AUTHOR: Rama Krishna Vadlamudi vrk_100@yahoo.co.

in
MUMBAI
October 5th, 2009

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Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 5th, 2009 Page 1 of 7

 INTRODUCTION OF BONDS

Bonds form a major part of treasuries. They are vital to the

functioning of a treasury. Debt market in India is awash with various
types of instruments. The debt market has registered an impressive
growth since the early 90s with the liberalization of financial markets
and the implementation of the Vaghul Committee recommendations.
In the world of finance, debt instruments play a crucial role; hence, a
basic understanding of certain concepts and methods used in debt
valuation is essential for treasury managers. This assumes added
significance in the light of the fact that the Government and the RBI
have initiated a slew of measures to deepen and widen the debt
markets in India and a new trading platform is being readied for a
comprehensive debt market.

In this article, the fundamentals of bonds, ranging from bond features,

factors influencing bond prices, bond risks to bond yields are
analyzed. After reading this, readers will be in a better position to
appreciate how bonds are valued, what causes the bond prices to
move on a daily basis in the market and how to mitigate risks
involved in bond prices.

DEFINITION OF BONDS

There are a whole host asset classes that are available for investors. A bond is
one of them to meet the financial goals of the respective investors. A bond is a debt
security or an obligation to repay money. Bonds are usually considered as fixed-income
securities because they carry a fixed rate of interest. Bonds provide a steady stream of
cash flows to the bondholders. Typically, interest is paid by the issuer at half-yearly
intervals. Governments issue bonds to raise money for spending on infrastructure
projects or for their day-to-day expenditure. Likewise, companies also raise money
through bonds to meet their capital expenditure or working capital needs. In the Indian
Securities Market, the term ‘bonds’ is generally used for debt instruments issued by the
Central and State Governments and public sector organizations; and the term
‘debentures’ is used for debt instruments issued by the private corporate sector.
However, the terms bonds, debentures, and debt instruments are used by the general
public inter-changeably.

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 BOND FEATURES

The leading attributes of a bond are:

1. The face value of the bond-face value or par value or principal refers to the
amount that will be paid to the bondholder at the time of maturity

2. The coupon rate or interest rate-the coupon is the amount the bondholder will
receive as interest payments and it is expressed as a percentage of the face
value

3. The maturity date-the date on which the issuer of the bond has to return the
principal to the investor

4. The name of the issuer-the borrower who receives the money at the time the
bond is issued
Government bonds provide high safety as they carry sovereign guarantee. They offer
sufficient liquidity, so that they can be encashed easily. The returns from the
Government bonds are moderate. However, corporate bonds carry higher returns, as
investors expect higher interest rates to offset the lower safety. Investors demand much
higher interest rates from companies which entail higher risk of default.
There are various financial investments, like, bonds, equity shares and bank deposits
(including term deposits and savings accounts). Bonds are typically used to rebalance
risks in a portfolio of investments, especially when expectations from equities are low.
Corporate bonds are usually rated by credit rating agencies to determine the aspects of
safety of principal and interest payments. Bonds in India are rated by certain agencies,
namely, CRISIL, CARE, ICRA and FITCH. They give ratings from ‘AAA’ to ‘D’-‘AAA’
carries the highest rating as to the safety of payment of principal and interest and ‘D’ the
lowest. Investors, who require bonds with higher safety, opt for AAA bonds and
investors, who are in need of higher interest, tend to choose AA or A bonds,
compromising a little on the safety aspect.

BOND RISKS

A bond by and large carries the following risks:

1. Interest rate risk-if interest rates rise, the bond prices will fall. Similarly, if interest
rates fall, the bond prices will go up

2. Credit risk-if there is any change in the issuer/debtor’s credit rating due to any
deterioration in the fundamentals of the issuer

3. Default risk-refers to the possibility that the bondholder will not be able to receive
either the principal or interest payments from the issuer, and

4. Liquidity risk-the possibility that the bondholder will not be able to encash the
bond due to non-marketability of a particular bond

