Bond Prices

Bond prices move inversely to interest rates. When interest rates go up, bond prices go down
and when interest rates go down, bond prices go up. Remember, we’re talking about
previously issued bonds trading on the open market.

The inverse relationship is easy to see with this simple illustration.

A bond is issued for $10,000 for five years with a 5% coupon or interest rate, paid every six
months. Then interest rates rise to 6%.

If you want to sell this bond, who would buy it when it is paying 1% below market rates (5%
vs. 6%)? You have to sweeten the deal so the buyer gets a market rate for the bond.

You can’t change the interest rate on the bond. That’s fixed at 5%. You can, however change
the price you will take for the bond.

The annual payment of $500 ($10,000 x 5%) must equal a 6% payment. Doing the math, you
discover that the face value of the bond must be discounted to $8,333 so that the $500 fixed
payment equals a 6% yield on the buyer’s investment ($8,333 x 6% = $500).

If interest rates went down instead of up, you could then sell your bond at a premium over
face value because the fixed interest rate would be higher than the market rate.

Zero coupon bonds or zeros don’t make regular interest payments like other bonds do. You
receive all the interest in one lump sum when the bond matures.

You purchase the bond at a deep discount and redeem it a full face value when it matures.
The difference is the interest that has accumulated over the years

Zero coupon bonds generally come in maturities from one to forty years. The U.S. Treasury
issues are the most popular ones, along with municipalities and corporations.

Here are some general characteristics of zero coupon bonds:

• Issued at deep discount and redeemed at full face value

• Some issuers may call zeros before maturity
• You must pay tax on interest annually even though you don’t receive it until maturity
• Zero coupon bonds are more volatile than regular bonds

Of the three kinds of zero coupon bonds, U.S. Treasury bonds are the most popular.

However, the U.S. Treasury doesn’t issue them directly; you have to buy “STRIPS” from
qualified financial institutions or brokers.
STRIPS stands for Separate Trading of Registered Interest and Principal of Securities and it
means a financial institution has taken a regular U.S. Treasury issue and separated the
principal and interest payments into two separate securities.

The normal income is packaged and sold to investors who need a reliable cash flow and the
principal becomes a zero coupon bond.

Basic Bond Concepts

There are four basic concepts that will help you understand bonds:

• Par value - Par value, also known a face or principal value, is how much the
bondholder will receive at maturity. A $1,000 par value bond will be worth $1,000 when it
matures.
• Coupon - Coupon is the interest rate the bond pays. It is called the coupon rate
because bonds once came with a book of coupons, which the holder had to clip and send in
to receive an interest payment. Bond investors are still referred to sometimes as "coupon
clippers." This interest rate does not vary over the life of the bond, although there are
some bonds, which have a variable interest rate tied to an external index.
• Maturity - Maturity refers to the length of time before the par value is returned to the

bondholder. It may be as short as a few months, 50 years, or more. At maturity, the

bondholder receives the par value of the bond.

Understanding Yield

The term you will hear about bonds the most is their yield and it can be the most confusing. I
broke this concept out separately because there are really three different types of yield to
explain:

1. Nominal Yield - This is the coupon or interest rate. Nothing else is factored in to this
number. It is actually not very helpful.
2. Current Yield - The current yield considers the current market price of the bond, which
may be different from the par value and gives you a different return on that basis.
For example, if you bought a $1,000 par value bond with an annual coupon rate of 6%
($1,000 x 0.06 = $60) on the open market for $800, your yield would be 7.5% because
you would still be earning the $60, but on $800 ($60 / $800 = 7.5%) instead of $1,000.
3. Yield to Maturity - Yield to Maturity is the most complicated, but the most useful
calculation. It considers the current market price, the coupon rate, the time to maturity
and assumes that interest payments are reinvested at the bond's coupon rate. It is a very
complicate calculation best done with a computer program or programmable business
calculator. However, when you hear the media talking about a bond's "yield" it is usually
this number they are talking about

Bonds can be classified based on the following

Issuer
Coupon Rate
Term to Maturity

Based on the type of issuer bonds can be classified as

Classification of bonds

Government bonds
Municipal bonds
Corporate bonds

Please visit "Bond Market/Fixed Income Market Basics" post for the detailed discussion
of issuer based bonds.

Based on the coupon payment mode bonds can be classified as

Fixed coupon
Floating coupon
Inverse floater
Zero coupon

Fixed Coupon bonds

Usually these bonds are long term in nature. The interest rate and hence the amount of
coupon is fixed irrespective of market conditions and the benchmark rate. The coupon is
payable at specified time intervals before bond maturity, usually semi annually.

Floating coupon

The interest rate is reset periodically on the coupon reset date, in advance of the period to
which it applies, based on some widely used benchmark rates LIBOR, treasury index
rate.
The general formula isreference rate/benchmark rate + quoted margin.

Inverse Floater

These bonds pay a variable coupon that changes in direction opposite to the benchmark
rate. An inverse floater subtracts the reference rate from the set coupon rate.
The general formula isInterest rate – reference rate/benchmark rate

Zero coupon bonds

Zero coupon bonds do not pay intermittent coupons. The accumulated coupons are paid
at the end of the maturity along with the principal. They are issued at a deep discount as
the face value which is paid out at the end of maturity contains principal as well as
interest. The difference between the face value (the amount received at the end of
maturity, in this case) and the issue price represents the coupon for zero coupon bonds.

