This article has been written by Sumanth D, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
It has been published by Rachit Garg.
Table of Contents
What are Bonds?
A bond is a financial instrument that allows you to borrow money. It’s similar to a promissory note. A bond can be launched or issued by the government of a country or by a company to raise cash. Government bonds (also known as G-secs in India, Treasury in the United States, and Gilts in the United Kingdom) are one of the safest investments since they are backed by the sovereign.
As a result, they also provide the lowest investment returns (or yield). Corporate bond investments are riskier since the odds of failure (and, as a result, the firm defaulting on the loan) is higher.
Different types of Bonds
Fixed Coupon Rate Bonds
In these types of bonds, “the interest is fixed from the date of issue. Most of the corporate and government bonds are of fixed coupon rate and the interest or coupon is provided annually, semi-annually, quarterly or monthly till the redemption date”.
Floating Coupon Rate Bonds
In these bonds, the “coupon rate fluctuates at a predefined time till the date of maturity. Here interest rate depends on a benchmark that it follows to determine the coupon rate in each coupon payment. In the case of FRB Bonds, the coupon rate depends on the Treasury bills (T-Bills) yield”.
Zero-Coupon Bonds
These bonds are those bonds where the issuer does not provide any coupon payment to the holder till the maturity date. Here the “bonds are issued below the face value amount and on the date of redemption or maturity.
Bonds are redeemed on the face value amount. Here the difference between the redemption price and the issue price is the return for an investor. In India, T-Bills are the Zero-Coupon Bonds”.
Cumulative Coupon Rate Bonds
These bonds are issued with a “coupon rate but the coupon payment is done at the time of redemption”. Usually, corporations issue these types of bonds.
Inflation-Indexed Bonds
These bonds provide protection from inflation. It is primarily issued by the government. Here the coupon rate is dependent on the inflation rate.
Usually, the coupon rate equals the inflation rate and the additional rate provided over the inflation rate.
Perpetual Bonds
Perpetual bonds have no maturity date. It means these are “not liable for redemption as per law or issuing entity. In these bonds, the Issuer pays the interest forever till it is in existence”.
Callable and Puttable bonds
In callable bonds, the issuer has an option to redeem the bonds earlier than the redemption date and in the case of Puttable Bonds, the holder has an option to get back the investment amount before maturity or redemption date.
RBI Bonds (The Floating Rate Saving Bonds) 2020
The RBI’s Floating Rate Savings Bonds 2020 are government-issued bonds with a 7.15 percent interest rate. The Bonds have a variable interest rate that is reset every six months, with the first reset scheduled for January 1, 2021. The interest rate is determined by the NSC interest rate (National Saving Certificate). The Bond pays out semi-annually on January 1st and July 1st of each year. The bonds are only issued electronically and are kept in the Bond Ledger Account (BLA). The bonds are held in the BLA, which is a bank account with the RBI or an agency bank.
What are Bond Yields?
The predicted profits created and realised on a fixed-income investment over a given period of time, expressed as a percentage or interest rate, is referred to as the yield on a bond.
The return on a bond is referred to as the bond yield. Bond yields can be defined in a variety of ways. The simplest definition is to set the bond yield equal to the coupon rate. If the bond’s price differs from its face value, the current yield is a function of the bond’s price and its coupon or interest payment, and it will be more accurate than the coupon yield.
Simply explained, a bond’s yield is the effective rate of return it receives. However, the rate of return is not constant; it fluctuates with the bond’s price. However, in order to comprehend this, one must first comprehend the structure of ties. There is a face value and a coupon payment on every bond. There’s also the bond’s price, which may or may not be equal to the bond’s face value.
Assume a 10-year G-sec has a face value of Rs 100 and a coupon payment of Rs 5. Buyers of this bond will provide the government Rs 100 (face value), in exchange for which the government will pay them Rs 5 (coupon payment) every year for the following ten years, and will refund their Rs 100 at the end of the term. The bond’s yield, or an effective rate of interest, in this case, is 5%. The yield is the investor’s reward for parting with Rs 100 today, but for staying without it for 10 years.
Overview of Bond Yields
When investors purchase bonds, they are effectively lending money to bond issuers. Bond issuers commit to pay investors interest on bonds for the duration of the bond’s life and to reimburse the face value of bonds at maturity in exchange. The most straightforward technique to determine a bond yield is to divide the coupon payment by the bond’s face value. This is referred to as the coupon rate.
If a bond has a face value of $1,000 and receives 100 interest or coupon payments each year, the coupon rate is 10% (100 / 1,000 = 10%). However, a bond might be purchased for more than its face value (premium) or for less than its face value (discount), which will affect the bond’s yield.
Coupon rate = Annual Coupon Payment/Face Value
Different types of Bond Yields
- Running Yield: The same as the current yield – earnings from a bond divided by its current market value
- Nominal Yield: The same as coupon rate or coupon yield – the rate of interest you’ll earn annually from a bond
- Yield to Maturity (YTM): Indicates the interest you’ll earn if you buy a bond and hold it until its maturity date
- Tax-Equivalent Yield (TEY): Helps you compare bonds that are tax-exempt and those that are not; calculated by taking the yield on the tax-exempt bond and dividing by [one minus your marginal tax rate]
- Yield to Call (YTC): A calculation of your long-term interest if you sell the bond prior to maturity; uses a “call date” – or the date on which you have the right to sell the bond, as well as the bond’s price for that day
- Yield to Worst (YTW): Either the YTM or the YTC, whichever is the lowest; gives investors an idea of the lowest possible returns the bond offers
Is it difficult to invest in bonds as compared to equity shares?
