Bonds & Debentures

 Bonds:-

A bond is a debt security, by which you are lending money to a government, municipality, corporation, or other entity known as the issuer.

In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures or becomes due.

Why Invest in Bonds?

Because bonds typically have a predictable stream of payments and repayment of principal, many people invest in them to preserve and increase their capital or to receive dependable interest income.

What should be the key Bond Investment Considerations?

There are a number of key variables to look at when investing in bonds: the bond’s maturity, redemption features, credit quality, interest rate, price and yield. Together, these factors help determine the value of your bond investment and the degree to which it matches your financial objectives.

  Face Value:-

Securities are generally issued in denominations of 10, 100 or 1000. This is known as the Face Value or Par Value of the security.

What is the Coupon rate of the Security?

The Coupon rate is simply the interest rate that every debenture/Bond carries on its face value and is fixed at the time of issuance. For example, a 10% p.a coupon rate on a bond/debenture of Rs 100 implies that the investor will receive Rs 10 p.a. The coupon can be payable monthly, quarterly, half-yearly, or annually or cumulative on redemption

 Interest Rate:-

Bonds pay interest that can be fixed, floating or payable at maturity. Most debt securities carry an interest rate that stays fixed until maturity and is a percentage of the face (principal) amount. Typically, investors receive interest payments semiannually. For example, a Rs.1000 bond with an 8% interest rate will pay investors Rs.80 a year, in payments of Rs.40 every six months. When the bond matures, investors receive the full face amount of the bond—Rs.1, 000. 
Floating Interest rate:-

Some sellers and buyers of debt securities prefer having an interest rate that is adjustable, and more closely tracks prevailing market rates. The interest rate on a floating—rate bond is reset periodically in line with changes in a base interest—rate index, such as the rate on Treasury bills.

Zero Coupon Bond:-

Some bonds have no periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the purchase price (principal) plus the total interest earned, compounded semiannually at the (original) interest rate. Known as zero coupon bonds, they are sold at a substantial discount from their face amount. For example, a bond with a face amount of Rs.10, 000 maturing in 5 years might be purchased for about Rs.7130. At the end of the 5 years, the investor will receive Rs.10, 000. The difference between Rs.10, 000 and Rs.7, 130 represents the interest, based on an interest rate of 7%, which compounds automatically until the bond matures.

What do you mean by the Maturity of the bond?

Securities are issued for a fixed period of time at the end of which the principal amount borrowed is repaid to the investors. The date on which the term ends and proceeds are paid out is known as the Maturity date. It is specified on the face of the instrument. Maturity ranges are often categorized as follows:

• Short—term notes: maturities of up to five years
  
  
  
• Intermediate notes/bonds: maturities of five to 12 years
  
  
  
• Long—term bonds: maturities of 12 or more years
  
  
  

What is redemption and what are the various Redemption Features?

On reaching the date of maturity, the issuer repays the money borrowed from the investors. This is known as Redemption or Repayment of the bond/debenture.

• Call Provisions: Some bonds have redemption, or “call” provisions that allow or require the issuer to repay the investors’ principal at a specified date before maturity. Bonds are commonly “called” when prevailing interest rates have dropped significantly since the time the bonds were issued.
  
  
  
• Puts: Conversely, some bonds have “puts,” which allow the investor the option of requiring the issuer to repurchase the bonds at specified times prior to maturity. Investors typically exercise this option when they need cash for some purpose or when interest rates have risen since the bonds were issued. They can then reinvest the proceeds at a higher interest rate.
  
  
  

How is the Price of the bond calculated?

The price paid for a bond is based on a whole host of variables, including interest rates, supply and demand, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to their face value. Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount. When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher—interest new issues.When prevailing interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues.

What is the Yield on a Bond?

Yield is the return you actually earn on the bond—based on the price you paid and the interest payment you receive. There are basically two types of bond yields you should be aware of: current yield and yield to maturity or yield to call.

