / Purchase price) x 100

Example:
The current yield for a 10 year 8.24% coupon bond selling for Rs.103.00 per Rs.100 par value is calculated below:
Annual coupon interest = 8.24% x Rs.100 = Rs.8.24
Current yield = (8.24/Rs.103) x 100 = 8.00%

The current yield considers only the coupon interest and ignores other sources of return that will affect an investors return.

(3) Yield to Maturity

Yield to Maturity (YTM) is the expected rate of return on a bond if it is held until its maturity. The price of a bond is simply the sum of the present
values of all its remaining cash flows. Present value is calculated by discounting each cash flow at a rate; this rate is the YTM. Thus YTM is the discount
rate which equates the present value of the future cash flows from a bond to its current market price. In other words, it is the internal rate of return
on the bond. The calculation of YTM involves a trialanderror procedure. Its calculation is a complex process.

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5.0 Bonds issued by Governments in India

5.1 A Government Security


It is a tradable instrument issued by the Central Government or the State Governments. It means that the Government has a debt obligation. Such

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securities can be short term (usually called treasury bills, with original maturities of less than one year) or long term (usually called Government
bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both, treasury bills and bonds while
the State Governments issue only bonds, which are called the State Development Loans (SDLs).

As said earlier, Government securities carry practically no risk of default and, hence, are called riskfree giltedged instruments. Government of India
also issues savings instruments (Savings Bonds, National Saving Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation of India
bonds, fertiliser bonds, power bonds, etc.). They are, usually not fully tradable and are, therefore, not eligible to be SLR securities (SLR = Statutory
Liquidity Ratio).

5.2 Treasury Bills (Tbills) Tbills, which are money market instruments, are short term debt instruments issued by the Government of
India and are presently issued in three tenors, namely, 91 day, 182 day and 364 day. Treasury bills are zero coupon securities and pay no interest. They
are issued at a discount and redeemed at the face value at maturity. For example, a 91 day Treasury bill of Rs.100/ (face value) may be issued at say
Rs. 98.20, that is, at a discount of say, Rs.1.80 and would be redeemed at the face value of Rs.100/. The return to the investors is the difference
between the maturity value or the face value (that is Rs.100) and the issue price. The RBI conducts auctions usually every Wednesday to issue Tbills.
Payments for the Tbills purchased are made on the following Friday. The 91 day Tbills are auctioned on every Wednesday. The Treasury bills of 182
days and 364 days tenure are auctioned on alternate Wednesdays. Tbills of of 364 days tenure are auctioned on the Wednesday preceding the reporting
Friday while 182 Tbills are auctioned on the Wednesday prior to a nonreporting Fridays. The Reserve Bank releases an annual calendar of Tbill
issuances for a financial year in the last week of March of the previous financial year. The Reserve Bank of India announces the issue details of Tbills
through a press release every week.

5.3 Cash Management Bills (CMBs) The GoI, in consultation with the RBI, has decided to issue a new shortterm instrument, known as
Cash Management Bills (CMBs), to meet the temporary mismatches in the cash flow of the Government. The CMBs have the generic character of Tbills
but are issued for maturities less than 91 days. Like Tbills, they are also issued at a discount and redeemed at face value at maturity. Investment in
CMBs is also reckoned as an eligible investment in Government securities by banks for SLR purpose under Section 24 of the Banking Regulation Act,
1949. First set of CMBs were issued on May 12, 2010.

5.4 Dated Government Securities Dated Government securities are long term securities and carry a fixed or floating coupon^ Top
(interest rate) which is paid on the face value, payable at fixed time periods (usually halfyearly). The tenor of dated securities can be up to 30 years.

The nomenclature of a typical dated fixed coupon Government security contains the following features coupon, name of the issuer, maturity and face
value.

For example, 7.49% GS 2017 would mean:

Coupon 7.49% paid on face value


Name of Issuer Government of India
Date of Issue April 16, 2007
Coupon Payment Dates Halfyearly (October 16 and April 16) every year
Minimum Amount of issue/ sale Rs.10,000

5.5 Types of Instruments


Fixed Rate Bonds These are bonds on which the coupon rate is fixed for the entire life of the bond. Most Government bonds are issued as fixed rate
bonds.