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 5th, 2009 Page 3 of 7

The above risks are explained in detail below:
Interest Rate risk: Interest rates are defined in nominal terms. However, what really
matters is the real interest rates, which take into account the rise/fall in prices of future
goods and services. If nominal interest rate is eight per cent and the inflation rate is five
per cent, the real interest rate will be approximately three per cent (8%-5%). The
purchasing power of money decreases with every percentage rise in inflation, hence the
real return for the investor will come down. As experienced between the periods of 2000
to 2004 in India, savers suffered due to low interest rates. But of late, interest rates have
been on upward trajectory. The rising interest rates have benefited the savers.
Default Risk: It refers to the risk accruing from the fact that a borrower may not pay
interest and/or principal on time. It is involved when a party to a financial transaction is
unable or unwilling to meet the obligation under the contract.
Liquidity Risk: Barring some of the popular Government of India securities which are
traded actively, most debt instruments do not seem to have a very liquid market. (An
active debt market is under development-the Government and the RBI have of late been
taking various measures to deepen and widen the bond markets in India). Given the
poor liquidity, investors face difficulty in trading debt instruments, particularly when the
quantity is large. The investors may not be able to encash the bond immediately, that is,
the bond cannot be easily converted into cash.

VALUATION OF BONDS

The value of a bond is the present value of the promised cash flows on the
bonds, discounted at an interest rate that reflects the default risk in these cash flows.
Since the cash flows on a straight bond are fixed at issue, the value of a bond is
inversely related to the interest rate that investors demand for that bond. The straight
bond, also called a plain vanilla bond, is the most popular type of bond. It pays a fixed
periodic (usually semi-annual) coupon over its life and returns the principal on the
maturity date. The interest rate charged on a bond is determined by both the general
level of interest rates and the default premium specific to the entity issuing the bond.
There are two features that set bonds apart from equity investments. First, the
promised cash flows on a bond (that is, the coupon payments and the face value of the
bond) are usually set at issue and do not change during the life of the bond. Even when
they do change, as in floating rate bonds, the changes are generally linked to changes in
interest rates. Second, bonds usually have fixed lifetimes, unlike stocks; since most
bonds specify a maturity date (perpetual bonds are exception since they do not carry
any maturity date).

The effect of interest rate changes on bond prices will vary from bond to bond and
will depend on a number of characteristics of the bond:

1. Maturity of a bond: Holding coupon rates and default risk constant, increasing
the maturity of a straight bond will increase its sensitivity to interest rate changes.
The present value of cash flows changes much more for cash flows further in the
future, as interest rate changes, than for cash flows that are nearer in time. The
longer-term bonds are much more sensitive to interest rate changes than the
shorter-term bonds.

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 2. Coupon rate of the bond: Holding maturity and default risk constant, increasing
the coupon rate of a straight bond will decrease its sensitivity to interest rate
changes. Since higher coupons result in more cash flows earlier in the bond’s
life, the present value will change less as interest rates change. At the extreme, if
the bond is a zero coupon bond, the only cash flow is the face value at maturity,
and the present value is likely to vary much more as a function of interest rate
changes. The bonds with the lower coupons are much more sensitive, in
percentage terms, to interest rate changes than those with higher coupons.

While the maturity and the coupon rates are the key determinants of how sensitive
the price of a bond is to interest rate changes, a number of other factors impinge on this
sensitivity. Any special features that the bond has, including convertibility (as in the case
of convertible bonds) and callability (as in the case of callable bonds), make the maturity
of the bond less definite and can therefore affect the bond price’s sensitivity to interest
rate changes.

FACTORS INFLUENCING BOND PRICES

• Supply and demand factors for money in the monetary system

(the supply comes from the bank deposits, household savings, ECBs, FCCBs,
private corporate savings, public sector investments, etc; and the demand is from
the Governments, the private sector and the household sector)

• Market interest rates: any factors like, fluctuations in crude oil prices or revision in
administered fuel prices in India, policy actions from central bank or
governments, inflationary or deflationary pressures and other factors that
influence the market interest rates, will have a huge bearing on bond prices (if
inflation goes up, bond prices will come down and vice versa)

• Total borrowing of the Central and State Governments (As the Government
borrowing has reached gargantuan proportions, India’s G-Sec prices have fallen
heavily with the 10-yeach benchmark yield moving up from a level of 6.50 per
cent in the first week of June 2009 to a level of 7.50 per cent in the first week
September 2009)

• Market expectations/sentiments with regard to inflationary pressures

• Inflationary pressures in the economy and the policy makers’ response or non-
response to them

