BOND MARKET

Prepared by
Dr Snigdha Sarkar
K.S.O.L., Bhubaneswar
 INTRODUCTION
Bond markets are biggest market in the world.
These are the most important and required debt
market for any economy.
These are the traded in capital market as debt
instrument. As we know capital market is famous
for long term funding for long term investment. the
capital market provide the investors the source of
capital expenditure.
Capital expenditure refers to the purchase of a long
term asset which can be used for long duration in
economic activities. It involves return.
 BOND
Definition: It is a long term obligation.it is issued
by government or corporation. It includes face
value and coupon rate or coupon.
Face value is a round number like
₹1,000,₹10,000,₹100 etc. coupon rate is the rate
of interest or periodic earning from the bond. It
may involve semi annual payment or annual
payment.
 What is Coupon?
• Coupon is nothing but the interest or the returns earned
from an investment in a bond or debt instrument.
• It is the amount paid by the borrower to the lender.
The borrower has the right to use the money
borrowed for a specified period. The coupon amount is
paid by the borrower to the lender for this right earned.
• Coupon is expressed as a percentage on the principal
amount.
• Principal amount means the amount that has been lent
originally by the lender to the borrower and coupon is
the percentage of that amount.
It is denoted on a per annum basis.
For example, 772GS8025 means that the coupon
rate is 7.72% per annum.
On the basis of the loan arrangement, the coupon
can be paid monthly, quarterly, semi-annually or
annually.
While entering into a loan transaction or buying the
debt instrument you will come to know whether the
instrument is coupon bearing or not.
In case it is, you may receive the coupon/ interest
amount periodically, say semi-annually or quarterly,
as mentioned above.
 TYPES OF BONDS
1. Treasury Bonds: issued by central
government.
(i) T-Bonds: Maturity period is more than 10
years
(ii) T-Notes: Maturity period is 1-10 years
2. Municipal Bonds
3. Corporate Bonds
 TREASURIES
Issued by Central Government. These are issued to
raise funds for national debt.
Government Revenue>Government
Expenditure=fiscal surplus (it is a rare situation)
Government Revenue<Government
Expenditure=fiscal deficit (national Debt for that year)
Nation Debt : all the money that the nation owe.
Nation Debt: Def 2019+Def 2018+……..+Def of all the
previous years including interest.
Default Free: Investment in Bond involves no risk of
default if these bond are issued in the country’s
home currency or Face value of the bond is bearing
the value in terms of country’s currency not in the
form of foreign currency. (Currency Risk)
When ever the government is issuing debt item
they always want to issue in their own currency to
save them selves from currency risk. But to raise
more funds or attract more investors they issue
bonds with face value bearing foreign currency.
Because investors wants to make themselves free
from currency risk. This is high when they are
purchasing debt instrument in home currency.
 Different Issues
• On the run issues: is the bond which is issued
recently. These bonds are more liquid or
highly liquid because they are in demand.
• Off the run issues: it is relatively old, illiquid
and little traded. It is not quick or easy to sell.
• Fixed principal :Investors will get total amount
of face value at the time of maturity.
• Inflation indexed: These bonds are protected
from inflation.
 Strip
The preference of investment differs according
to the investors’ need. Some investors are
interested in current yield, some are interested
in pure investment and some are interested in
both.
Through stripping of bonds by investment bank
it becomes possible to provide debt instruments
or securities according to the need of the
investors.
• Strip means to separate or remove the coupon
from the bond. It is a special type of security
and involves the process of separating coupons
and packaging them and separate the face
value into a different security.
• Strip: (i) Coupon: purpose of stripping is to
provide the investors the current income.
• (ii) Face value: purpose of stripping is
to provide the investors a yield at the time of
maturity of the bond i.e. after 10 years, 20
years, 30 years etc.
 Example of Strip
• FV=₹1000/-
• Coupon=₹600/-
• Face value:₹400/-
• Investment Bank will sell these stripped securities at
price
• Coupon=₹603/-
• Face value:₹402/-
• The extra money IB will keep for processing the
stripping and facilitating the selling of these securities.
This is termed as income of these banks.
(1) Treasury Zero Coupon Bonds: Zero refers to
no coupon only face value.
(2) Treasury Zero Bonds: Zero refers to no face
value only current income or coupon.
 What is Current Yield?
Current Yield is the return/ income earned by
the lender from the borrower. It is expressed as
the percentage (annual return) based on the
investment’s cost, its current market value or
the face value.
COUPON CURRENT YIELD

