Wednesday, July 28, 2010

All you want to know about bonds

Individuals have surplus funds in the form of savings which they want to invest. Companies need funds to undertake good projects with high returns. Companies provide individuals with instruments to invest their savings in. One such instrument is corporate bonds. Similarly, governments also need funds for various developmental projects. Further, the government also needs to raise money to finance the fiscal deficit.

Characteristics of a bond
A bond, whether issued by a government or a corporation, has a specific maturity date, which can range from a few days to 20-30 years or even more. Based on the maturity period, bonds are referred to as bills or short-term bonds and long-term bonds.
Bonds have a fixed face value, which is the amount to be returned to the investor upon maturity of the bond. During this period, the investors receive a regular payment of interest, semi-annually or annually, which is calculated as a certain percentage of the face value and know as a 'coupon payment.'

Here is small presentation of outstanding govt bonds with Date of Maturity on X-axis
Government needs to repay it either by raising taxes, or issuing new debt. Issuing new Debt will again Interest Burden to Government, though we are not in position like that of Greece coz unlike Greece where debt is owned by other countries here debt is owned by local people like Banks,MF etc . I guess Govt is in Long term process of selling a few PSU and closing this Gap as  one can see that Govt has very large outstanding amount need to be repaid in 2014.

Issuing a bond
The government, public sector units and corporates are the dominant issuers in the bond market. The central government raises funds through the issue of dated securities (securities with maturity period ranging from two years to 30 years, long-term) and treasury bills (securities with maturity periods of 91 or 364 days, short-term).
The central government securities are issued for a minimum amount of Rs 10, 000 (face value). Thereafter they are issued in multiples of Rs 10,000. They are issued through an auction carried out by the Reserve Bank of India

Returns from the bond
The return on investment into bonds is in the form of coupon payments, as already mentioned before, and through capital gains. Capital gain occurs when the bond is bought at a discount. Bonds bought at a premium would result in capital loss.
And bonds bought at par would have no capital gain or loss. Together, the total return is known as the Yield from the bond.

Interest rate risk
Price and Yield share an inverse relationship. When price is high, yield is lower and when price is low, yield is higher (As can be seen in the way equation 1 would work). This brings us to the problem of Interest rate risk faced by bonds.
If the government suddenly decides to raise the prevailing interest rates, the expected yield from bonds held by the investors would go up. This would result in a drop in the price of the bonds. And if the investor wants to sell the bond for some reason, instead of holding it till maturity, he will have to suffer a capital loss.
On the contrary, if the interest rates are falling, the price of the bonds will rise and the investors can sell their bonds at higher prices in the secondary market than the price at which they bought the bond initially.
The reason for this inverse relationship is that, when interest rates are raised, the newer bonds issued by the government and the corporates, other investments like fixed deposits, post office savings schemes,etc offer greater return, with more or less the same kind of risk.
So an existing bond becomes less attractive. Investors want to sell off their existing investment in bonds and switch to other more attractive investments. The selling pressure in the bond market causes the prices of the bonds to drop. Similarly, when interest rates are dropped, price of bonds increases due to increase in demand.

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