Floating Rate Bonds Floating Rate Bonds are securities which do not have a fixed coupon rate. The coupon is reset at preannounced intervals (say,
every six months or one year) by adding a spread over a base rate.

Zero Coupon Bonds Zero coupon bonds are bonds with no coupon payments. Like Treasury Bills, they are issued at a discount to the face value. The
Government of India issued such securities in the nineties, It has not issued zero coupon bond after that.

Capital Indexed Bonds These are bonds, the principal of which is linked to an accepted index of inflation with a view to protecting the holder from
inflation. A capital indexed bond, with the principal hedged against inflation, was issued in December 1997. These bonds matured in 2002. The
government is currently working on a fresh issuance of Inflation Indexed Bonds wherein payment of both, the coupon and the principal on the bonds,
will be linked to an Inflation Index (Wholesale Price Index). Bonds with Call/ Put Options Bonds can also be issued with features of optionality
wherein the issuer can have the option to buyback (call option) or the investor can have the option to sell the bond (put option) to the issuer during the
currency of the bond.

Special Securities In addition to Treasury Bills and dated securities issued by the Government of India under the market borrowing programme, the
Government of India also issues, from time to time, special securities to entities like Oil Marketing Companies, Fertilizer Companies, the Food
Corporation of India, etc. as compensation to these companies in lieu of cash subsidies. These securities are usually long dated securities carrying
coupon with a spread of about 2025 basis points over the yield of the dated securities of comparable maturity. These securities are, however, not
eligible SLR securities but are eligible as collateral for market repo transactions. The beneficiary oil marketing companies may divest these securities in
the secondary market to banks, insurance companies / Primary Dealers, etc., for raising cash.

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5.6 Open Market Operations (OMOs)
OMOs are the market operations conducted by the Reserve Bank of India by way of sale/ purchase of Government securities to/ from the market with
an objective to adjust the rupee liquidity conditions in the market on a durable basis. When the RBI feels there is excess liquidity in the market, it
resorts to sale of securities thereby sucking out the rupee liquidity. Similarly, when the liquidity conditions are tight, the RBI will buy securities from
the market, thereby releasing liquidity into the market.

5.7 Liquidity Adjustment Facility (LAF)


LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks (excluding RRBs) and primary dealers to avail of liquidity in
case of requirement or park excess funds with the RBI in case of excess liquidity on an overnight basis against the collateral of Government securities
including State Government securities. Basically LAF enables liquidity management on a day to day basis. The operations of LAF are conducted by way
of repurchase agreements with RBI being the counterparty to all the transactions. The interest rate in LAF is fixed by the RBI from time to time.
Currently the rate of interest on repo under LAF (borrowing by the participants) is 6.25% and that of reverse repo (placing funds with RBI) is 5.25%. LAF
is an important tool of monetary policy and enables RBI to transmit interest rate signals to the market.

5.8 Major players in the Government Securities market


Major players in the Government securities market include commercial banks and primary dealers besides institutional investors like insurance
companies. Primary Dealers play an important role as market makers in Government securities market . Other participants include cooperative banks,
regional rural banks, mutual funds, provident and pension funds. Foreign Institutional Investors (FIIs) are allowed to participate in the Government
securities market within the quantitative limits prescribed from time to time. Corporates also buy/ sell the government securities to manage their
overall portfolio risk.

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5.9 Repo / Reverse Repo
Repo means an instrument for borrowing funds by selling securities of the Central Government or a State Government or of such securities of a local

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authority as may be specified in this behalf by the Central Government or foreign securities, with an agreement to repurchase the said securities on a
mutually agreed future date at an agreed price which includes interest for the fund borrowed.

Reverse Repo means an instrument for lending funds by purchasing securities of the Central Government or a State Government or of such securities of
a local authority as may be specified in this behalf by the Central Government or foreign securities, with an agreement to resell the said securities on a
mutually agreed future date at an agreed price which includes interest for the fund lent.

Repo Rate
Repo rate is the return earned on a repo transaction expressed as an annual interest rate.