While there are a variety of investment options available in India, bonds and stocks are the most popular. Bonds can be purchased on the primary or secondary markets. One can subscribe to a public issue of a significant company on the primary market. Alternatively, bonds can be purchased on the secondary market, which is where they are exchanged on exchanges.
Bonds are often considered illiquid and are held till maturity. However, if you need to sell your investment before it matures, you may do so on the secondary market.
- In the case of a bond, the holder is dependent on the issuer for getting back the lent money. Therefore, it is vital to check the creditworthiness of the issuer.
- As a purchaser of bonds, one should buy bonds or debentures issued by a good-quality issuer.
- The way to ascertain the quality of the issuer is to look at their credit rating.
Credit rating companies assign ratings to issuers and express an opinion on their creditworthiness.
AAA (triple-A) rated companies are thought to be high-quality issuers. Professional investors, such as fund managers and corporate treasury managers, do due diligence on the issuer’s fundamental quality.
However, because not every investor has the time or resources to do so, it is a good idea to verify with credit rating organisations.
The implication of rising bond yields in India
A number of factors have contributed to the rapid spike in bond rates. The first is inflation, which has been on a steady upward trajectory since June of last year and has just now begun to decline. The rate of inflation is beyond the RBI’s tolerance level, and inflation forecasts remain high. Second, the Fed has already indicated three rate rises this year, with strong economic statistics suggesting as many as four. As a result, Indian yields have remained rising in line with global trends. Finally, markets are pricing in the possibility that the RBI would be required to raise rates by 25-50 basis points this year in order to make the yield disparity appealing to international investors. What, though, are the consequences of increasing bond yields? There might be five major ramifications.
Higher bond yields will create a problem for bank bond portfolios
Indian banks, particularly public sector banks, are among the country’s major bondholders. Because banks must maintain a statutory liquidity ratio (SLR) with the RBI as a safety net to safeguard their solvency, this is the case. The SLR is mostly made up of government bonds, and the RBI utilises it to fund the government’s borrowing needs. SBI recorded a large loss in the prior quarter’s earnings due to two factors: an increase in Non-Performing Assets (NPAs) and bond losses. Bond losses are a key issue for banks since rising rates cause bond values to decline, resulting in losses that must be booked by the banks. This might lower bank earnings and make any fund-raising ambitions more difficult.
Rising bond yields is not great news for Net Asset Value (NAV) of debt funds
Debt funds that hold these government bonds see their NAV values erode, much as banks do with their bond holdings. This issue is exacerbated for mutual funds that own long-term government bonds, which are the most sensitive to rising bond rates. In fact, bond prices have plummeted so much in recent months that bond dealers have almost pleaded with the RBI to join the market and defend prices by purchasing at lower levels. In the end, a drop in NAVs diminishes the wealth of both retail and institutional investors.
Indian corporates may be forced to borrow at higher rates of interest
A number of prominent banks have begun to raise their lending rates in recent months. Rising bond yields are a direct cause of this. To maintain the appeal of deposit rates when bond yields increase, banks will have to hike deposit rates. However, in order to preserve their spread, they are required to boost lending rates to compensate. It may be remembered that demonetization caused a liquidity surplus in the financial sector, causing yields to plummet. The rise in rates may negate this advantage, and it may stymie the capital investment cycle’s fledgling rebound.
Government borrowing programs will be impacted negatively
In the next two years, India’s government has already resolved to exceed its budget deficit targets by 30 basis points. This means the government will have to rely on the bond market to raise cash on a regular basis. However, increasing bond yields will force the government to borrow at much higher rates, which it will not be willing to do because it would significantly raise its borrowing costs. This is bad news given the government’s need to borrow substantially to satisfy its budget obligations over the coming year. Higher rates might put a crimp in the government’s borrowing plan.
It could also have a negative impact on equity valuations
The equity markets have also corrected sharply since February when bond yields spiked. While the LTCG tax played a role, one of the most important factors was the worldwide trend of rising bond rates. But why do higher bond rates have an effect on the stock market? Remember that the discounted cash flow (DCF) approach is used to value stocks. The cost of capital is used as the denominator to discount future cash flows to the present year. The weighted average of the cost of stock and the cost of debt is the cost of capital. If bond rates rise, the cost of capital rises as well, implying that existing values are more depressed. One of the main reasons why markets have been falling over the previous two months is because of this.
Financial takeaway
Bonds are often regarded as one of the safest investment options available. The varied yields on a bond may tell you a lot about how risky the investment is and what kind of returns you might expect.
Before making any decisions, consult with a knowledgeable investment expert or financial advisor if you’re unclear whether a bond or investment is right for you.
Conclusion
Bond yields can be applied in a variety of ways. To begin, they can tell you how much you may expect to earn on a bond versus another investment.
Bonds with higher yields, for example, have greater profit potential. Keep in mind, too, that while high-yield bonds are appealing, they also carry a higher risk.
If a bond’s yield is greater than most other bond yields, it indicates that the bond’s risk is higher, because investors will often pay less for a riskier investment. If that danger of default does not materialise, the bond will be more valuable than other bonds since it will pay a greater return. To put it another way, the greater the risk, the lower the price, and hence the greater the return.
References
- https://www.incometaxindia.gov.in/Acts/Finance%20Acts/2000/102120000000009405.htm
- https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11196&Mode=0
- https://www.sebi.gov.in/sebi_data/attachdocs/1288587929503.pdf
- https://www.mondaq.com/india/debt-capital-markets/227488/corporate-bonds-in-india
- https://indianexpress.com/article/explained/explained-why-rbi-wants-moderate-bond-yields-and-what-it-means-for-investors-7304997/
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