  Current Yield:-

Current yield is the annual return on the amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price. If you bought at Rs.1, 000 and the interest rate is 8% (Rs.80), the current yield is 8% (Rs.80 ÷ Rs.1, 000). If you bought at Rs.800 and the interest rate is 8% (Rs.80), the current yield is 10% (Rs.80 ÷ Rs.800).

What is Yield to Maturity/Yield to Call?

Yield to maturity and yield to call, tell you the total return you will receive by holding the bond until it matures or is called. It also enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity (including interest on interest at the original purchasing yield), plus any gain (if you purchased the bond below its par, or face, value) or loss (if you purchased it above its par value). Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor will receive face value back at the call date.

  Yield Curve:-

The relationship between time and yield on a homogenous risk class of securities is called the Yield Curve. The relationship represents the time value of money - showing that people would demand a positive rate of return on the money they are willing to part today for a payback into the future. A yield curve can be positive, neutral or flat. A positive yield curve, which is most natural, is when the slope of the curve is positive, i.e. the yield at the longer end is higher than that at the shorter end of the time axis. This result, as people demand higher compensation for parting their money for a longer time into the future. A neutral yield curve is that which has a zero slope, i.e. is flat across time. This occurs when people are willing to accept more or less the same returns across maturities. The negative yield curve (also called an inverted yield curve) is one of which the slope is negative, i.e. the long term yield is lower than the short term yield.

How are the Interest Rates and Maturity related?

Changes in interest rates don’t affect all bonds equally. The longer it takes for a bond to mature, the greater the risk that prices will fluctuate along the way and that the fluctuations will be greater—and the more the investors will expect to be compensated for taking the extra risk. There is a direct link between maturity and yield.

Who are institutional investors in the Indian Debt Market?

Institutional investors operating in the Indian Debt Market are: Banks, Insurance companies, Provident funds, Mutual funds, Trusts, Corporate, treasuries, Foreign investors (FIIs)

What factors determine interest rates?

When we talk of interest rates, there are different types of interest rates - rates that banks offer to their depositors, rates that they lend to their borrowers, the rate at which the Government borrows in the bond/G-Sec, market, rates offered to small investors in small savings schemes like NSC rates at which companies issue fixed deposits etc.

The factors which govern the interest rates are mostly economy related and are commonly referred to as macroeconomic. Some of these factors are:

• Demand for money
  
  
  
• Government borrowings
  
  
  
• Supply of money
  
  
  
• Inflation rate
  
  
  
• The Reserve Bank of India and the Government policies which determine some of the variables mentioned above.
  
  
  

What is record date/shut period?

G-Sec/Bonds/Debentures keep changing hands in the secondary market. Issuer pays interest to the holders registered in its register on a certain date. Such date is known as record date. Securities are not transferred in the books of issuer during the period in which such records are updated for payment of interest etc. Such period is called as shut period.

What do you mean by "Cum-Interest" and "Ex-Interest"?

Cum-interest means the price of security is inclusive of the interest accrued for the interim period between last interest payment date and purchase date. Security with ex-interest means the accrued interest has to be paid separately

What are G-Secs?

G-Secs or Government of India dated Securities are Rupees One hundred face-value units / debt paper issued by Government of India in lieu of their borrowing from the market. These can be referred to as certificates issued by Government of India through the Reserve Bank acknowledging receipt of money in the form of debt, bearing a fixed interest rate (or otherwise) with interests payable semi-annually or otherwise and principal as per schedule, normally on due date on redemption

What are ‘Gilt edged’ securities?

The term government securities encompass all Bonds & T-bills issued by the Central Government, state government. These securities are normally referred to, as "gilt-edged" as repayments of principal as well as interest are totally secured by sovereign guarantee.

'Gilt Securities' are issued by the RBI, the central bank, on behalf of the Government of India. Being sovereign paper, gilt securities carry absolutely no risk of default.

What is Inflation linked bond?