Coupon amount remains fixed Current yield changes regularly

Current yield also considers the

Coupon only talks about the price at which the debt instrument
interest amount. is bought and accordingly,
measures the return/ income.
 Formula : Current Yield
𝒄𝒐𝒖𝒑𝒐𝒏
CURRENT YIELD=𝒃𝒐𝒏𝒅𝒑𝒓𝒊𝒄𝒆 × 𝟏𝟎𝟎
Example:
If the face value of a bond is ₹100/-, coupon is 8% per
annum and you have purchased the debt instrument
at ₹90/-this year but your friend has purchased the
instrument by paying ₹110/- previous year then
calculate the current yield for both of you and actual
coupon rate of the bond.
𝟖
Your current yield = × 𝟏𝟎𝟎=₹8.88
𝟗𝟎
𝟖
Your friend’s current yield =𝟏𝟏𝟎 × 𝟏𝟎𝟎=₹7.27
𝟖
actual coupon rate of the bond=𝟏𝟎𝟎 × 𝟏𝟎𝟎=₹8
Fact:
• However, the price of this instrument will not remain same during
the tenure of the instrument. It may fluctuate and may make an
upward or a downward move.
• On the other hand, in case you buy the debt instrument at higher
price than the face value then the current yield will be less than the
coupon rate and vice versa.
• Investors will not buy the instrument always at the face value.
Because when they buy the debt instrument from the market, the
price can be less or more than the face value or same as the face
value depending on the demand and supply of the said instrument.
• Your yield or return will depend on the price you pay for the
purchase of the debt instrument initially.
• This means: yield and price of a bond share an inverse relationship.
As yield increases, the price of the bond decreases and vice versa.
 The relation between bond price and
Yield To Maturity (YTM)
YTM is the total return anticipated on a bond if the bond is held
until its lifetime. It is considered as a long-term bond yield but is
expressed as an annual rate.
Basically, YTM is the internal rate of return (IRR) of an investment
in the bond if the following two conditions are satisfied:
1. If the bond investor hold the debt instrument until maturity.
2. If the scheduled payments are duly cleared.
Further, YTM also assumes that the coupon amount earned by you
periodically is re-invested in the same debt instrument at the
prevailing market prices.
Hence, the calculation of YTM is different from that of the current
yield.
 Price determination
Let us understand as to how bond prices are determined:
Full Price=Price + Accrued Interest (Dirty Price)
Accrued interest: It is the interest which accumulates after
the last payment of interest until the point of sell.
This unpaid interest between the previous coupon payment
date and the date of purchase is called accrued interest.
Accrued interest is the interest that accumulates on a bond
between coupon payments. This means that accrued
interest is the amount earned and not paid.
In India, it is counted assuming 30 days in a month using
30/360 days.
Example
A 6% coupon bond is trading at Rs. 950 (FV=₹1000)and the
last record date for an interest payment was 2 months ago.
What is the full price of bond if the bond involves semi
yearly payments of coupon?
Accrued interest for 2 months will be
2
A.I.= FV × 𝐶𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 × 𝐴. 𝐼. 𝑓𝑜𝑟 2 𝑚𝑜𝑛𝑡ℎ𝑠
12
6 2
A.I. =1000 × × = Rs. 10/-
100 12
Full price=price +A.I.
=₹950+₹10=₹960/-
Note: The coupon amount is always paid on face value. Here,
face value = Rs. 1000/– and Rs. 950/– is the prevailing
market price.
 Problem
• If the C.R. 8%, face value of a long term bond
is ₹10,000, the market price of the said bond
is ₹8,990 and the last record date for an
interest payment was 3 months ago. What is
the full price of bond?
8 3
• A.I. =10,000 × 100 × 12= Rs. 200/-
• Full price= Market Price + A.I.
• Full price= ₹8,990 + Rs. 200/-=₹9,190/-
Clean Price and Dirty price
• As you can see above, the basic structure of the bond.
In case of a bond, there are two parties. One is the
issuer and the other one is the lender.
• The issuer is the borrower who issues bonds in the
market to borrow money from the public.
• The lender is the person having surplus cash, who
invests in the debt instrument.
• Suppose the above-mentioned bond that we are
talking about has a maturity period of 5 years.
• Now the borrower/ issuer will pay x% of coupon
amount to the lender as per the payment schedule.
• On the final year, the lender not only receives the
coupon amount but also the final repayment of the
amount lend or the principal amount.
 What Is a Yield Curve?

A yield curve is a line that plots yields (interest

rates) of bonds having equal credit quality but
differing maturity dates. The slope of the yield
curve gives an idea of future interest rate
changes and economic activity.
 Types of Yield Curve

There are three main types of yield curve

shapes:
1. Normal yield curve (upward sloping
curve/economic expansion),
2. Inverted yield curve (downward sloping
curve/economic recession)
3. Flat yield curve (parallel to ox axis/transition
period it may be developed from economic
expansion or recession )
 Normal Yield Curve

• A normal or up-sloped yield curve indicates yields on longer-

term bonds may continue to rise, responding to periods of
economic expansion.
• When investors expect longer-maturity bond yields to
become even higher in the future, many would temporarily
park their funds in shorter-term securities in hopes of
purchasing longer-term bonds later for higher yields.
Graph: Normal Yield Curve
 Inverted Yield Curve

• An inverted or down-sloped yield curve

suggests yields on longer-term bonds may
continue to fall, corresponding to periods of
economic recession.
• When investors expect longer-maturity bond
yields to become even lower in the future,
many would purchase longer-maturity bonds
to lock in yields before they decrease further.
Graph: Inverted Yield Curve
 Flat Yield Curve

• A flat yield curve may arise from the normal or inverted

yield curve, depending on changing economic conditions.
• When the economy is transitioning from expansion to
slower development and even recession, yields on longer-
maturity bonds tend to fall and yields on shorter-term
securities likely rise, inverting a normal yield curve into a
flat yield curve.
• When the economy is transitioning from recession to
recovery and potential expansion, yields on longer-maturity
bonds are set to rise and yields on shorter-maturity
securities are sure to fall, tilting an inverted yield curve
toward a flat yield curve.
Graph: Flat Yield Curve
 KEY CONCEPTS
1. Yield curves plot interest rates of bonds of equal
credit and different maturities.
2. The three key types of yield curves include normal,
inverted and flat. Upward sloping (also known as
normal yield curves) is where longer-term bonds have
higher yields than short-term ones.
3. While normal curves point to economic expansion,
downward sloping (inverted) curves point to
economic recession.
4. Flat yield curve represents change of economic
condition of the said country. This change may result
from economic expansion or economic recession.