• Tax factors

• Bank credit off-take from the corporate sector

• The quantum of liquidity situation in the system

• Actions of the central bank in the country

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 • Overall GDP Growth rate and its expectations of the overall economy (As
recently as 2008, Government Bond – G-Secs – prices witnessed unprecedented
volatility driving down the 10-year G-Sec benchmark yield from a high of 9.54 per
cent in the last week of July 2008 to a low of 4.86 per cent in the first week of
January 2009. Some of the important factors that caused such huge increase in
bond prices were: 1. the perception that India’s GDP growth rate will shrink to
four or five per cent following the global financial crisis peaked in September
2008; 2. unprecedented interest rate cuts from RBI; and 3. sudden decline in
inflation rate – WPI – from a peak of 13 per cent to 6.50 per cent during that
period)

• The movements of bond, currency and derivatives markets are closely inter-
linked (well-known phrase used here is ‘BCD’ nexus) and as such the
movements of exchanges rates of the domestic country vis-a-vis other currencies
of the competing countries or trading partners influence the domestic bond prices
(After the collapse of Lehman Brothers in September 2008, the financial markets
had experience a ‘flight to safety’ and dollar money has moved from emerging
markets to the US and strengthening the US dollar in the process tremendously
and driving down the US bond yields to one of their lowest in several decades.
Since March 2009, the US dollar has started its decline against major currency
and in its wake the US yields have recorded a sudden surge taking the 10-year
US Treasury benchmark yield up to 4 per cent in the second week of June 2009)

• Forward looking or policy-related statements from officials (Governor or Deputy

Governors) of the Reserve Bank of India, the central bank in India

• Forward looking or policy-related statements from the Finance Minister or other

officials, like, Finance Secretary in the Ministry of Finance, Government of India

• Security provided

• Maturity period

• Callable feature of the bond

• Credit rating of the issuer

BOND YIELDS

The yield on an investment is loosely defined as the income one earns on it as a

percentage of what one spent on it. The crucial piece of information to know in order to
compare a bond with other potential investments is its ‘yield’, calculated by dividing the
amount of interest it will pay during a year by its price.
A bond’s yield need not always be same as its coupon rate. That’s because
some bonds can be bought and sold in the market; their open-market prices may go
above or below the par value as interest rates in the economy change. When bond
prices rise, the yield on them falls and vice versa. The reasons for the rise and fall in
bond prices are mainly due to:

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 5th, 2009 Page 6 of 7

 1. Changes in the company’s (that issued the bond) outlook, particularly risk profile,
and interest rate changes. Say a company offers a coupon of 10 per cent on its
bonds; if, however, interest rates fall two years later, the company may be able to
raise funds at eight per cent. Here, the older issue becomes more attractive and
an investor would pay more for a bond that returns 10 per cent.
2. If, however, there are project delays and the company is at risk of not being able
to service the interest, risk-averse investors may sell the bonds at a discount to
face value, pushing up the yield.
There are two important yield measures that are commonly used: current yield and yield-
to-maturity. They are explained below:

CURRENT YIELD

It is the simplest measure of the return one gets from a bond. It tells us how much return
the investor gets, in percentage terms, from the coupon rate against the market price of
a bond (that is, the coupon divided by market price). This does not take into account the
capital gain (or loss) that investor will realize if the bond is purchased at a discount (or
premium) and held till maturity. It also ignores the time value of money. If a bond that
cost Rs. 1,000 paid Rs. 80 a year in interest, its yield is eight per cent.

Current Yield = (Annual interest received / market price of bond) x 100

YIELD-TO-MATURITY (YTM)

It takes into account a lot more than the current coupon payment. Keep in mind bonds
make several coupon payments over a period of time. Towards maturity, we get only the
face value of the bond. As the date of maturity approaches for the bond, the market price
moves closer to the face value. The YTM takes into account all the coupon payments,
gains or losses on the price of the bond as it approaches maturity. The YTM of a bond is
the interest rate that makes the present value of the cash flows receivable from owing
the bond equal to the price of the bond.
If the bond is traded, and a market price is therefore available for it, the internal
rate of return can be computed for the bond (that is, the discount rate at which the
present value of the coupons and the bond’s face value is equal to the market price).
This internal rate of return is called the yield to maturity on the bond.

PRICE-YIELD RELATIONSHIP

A basic property of a bond is that its price varies inversely with yield. The reason
is simple. As the required yield increases, the present value of the cash flow decreases;
hence the price decreases. Conversely, when the required yield decreases, the present
value of the cash flow increase; hence the price increases.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Oct. 5th, 2009 Page 7 of 7