Module-16 Session-31 Introduction to Analysis

31.1 What is Bond?

Bond is a which pays a fixed amount of interest periodically to the holder of record. It also repays a fixed amount of principal at the date of . Generally bonds are issued by the government, states, municipalities and corporations. Some bonds do not pay interest, but all bonds require a repayment of principal. When an investor buys a bond, he/she becomes a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities. On the other hand bond holder has a greater claim on an issuer’s income than a shareholder in the case of financial distress. The important intrinsic features of bond are , maturity, principal value, and the type of ownership are. The coupon of a bond indicates the income that the bond investor will receive over the life (or holding period) of the issue. This is known as interest income or coupon income. The term to maturity specifies the date or the number of years before a bond matures (or expires). The principal, or par value, of an issue represents the original value of the obligation. This is generally stated in Rs1, 000 increments from Rs1, 000 to Rs. 25,000 or more. Bonds also differ in terms of ownership. With a bearer bond, the holder, or bearer, is the owner, so the issuer keeps no record of ownership. Interest from a bearer bond is obtained by clipping coupons attached to the bonds and sending them to the issuer for payment. In contrast, the issuers of registered bonds maintain records of owners and pay the interest directly to them. 31.2 Types of Generally the bond markets are divided by the maturity of the bond. • Money Market – This market deals with the short-term issues that mature within one year • Notes – This market comprises the intermediate-term issues that mature between one and ten years • Bonds – This market deals with the long-term obligations with maturity greater than ten years

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All these bond markets vary across the countries on the basis of the term to maturity of the instruments available in that market. 31.3 Types of Bonds Along the dimension of bonds can be classified into secured and secured bonds. Secured (senior) bonds are backed by a legal claim on some specified property of the issuer in the case of default. For example, mortgage bonds are secured by real estate assets; equipment trust certificates etc. Unsecured bonds () are backed only by the promise of the issuer to pay interest and principal on a timely basis. As such, they are secured by the general credit of the issuer. Bonds also can be classified into convertible and non-convertible depending upon whether they carry a conversion feature or not. Convertible bonds are those which can be converted into equity shares at the option of the bondholders. In this case the ratio of conversion (the number of shares exchanged for the converted portion) or alternatively the conversion price (the price at which equity shares are exchanged for the converted portion of the debentures) and the period during which the conversion can be effected are specified at the time of the issue. Convertible bonds can either fully convertible or partly convertible. In the case of partly convertible bonds, the non-convertible portion will carry interest until it is repaid as per the provisions in the indenture. Non-convertible bonds cannot be converted to equity share. The bonds are also categorized by their issuers. Bonds issued by the government are termed as treasury bonds. For example, dated securities released by the government. These bonds are normally issued for longer maturity. Municipal bonds are debt securities issued by states, cities, counties and other governmental entities to finance capital projects, such as building schools, highways or sewer systems, and to fund day-to-day obligations. Investors who buy municipal bonds are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.” The date when the issuer repays the principal, the bond’s maturity date, may be years in the future. Short-term bonds mature in one to three years, while long- term bonds generally will not mature for more than a decade. The bonds are issued by the corporations are termed as corporate bonds. These bonds are traded in the secondary market and the price of the bonds depends on the market interest rates ruling at the time of trading. Some of the bonds are defined on the basis of interest rate structure also. In the case of floating rate bonds interest rates are floated with some reference rate in the market. For

2 example, a bond can be issued with a feature that the interest rate on this bond is 1 percent above the bank rate. The rates of interest are always in tune with the market rates because of this special feature of floating. Other type of bond available in the market is indexed bonds. In these bonds the principal and coupon payments are linked to the market index like inflation and price index. Index bonds are attractive to investors as they are safer than the convention bonds in terms of real interest rate risk and inflation expectation risk. Indexed bonds apart from providing safety to investors also provide a steady interest income from investment while keeping the principal intact. Because both coupon and principal payments of an indexed bond are adjusted for inflation, an investor can count on the steady purchasing power provided by the coupon interest payment during the life of the bond. Further when an indexed bond matures, its principal has the same purchasing power as when it was invested. Junk bonds are high yield bonds issued by companies and are considered highly speculative because of high risk of default. Callable bonds give the right to the issuer to redeem the bond the bond prior to its maturity to date at a specified call price. The bonds are beneficial to its issuer when the coupon interest paid by the bond is higher than the prevailing interest rates. Basically the company can issue the same bonds at a lower interest rate leading to lower cost of financing. Puttable bonds can be redeemed prior to maturity at the initiative of the bondholder. These bonds are more advantageous to the investors as they get an opportunity to redeem their bonds when the prevailing market interest rate is more than the coupon interest on bonds. This feature enables the investors to unlock their current investment and invest in more profitable avenues. 31.4 Types of Bonds in India (1) Money Market Instruments (A) Treasury Bills . Represent short-term obligations of the Government . Maturity Period: 91 Days, 182 Days and 365 days . They don’t carry any explicit coupon rate . They are sold at a discount and redeemed at par value . There is a very active secondary market for this (B) Certificate of Deposits . Represents a negotiable receipt of funds deposited in a bank for a fixed period . They are sold at a discount and redeemed at par value

