What is a bond?
A bond is a debt instrument that offers investors a reliable income stream through interest payments, with the principal amount being repaid on a specified maturity date. Bonds play a vital role in the financial market, serving as an essential source of capital for both corporations and government entities.
Different features of a Bond?
a. Issuer: Bond issuers borrow money from investors against bonds. Commonly known bond issuers are Central and State Governments, Municipal Corporations, Financial Institutions, Banks, Public Sector Units, Public and private limited companies.
b. Face Value: The face value or par value of the bond is the amount so declared by the issuer at the time of issuance, in the offer document. Usually face value is equal to the price of the bond at the time of issuance. In case of private placements of bonds, the face value is Rs.1 lac per bond. In case of public issue, the issuer is free to choose the face value; the industry practice is to fix it at Rs. 1,000/- per bond.
c. Price of bond: The price at which a bond is issued (issue price) or trades at (trading price).
d. Coupon rate: The issuer of the bond compensates the bondholders by paying them interest; the rate of interest is called the ‘coupon’ rate. The rate of interest or coupon payment varies depending upon the economic circumstances, the creditworthiness of the issuer, type of bond, maturity, etc.
e. Maturity: Bondholders get repaid at a specific date when the bonds get matured. The bonds are categorized as short-term (say 3-5 years) or long-term bonds (say 10 years and more) based on maturity period.
f. Yield: Yield means the return an investor gets from the bond for a specific time. If the bond is held till maturity, the return is termed as yield to maturity. The yield can be calculated considering the face value, interest payment frequency, maturity, and the market price of the bond.
Difference between coupon and yield
Coupon is the interest received by the bond holder till maturity. Yield is the return received by the bond holder from his date of investment at the then prevailing market price of the bond. On the date of allotment when the price of the bond is at par the coupon and yield of a bond is the same. The yield may be different once the bond price changes based on demand and supply
Relationship Between Bond Price and Yield
A direct bond sale to investors is a primary market transaction. But bonds can also change hands between investors in the secondary market. This is because bonds are tradable securities, like stocks. bond price changes based on demand and supply .
In a bond, the price and yield are inversely related to each other. i.e. if the price of the bond increases, its yield falls and if the price of a bond decreases, its yield increases.
When a bond’s price is lower than its face value, the bond yield exceeds the coupon rate. Conversely, when the bond price is above its face value, the yield falls below the coupon rate. Therefore, the calculation of bond yield is influenced by both the bond’s price and its coupon rate.
If the bond price decreases, the yield increases; if the bond price increases, the yield decreases. Let’s explore why this occurs:
When interest rates decline, the value of related investments typically falls. However, existing bonds maintain their original coupon rates, which may be higher than the current market rates. This higher coupon rate makes these bonds attractive to investors, prompting them to purchase them at a premium.
On the other hand, when interest rates rise, newly issued bonds offer higher returns than existing bonds. As a result, older bonds become less appealing, leading to a decrease in their prices as a form of compensation, causing them to be sold at a discount.
Understanding the Inverse Relationship Between Bond Price and Yield
Example 1: Price Increase Impact on Yield
Consider a 10-year bond priced at Rs 5000, featuring a coupon payment of Rs 200. The yield of the bond can be calculated using the following formula:
Yield = (Interest on Bond / Market Price of Bond) x 100
For this bond, the initial yield is calculated as follows:
Yield = (200 / 5000) x 100% = 4%
Now, let’s assume that due to strong investor demand, the price of the bond increases from Rs 5000 to Rs 5500. Despite the rise in price, the coupon amount remains unchanged at Rs 200. As a result, the new yield is recalculated:
Yield = (200 / 5500) x 100% = 3.64%
This example illustrates how an increase in the bond price leads to a decrease in yield.
Example 2: Price Decrease Impact on Yield
Now, let’s examine a scenario where the bond price decreases. Starting again with the bond priced at Rs 5000 with a coupon of Rs 200, suppose the price falls to Rs 4300 while the coupon payment remains the same:
Initial Bond Price = Rs 5000
Coupon = Rs 200
-New Bond Price = Rs 4300
The yield is now calculated as follows:
Yield = (200 / 4300) x 100% = 4.65%
In this situation, a decrease in the bond price results in an increase in yield.
These examples highlight the fundamental inverse relationship between bond prices and yields: as bond prices rise, yields fall, and conversely, as bond prices fall, yields rise.
Inflation impact on bond investments
Inflation impacts bond investments in two main ways:
Lower Real Returns: As bond payments are fixed, higher inflation diminishes the “real” value of these fixed returns. This occurs because the purchasing power of the interest payments you receive decreases when inflation rises.
Impact on Bond Prices and Yields:There is an inverse relationship between bond prices and yields. When inflation increases, central banks typically raise interest rates to mitigate inflationary pressures. Higher interest rates render existing bonds with lower coupon rates less appealing, resulting in a decline in their prices.
For instance, consider a bond that pays a 4% coupon. If inflation surges and the Reserve Bank of India raises interest rates to 6%, new bonds will offer higher yields. Consequently, investors will gravitate towards these new bonds, leading to a decrease in the price of your 4% bond in the secondary market.
Thus, in a scenario of rising inflation and interest rates, the prices of existing bonds tend to fall, which can result in potential losses if you decide to sell before maturity. Conversely, in an environment of declining inflation, bond prices typically rise as interest rates decrease, allowing for capital appreciation.