Based on the term to Maturity bonds can be classified as

Callable bonds
Puttable bonds
Convertible bonds

Callable bonds

A bond which gives the issuer right to call back (redeem) a bond prior to its maturity
under certain conditions. These conditions and the price of redemption are
predetermined. Usually the redemption value is slightly more than the par value. The
earlier the bond is called the higher is the redemption value. A company calls a bond if
the interest rate of the issued bond is high compared to the market rate on similar
instruments. It can reissue bonds at lower coupon rates by calling back the high interest
rate bonds. Usually callable bonds carry call protection i.e. there is some period of time
after issuance of bonds during which the issuer can’t call them.

Puttable bonds

Investors can sell the bond back to the issuer, prior to maturity, at a price decided when
the bond is issued. If the market interest rate is higher than the coupon rate of the bond
then the investors can exercise the right of put and purchase another bond from the
market.

Differences between Callable and Puttable bonds

A call option is positive for the issuer where as a put option is good for the
investors.Callable bonds are issued at discount prices compared to puttable bonds for the
same profile. In the case of a callable bond, the individual with a long position in this
security will essentially long the bond and short the embedded call option. In a puttable
bond, the individual with a long position in this security will essentially long the bond
and long the embedded put option.

Convertible bond

A convertible bond gives the holder of the bond to convert the debt securities to common
shares of the issuer. The equity shares are allocated based on a convertible ratio.

What is Investment?

Investment is referred to as the concept of deferred consumption, which might comprise

of purchasing an asset, rendering a loan, keeping the saved funds in a bank account such
that it might generate lucrative returns in the future. The options of investments are huge;
all of them having different risk-reward trade off. This concludes that the investment
industry is really broad and that is why understanding the core concepts of investments
and accordingly analyzing them is essential. After thorough understanding of the
 investment industry, can an investor create and manage his own investment portfolio
such that the returns are maximized with the least risk exposure

Types of Investments in the investment industry

As stated earlier, the investment industry is huge; therefore the types of investments are
also varied. Different types of investments are: Cash investments: Cash investments
comprise of savings bank accounts, certificates of deposit (CDs) and treasury bills (TBs).
All these types of investments render a low interest rate and prove to be quite risky
during times of inflation.

Debt securities: This type of investment gives returns in the form of fixed periodic
payments and the fixed capital appreciate at maturity. This is safe bait for the investors in
the investment industry and has always proved to be the risk free investment tool.
Though, it is generally low in risks, the returns are also lower than the other peer
securities.

Stocks: Investors can also buy stocks (equities) from the secondary markets and be a part
of any business corporates that are listed in the bourses. By this way, one can become the
part of the profits that the company generates. But one should remember that stocks are
generally more volatile and carries more risk than bonds.

Mutual funds: They are usually a collection of stocks and bonds that a fund manager
selects for an investor such that the returns are maximum. The investor does not have to
track the investment, be it a bond, stock- or index-based mutual funds.

Derivatives: Derivatives are financial contracts, whose value is derived from the value of
the underlying assets like equities, commodities and bonds. They can take the form of
futures, options and swaps. Investors choose derivatives as they are used to minimize the
risk of loss that result from variations in the underlying asset values.

Commodities: The items that are traded on the commodities market are agricultural and
industrial commodities and they need to be standardized. Commodities trading have
always been giving high returns and thus they are the riskiest of all investment options.
One, who trades in commodities, requires specialized knowledge and analytical
capabilities.

Real estate: Investing in real estate has to be a long term affair. Funds get hooked into
the real estate sector for a considerable time period.

The investment industry in India - how is it going? India's equity market has doubled
since March 2009, with ADRs like Dr. Reddy's Laboratories and Tata Motors only
getting doubled and tripled. So, do we say that the Indian investment industry is
overheated at the moment or may we infer that the stocks are fairly valued?
Warren Buffett has always mentioned that investment in India should always be a long-
term story - as the industry has been growing from an emerging market to a developed
one. The next 10 years in India will surely give good returns.

India's GDP growth would be around 6.5% to 7% in 2010. The sustainable growth rate of
India would however hover around 7%. Before becoming a mature economy, India has
another 20 to 40 years to spare.

Where to invest in India?

The financial sector in India, specifically the banking stocks have been doing well now.
The health of the Indian banks seems to be strong and a lot of growth is expected in the
organic frontier. The IT stocks too have been faring well and that is why it is advisable
that the investors invest in stocks of quality companies that have a good earnings track
record. The other choice of stocks has been the consumer goods stocks, auto stocks,
agriculture-related stocks. Some of the favorite scrips that investors can look forward to
are Infosys Technologies, HDFC Bank, ICICI Bank.

Challenges of Indian Investment industry

The investing story in India has not been always that smooth. Pitfalls are sure to co-exist.
The main restraint on India's growth now happens to be its infrastructure. On the other
hand, infrastructure is India's biggest opportunity as well. The fiscal deficit of India also
poses a big threat to the investment industry in India. For an emerging economy like
India, it is recommended that an investor always balances the unique risks against the
potential for high long-term growth. Accordingly the decision for investment should be
made.

Of late, the Indian economy is turning out to be extremely conducive in terms of

domestic and foreign investments. India Investments has been the major propelling force
towards India's attainment of self-sustained growth by way of rapid industrialization. The
pioneers of the investment industry has been Foreign Direct Investment (FDI) and
Investments made by NRIs.

Foreign Direct Investments in India has been gearing up momentum every passing day.
So, to view an economy which is entirely open to the global markets, the investment
industry in India should be groomed in a manner that the maximum returns are achieved.
It is advisable that the investment industry's potential should neither be overestimated nor
underestimated. We should know how to deal with the complexities of the investment
industry and grow along with it
From last bull.com
http://www.treasurer.ca.gov/cdiac/publications/duration.pdf- bond duration