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The bond market is the focus of much attention these days with the U.S. Federal Reserve’s announcement of its intention to ease the monetary stimulus programme making foreign investors exiting the bond market in large swathes . So, what are bonds and what influences bond prices?
A bond is an instrument used by a company or a government for borrowing money for a specified period of time at a certain interest rate – fixed or floating. A bond is a debt instrument and the buyer of these is a company’s or a government’s creditor.
TERMINOLOGY
The face value of a bond, also called the par value, is the amount that a bondholder gets when a bond matures. The coupon is the interest rate that the bondholder receives (usually half yearly) till the date of maturity which is when the money borrowed is paid back. Another term associated with a bond is yield. It refers to the return one earns from investing in a bond. Yield is equal to coupon (interest) amount divided by the bond price. That is, the bond price and the yield are inversely related. The price of a bond keeps on changing in response to many factors. A bond is said to be trading at a premium when its price exceeds the face value and is said to be at a discount when its price is below the face value.
Let’s assume you buy a bond with a face value of Rs 1000 at a coupon (interest rate) of 7 per cent with a 10 year maturity. You will then receive an interest of Rs 70 per year for the next 10 years at the end of which you will be paid back Rs 1000.
Even though investing in bonds is supposed to be safe relative to equity, there are risks involved. There is an interest rate risk -- change in bond price in response to changing interest rates. Besides, the risk of not being paid the interest or principal -- credit risk – if the company or the government falls upon bad times also exists.
INDIAN MARKET
In India, bonds or dated government securities (G – Secs) are issued by the RBI on behalf of the government of India with the maturity period ranging up to 30 years. Corporate bonds are issued by companies with tenors of up to usually 15 years. While corporate bonds are relatively riskier (depending on the company issuing them) they may offer better returns. With government securities accounting for a major chunk of the debt market, they set a benchmark for the rest of the market.
If you intend on holding a bond till maturity, the variations in price may not bother you but for someone wanting to trade in bonds, these matter. The price (and so the yield) of a bond is influenced by a number of factors, an important one being the prevailing rate of interest. How do changing interest rates affect bond prices and yields? If the prevailing rates of interest rise then the newer bonds will be offered at higher rates of interest compared to the older bonds. Consequently, investors would prefer these to the older bonds which would no longer be in demand. The prices of the older bonds will therefore have to fall justifying the lower returns offered by them.
So, rising interest rates imply lower prices and higher yields for existing bonds. Likewise, if the prevailing interest rates fall, it will make the existing bonds that offer higher interest rates more attractive. This in turn will push up their prices and bring down the yields.
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