These are bonds for which the coupon payment in a particular period is linked to the inflation rate at that time - the base coupon rate is fixed with the inflation rate (consumer price index-CPI) being added to it to arrive at the total coupon rate. The idea behind these bonds is to make them attractive to investors by removing the uncertainty of future inflation rates, thereby maintaining the real value of their invested capital.

What is SDL?

State government securities (State Loans): These are issued by the respective state governments but the RBI coordinates the actual process of selling these securities. Each state is allowed to issue securities up to a certain limit each year. The planning commission in consultation with the respective state governments determines this limit. Generally, the coupon rates on state loans are marginally higher than those of GOI-Secs issued at the same time.

What is a PSU Bond?

Public Sector Undertaking Bonds (PSU Bonds): These are Medium or long term debt instruments issued by Public Sector Undertakings (PSUs). The term usually denotes bonds issued by the central PSUs (i.e. PSUs funded by and under the administrative control of the Government of India). Most of the PSU Bonds are sold on Private Placement Basis to the targeted investors at Market Determined Interest Rates.

What is a Debenture?

A Debenture is a debt security issued by a company (called the Issuer), which offers to pay interest in lieu of the money borrowed for a certain period. In essence it represents a loan taken by the issuer who pays an agreed rate of interest during the lifetime of the instrument and repays the principal normally, unless otherwise agreed, on maturity. These are long-term debt instruments issued by private sector companies. These are issued in denominations as low as Rs 1000 and have maturities ranging between one and ten years.

What is the difference between a bond and a debenture?

Long-term debt securities issued by the Government of India or any of the State Government’s or undertakings owned by them or by development financial institutions are called as bonds. Instruments issued by other entities are called debentures. The difference between the two is actually a function of where they are registered and pay stamp duty and how they trade.

What are the different types of debentures?

Debentures are divided into different categories on the basis of Convertibility of the instrument and security

On the basis of convertibility, debentures are classified into:

• Non Convertible Debentures (NCD): These instruments retain the debt character and can not be converted in to equity shares
  
  
  
• Partly Convertible Debentures (PCD): A part of these instruments are converted into Equity shares in the future at notice of the issuer. The issuer decides the ratio for conversion. This is normally decided at the time of subscription.
  
  
  
• Fully convertible Debentures (FCD): These are fully convertible into Equity shares at the issuer's notice. The ratio of conversion is decided by the issuer. Upon conversion the investors enjoy the same status as ordinary shareholders of the company.
  
  
  
• Optionally Convertible Debentures (OCD): The investor has the option to either convert these debentures into shares at price decided by the issuer/agreed upon at the time of issue.
  
  On the basis of Security, debentures are classified into:
  
  
  
• Secured Debentures: These instruments are secured by a charge on the fixed assets of the issuer company. So if the issuer fails on payment of the principal or interest amount, his assets can be sold to repay the liability to the investors
  
  
  
• Unsecured Debentures: These instrument are unsecured in the sense that if the issuer defaults on payment of the interest or principal amount, the investor has to be along with other unsecured creditors of the company.
  
  
  

Who Regulates Indian G-Secs and Debt Market?

RBI: The Reserve Bank of India is the main regulator for the Money Market. Reserve Bank of India also controls and regulates the G-Secs Market. Another major area under the control of the RBI is the interest rate policy. Earlier, it used to strictly control interest rates through a directed system of interest rates. Each type of lending activity was supposed to be carried out at a pre-specified interest rate. Over the years RBI has moved slowly towards a regime of market determined controls.

SEBI: Regulator for the Indian Corporate Debt Market is the Securities and Exchange Board of India (SEBI). SEBI controls bond market and corporate debt market in cases where entities raise money from public through public issues.

Apart from the two main regulators, the RBI and SEBI, there are several other regulators specific for different classes of investors, e.g. the Central Provision Fund Commissioner and the Ministry of Labour regulate the Provident Funds.