5.10 Yield
The annual percentage rate of return earned on a security. Yield is a function of a securitys purchase price and coupon interest rate. Yield fluctuates
according to numerous factors including global markets and the economy.

5.11 Yield Curve


The graphical relationship between yield and maturity among bonds of different maturities and the same credit quality. This line shows the term
structure of interest rates. It also enables investors to compare debt securities with different maturities and coupons.

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6.0 Indian bond markets 2014 current update (Dec 2014)
Yields on 10year Government of India bonds have dropped to 7.97 per cent, below the Reserve Bank of Indias (RBI) benchmark repo rate of 8
per cent.
Foreign institutional investors, for instance, have poured in $25.3 billion into Indias debt markets so far this year, as against just $ 16.5 billion of
net equity purchases.
Bonds are fixedincome securities offering investors an interest rate (coupon) along the original principal on maturity.
Returns on Indian bonds are amongst the highest in the world today. The last auction of 10year government security on November 28 fetched a
yield of 8.1 per cent, which, on a consumer price inflation of 6 per cent, translates into a real return of over 2 per cent. For global investors, an 8
per cent return is great, especially when the rupee isnt particularly vulnerable to depreciation (unlike last year) and 10year bond yields are
ruling at 0.4 per cent in Japan, 0.75 per cent in Germany and 2.3 per cent in the US.
It makes good business to borrow overseas in dollars or yen and invest in rupeedenominated Indian bonds.
The best time for this is now before RBI starts cutting policy interest rates.
The repo rate is what RBI charges for overnight, i.e. oneday maturity, lending to banks. Normally, shortterm interest rates are below longterm
rates. This results in an upward sloping yield curve, reflecting higher yields for longerterm investments. What we are now seeing is the reverse,
with the cost of 10year money being lower than that of oneday money. An inverted yield curve, in other words.
An inverted yield curve is usually associated with an impending recession. When shortterm interest rates exceed longterm rates, it points to lack
of lending opportunities for projects that take into account prospects for the economy beyond the immediate future.
If that outlook is poor, nobody would want to borrow for the longterm and the demand for funds is limited to the short end of the market.
Given our political reality today, the inverted yield curve in this case seems artificial, having more to do with a deliberate RBI move to keep policy
rates high.
Since September 30, 2014, when RBI presented its last monetary policy review, yields on 10year government bonds have fallen from 8.51 to 7.97
per cent and touching 7.94 per cent in intraday trade on Wednesday, the lowest levels since July 19, 2013.
This has happened despite RBI keeping its repo rate unchanged at 8 per cent. The repo rate was 8 per cent even when 10year yields hit a high of
9.1 per cent this year on April 7.
If market bond yields are falling with an unchanged repo rate, it suggests a deliberate central bank policy to push shortterm rates higher,
generating an artificial inverted yield curve.
Yields declines take place when there is expectation of interest rates falling. It results in high demand for bonds that were issued at high coupons.
As high demand pushes up bond prices, their yields drop correspondingly to even below the original coupon rates. For illustration, consider a bond
with 10 per cent coupon bought at an issue price of Rs 1,000. The annual yieldtomaturity in this case is 10 per cent (100/1000). But if the bond
price shoots up to Rs 1,200, the yield falls to 8.33 per cent (100/1200).
The bond yield declines now taking place are simply on account of the markets factoring in interest rate cuts which they see as inevitable in a
context of global crude prices crashing and reinforcing bearish pressures on other commodities as well.
The RBI, however, wants more conclusive evidence of the ongoing disinflationary impulses being real and durable.
This is not the first time we are seeing an inverted yield curve. It happened last year, too, when RBI raised lending rates under its marginal
standing facility as part of exceptional liquidity tightening measures aimed at defending the rupee.
The idea behind hiking the cost of shortterm borrowings, then, was to deter speculators who were allegedly using these to accumulate dollars and
short the rupee. But today, there is no such threat.
With inflation clearly on a downward trajectory, there is simply no reason for RBI to keep policy rates high for too long. At least, thats what the
markets believe. Governor Rajan seems to have different ideas, though!
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