BOND MARKET

INTRODUCTION
What is bond?
A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer.

INTRODUCTION(Cont..)
BOND MARKET: it also called debt market. In which the borrower can raised the money from secondary market. The primary goal of bond market is to provide mechanism for long term funding of public and private expenditures.

Bond differ in several respects

Repayment type Issuer Maturity Security Priority in case of default Spot and forward rates Nominal and real interest rates Zero coupon bonds Coupon bonds

Bond structure
Principal: The amount borrowed Par (Face) Value: The amount repaid at end of loan Usually face value is equal to principal, but for bonds the original issue price (principal) may be slightly higher or lower Maturity: Years Until Face Value Repaid Coupon: Interest Payment Bonds usually have a fixed interest payment Loans often have floating coupon rates, tied to an index Bonds/loans that have no interest are called zero-coupon or discount bonds/loans Typically paid out twice a year (semi-annually) for bonds Coupon typically quoted as coupon rate = coupon/face value (Current yield = coupon/current price)

Bond structure(cont..)
Bonds are standardized instruments that are generally tradable Debentures are unsecured bonds with maturities of at least 15 years Bills are bonds with less than 1 year maturity (no interest payments) Amortized loan (like a mortgage) - equal repayment each period (part principal, part interest) Covenants: legal provisions that when violated give bondholder right to specific action such as forcing bankruptcy and demanding repayment. Security: pledged assets committed to paying off debt Seniority: order of payment in bankruptcy Secured debt, then Senior Debt, then Subordinated Debentures. Call provision: enables corporation to repay and retire the debt at will. Sinking funds: fund that firm contributes cash to for repayment. Rating: Investment Grade Bonds: Bonds rated Baa or higher by Moody's or BBB or higher by Standard and Poor. High-yield or "junk" bonds: not investment grade

Indian debt / bond market

The Indian debt market while composed of bonds, both government and corporate, is dominated by the government bonds. The central government bonds are the predominant and most liquid component of the bond market.

In the offing is the new Interest Rate Derivatives Segment. The bond markets exhibit a much lower volatility than equities, and all bonds are prices based on the same macroeconomic information.
Bond market liquidity is normally much higher than stock market liquidity in most of the countries.

Features and characteristics bond market

Face Value/Par Value The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value. Coupon (The Interest Rate) The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon"

Features and characteristics bond market (cont..)

Maturity The maturity date is the date in the future on which the investor's principal will be repaid. Issuer Fix-income (interest income) security: not affected by the operation and financial status of issuers. Specific repay period: issuers are obligated to repay the principal amount at maturity.

Some types of bond can be transferred freely, or as collateral and/or as a guarantee for business purpose

What are the advantages to invest in bonds?

Stable rate of return: Usually bond has fix or float coupon rate and its principal and interest payments are paid back by the issuers in a certain period.

Lower risk: There is no credit risk of government bond, and the financial bond and corporate bond issued by sound financial institutions are safer than the other securities.

What are the advantages to invest in bonds? (cont..)

Higher liquidity: Government bonds can be traded on the market anytime and are easy to be liquidized. Also they could be treated as deposit or court guarantee. Exempt from taxation

Difference between wholesale and retail debt market

Wholesale debt market

Retail debt market

Factors that affects price

Interest rate Inflation Financial position of issuer

Importance of bond market

Types of bonds
Government Bond

Corporate Bond

Municipal Bond

Types of bonds (cont..)

Tax-Savings Bonds

Callable Bonds

Puttable Bonds

Types of bonds (cont..)

Convertible Bonds

Non-convertible Bonds

Deep Discount Bonds/Zero Coupon Bonds

Types of bonds (cont..)

Bull Dog Bonds

Inflation Index Bonds

Junk Bonds

Participants in bond market

Central government Reserve bank of India Primary dealers State government, municipalities and local bodies Public sector units Corporate treasuries

Participants in bond market (cont..)

Public sector financial institutions Banks Mutual funds Foreign institutional investors Provident funds Charitable institutions, trusts and societies

Bond rating
Moddys Aaa S&P AAA Highest quality. Very small risk of default. Aa A AA A High quality. Small risk of default. High-Medium quality. Strong attributes, but potentially vulnerable. Baa BBB Medium quality. Currently adequate, but Quality of Issue

potentially unreliable.
Ba BB Some speculative element. Long-run prospects questionable. B B Able to pay currently, but at risk of default in the future. Caa Ca CCC CC High speculative quality. May be in default. C C Lowest rated. Poor prospects of repayment. D Poor quality. Clear danger of default.

Bond Pricing
Formula:

Price
t 1

C M 1 r t 1 r n

P = Ct = r = M= t =

Price of the bond (in rs) Interest or coupon payments (in rs) Periodic required return Maturity value Time period when the payment is received

We can apply the formula for Present Value of an Ordinary Annuity

Price C PVIFAr1n M PVIFr1n

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Bond Pricing (cont..)

To illustrate how to compute the value of bond, consider a 10-year, 12% coupon bond with a par value of 1,000 let us assume the required yield on this bond is 13%. The cash flow of bond is are as follows: 10 annual coupon payments of Rs 120 Rs 1000 principal repayment 10 years from now
Price C PVIFAr1n M PVIFr1n P 120 PVIFA13%,10 yrs 1,000 PVIF13%,10 yrs

P 120 5.426 1,000 0.295

P = 651.1+295= Rs 946.1

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PricesYields 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 cash flow increases; hence the price increases.

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The Inverse Relationship Between Bond Prices and Yields

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Since the price of bond must equal its par value at maturity ( assuming that there is no risk default), bond price change with time. For example-

The commonly employed yield measures are : Current Yield Yield To Maturity Yield To Call Realized Yield To Maturity

The current yield relates the annual coupon interest to the market price. Its expressed as : current yield = Annual interest / Price Q. Find the current yield of a 10 year bond 12% coupon bond, which is par value of Rs 1,000/- & selling for Rs 950/-

BOND YIELD (CONT..)

Popularly referred to yield to maturity (YTM), it is the discount rate that make the present value of cash flow receivable from owning the bond equal to the price of bond. C ( M P) / n YTM Solve the bond formula for YMT 0.4M 0.6 P
Q. Considering a Rs 1,000/- par value bond, carrying a coupon rate of 9%, maturing after 8 years. The bond is currently selling for Rs 800. what is YTM on this bond??
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YTM vs. HPR

YTM
YTM is the average return if the bond is held to maturity. YTM depends on coupon rate, maturity, and par value. All of these are readily observable.

HPR (holding period return )

HPR is the rate of return over a particular investment period. HPR depends on the bonds price at the end of the holding period, an unknown future value. HPR can only be forecasted.

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Yield Spreads

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Risk associated with bonds

Default risk : unable to make timely payment of interest or principle Market risk: it is the uncertainty that the realized will deviate from the expected return because the interest rate changes. Interest rate risk: adverse change in interest rate Reinvestment rate risk: probability of a fall in rate resulting in lacks of option to invest interest at regular interval at higher rate

Counter party risk: it is normal risk associated with any transaction.

Price risk: it refers to the possibility of not being able to receive the expected price on any order due to adverse movement in the price.

Action innovation in bond market

Credit Policy - RBI Can Look At Opening Bond Markets Jan Dehn

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