Ask Mint | Insight into the bond family4 min read . Updated: 20 Aug 2007, 04:14 PM IST
Ask Mint | Insight into the bond family
Ask Mint | Insight into the bond family
Johnny: I heard someone say that gentlemen prefer bonds. I thought that he was referring to James Bond, but he started taking different names that I have not even heard of, such as convertible bonds, strip bonds, junk bonds and many others of the same family. How come this bond family has become a favourite choice of gentlemen?
Jinny: Well, gentlemen prefer bonds because gentlemen always like to get confused. In case you also want to confuse anybody, start talking to him about bonds, which come in so many varieties. Bonds are of different kinds, but all of them have essentially one common characteristic that makes all of them part of a family—they are all debt instruments. Like any other debt instrument, all of them pay interest. In financial terms, the payment of regular interest is also called “coupon" payments and the rate at which the interest is paid is called the “coupon rate". A bond of Rs100 face value having a 10% coupon rate per annum will fetch you a payment of Rs10 every year as interest. However, the manner in which this interest is paid may be different for different kinds of bonds. For instance, in a zero coupon bond, there is no regular payment of interest. You purchase the bond at a discounted value and, later on, redeem the same at its face value. The difference between the discounted value and the face value represents your interest earning. Similarly, in case of inflation-linked bonds, the rate of interest to be paid is decided by some benchmark index and hence your earnings may go up or down depending upon the index. The risk-return profile of different bonds differs. Government bonds are less risky but their return is also low. Junk bonds are more risky, but their return is high.
Johnny: So far so good. But I have heard bond traders talk about “current yield". What’s that?
Jinny: The coupon rate of a bond gives you the interest earned as a percentage of its face value, whereas current yield gives you the interest earned as a percentage of its current market price. A bond may trade in the market at a price different from its face value. A bond having Rs100 of face value may trade at a premium price of Rs105 or at a discount price of Rs95 depending on the current interest rates. Suppose you purchase a Rs100 bond, earning Rs10 of interest per annum at a market price of Rs105. Then you can calculate the yield by taking out the percentage of interest earned at the current market price. Since the earning will remain constant during the rest of the tenure of your bond, any rise in the market price will lower the yield. Similarly, any fall in the market price will increase your yield. Confused?
Johnny: I have many questions in mind. First of all, what makes a bond trade at a premium or discount to its face value? And what role does the change in interest rates play in the change of market price of bonds?
Jinny: Changes in interest rates play a very vital role. Bond prices and interest rates always move in reverse directions. If one rises, the other falls. As I have already said, all bonds pay you interest, which is also known as the coupon rate. A coupon rate of 10% per annum on a bond of face value Rs100 will fetch you an interest of Rs10 every year. You will continue earning Rs10 during the entire tenure of your bond. But suppose current interest rates fall tomorrow to 2%. Then what will happen? It will surely not affect the earning on your bond, which will continue to fetch you the same return. However, any new bond will fetch a coupon rate of 2% per annum only. So a new bond of Rs100 will fetch only Rs2 as return in a year. This scenario will push up the market price of your existing bond to a level where the current yield from your bond is aligned with the current interest rates. Likewise, any rise in the interest rates pushes down the price of bonds carrying lower coupon rates. Since your old bonds carry lower coupon rate than the prevailing interest rate, you sell your bonds at a discount to the face value.
Johnny: Enough, Jinny! I have started getting confused. Let the bond traders worry about bond prices. Lets talk about something different.
Jinny: I will spare you for now. But there are many interesting things about bonds, which I will like to share with a gentleman like you some other time.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@ livemint.com