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. There is a very active secondary market for this (C) . Represents the short-term unsecured promissory notes issued by firms . They are sold at a discount and redeemed at par value . There is not active secondary market for this (2) Government Securities and Govt. Guaranteed Bonds . Issued by RBI on behalf of GOI and State Governments . Interest payments are semi annually . They are essentially medium to long-term bonds (3) Corporate Bonds . Issued by corporations, banks, public sector units . Issued on the basis of maturity: (i) Short Term Maturity: - Security with maturity period less than one year, (ii) Medium Term: - Security with maturity period between 1year and 5 year, (iii) Long Term Maturity: -Such securities have maturity period more than 5 years, (iv) Perpetual: - Security with no maturity. Currently, in India Banks issue . . It can also be issued on the basis of coupon: (i) Fixed Rate Bonds:-have a coupon that remains constant throughout the life of the bond, (ii) Floating Rate Bonds: - Coupon rates are reset periodically based on benchmark rate, (iii) Zero-coupon Bonds no coupons are paid. The bond is issued at a discount to its face value, at which it will be redeemed. There are no intermittent payments of interest . Categorized on the basis on Option (i) Bond with call option: - This feature gives a bond issuer the right, but not the obligation, to redeem his issue of bonds before the bond's maturity at predetermined price and date, (ii) Bond with put option: - This feature gives bondholders the right but not the obligation to sell their bonds back to the issuer at a predetermined price and date. These bonds generally protect investors from interest rate risk. . These are classified on the basis of redemption: (i) Bonds with single redemption: - In this case principal amount of bond is paid at the time of maturity only, (ii) Amortising Bonds: - A bond, in which payment made by the borrower over the life of the bond, includes both interest and principal, is called an amortizing bond.

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Table 31.1 Participants and products in Debt Market in India Issuer Instruments Maturity Investors

Central T-Bills 91/364 days RBI Bank State Dated 5-13 Years Banks, Insurance Companies, Government Securities Provident Funds

PSUs Bonds 5-10 Years Banks, Corporates, Mutual Funds, Individuals Corpoartes Debentures 1-12 Years Banks, Mutual Funds, Individuals etc/ Commercial Certificate 15 days to 1 Year For Banks, Mutual Funds, Individuals Banks of Deposits FIs it is 1 to 10 Year etc/

31.5 Indenture Provisions of Bond It is the contract between the issuer and the bond holders specifying the issuer’s legal requirements. A trustee acting on behalf of the bond holders ensures that all the indenture provisions are met including the timely payment of interest and principal. 31.6 Calculation of Bond Return

Pi,t+1 + Inti,t HPR i,t = where: Pi,t

HPRi,t = the holding period for bond i during the period t

Pi,t+1 = the market price of bond i at the end of period t

Pi,t = the market price of bond i at the beginning of period t

Inti,t = the interest payments on bond i during period t The holding period yield (HPY) is: HPY = HPR - 1 31.7 Interpretation of Bond Quotes • Quoted on basis of yield or price • Price quotes are percentage of par Example: 98 1/2 is not $98.50 but 98.5% of par A municipal Rs. 5,000 bond quoted at 98 1/2 would be Rs. 4,925

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Corporate Bond Quotes

• Notations used in bond quotations – “cv” = convertible – “zr” = zero coupon – “dc” = deep discount (at time of issue) • Accrued interest must be added to price quoted

Questions and Answers Q1: What are the different types of Bond Market? Ans. Types of Bond Market: Bond market is divided by maturity

• Money Market - short-term issues that mature within one year • Notes - intermediate-term issues that mature between one and ten years • Bonds - long-term obligations with maturity greater than ten years Types of Bonds in India

(a) Money Market Instruments i. Treasury Bills • Represent short-term obligations of the Government • Maturity Period: 91 Days, 182 Days and 365 days • They don’t carry any explicit coupon rate • They are sold at a discount and redeemed at par value • There is a very active secondary market for this

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ii. Certificate of Deposits • Represents a negotiable receipt of funds deposited in a bank for a fixed period • They are sold at a discount and redeemed at par value • There is a very active secondary market for this iii. Commercial Paper • Represents the short-term unsecured promissory notes issued by firms • They are sold at a discount and redeemed at par value • There is not active secondary market for this (b) Government Securities and Govt. Guaranteed Bonds • Issued by RBI on behalf of GOI and State Governments • Interest payments are semi annually • They are essentially medium to long-term bonds (c) Corporate Bonds • Straight Bond (Plain Vanilla Bond) • Zero Coupon Bond • Floating Rate Bond • Bonds with Embedded Options • Commodity-Linked Bonds

Q2: How to calculate Rates of Return on a Bond Portfolio.

Ans. Holding Period Return (HPR) = Holding Period Yield (HPY) + 1

Pi,t+1 + Inti,t HPR i,t = Where, Pi,t

HPRi,t = the holding period for bond i during the period t

Pi,t+1 = the market price of bond i at the end of period t

Pi,t = the market price of bond i at the beginning of period t

Inti,t = the interest payments on bond i during period t

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Q3: Write short note on Floating Rate Notes. Ans. Floating Rate Notes (FRN) is a bond issued for medium to long-term which pays coupons that are pegged to a level of certain floating index which is called reference index. FRN A note with a variable interest rate. Features of Floating rate Notes: • Reference Index • Quoted margin to Reference Rate (default risk premium) • Reset Frequency (Period of Coupon Payment) • Observation Date (for Index) • Maturity Date

Q4: Explain the intrinsic features of a Bond. Ans. Intrinsic Features: . Coupon: Indicates the income that the bond investor will receive over the life of the issue. . Term to Maturity: The date or the number of years before a bond matures. • Term Bond: Single Maturity Date • Serial Obligation Bond: Series of Maturity Dates . Principal or Par value: It is the original value of obligation . Types of Ownership • Bearer Bond • Registered Bond . Types of Issues • Secured (Senior) Bond: Backed by a legal claim on some specified property of the issuer in the case of default. • Unsecured Bond (Debentures): Backed by the promise of the issuer to pay interest and principal on a timely basis. . Features Affecting a Bond’s Maturity • Callable • Non callable • Deferred call

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