Bonds may seem confusing, but they aren’t if you just spend 3 minutes understanding exactly how they work.
What are Bonds?
When a company or government needs money to fund their projects (Example: Huge infrastructure projects like the Bandra-Worli Sea Link in Mumbai), they borrow money by selling/issuing bonds to:
- Big financial institutions like insurance companies, mutual funds and banks called as institutional investors
- Extremely rich individuals like celebrities called as high net-worth investors
- Big financial institutions from abroad called as Foreign institutional investors
- Individuals like you and me called as retail investors
In return, these lenders get an interest (called as a coupon) and the principal amount back on maturity.
Usually, bonds issued by the government (sovereign bonds) are safe and less risky (because duh, its the government who is unlikely to go bankrupt!). While bonds issued by companies (corporate bonds) are slightly riskier because companies can go bankrupt.
That sounds simple, right?
But, bonds have their own lingo which might confuse you, here’s what those terms mean:
Coupon/Interest: The interest received on a bond is called as a coupon. Coupon is calculated as a fixed percentage on the face value (original price) of the bond. Example: you buy a 10-year bond at Rs. 1000 with a 10% coupon rate. You’ll get Rs.100 as interest annually for 10 years.
Maturity: The date your bond expires or when you’re supposed to get your initial investment back is the maturity or ‘redemption date’.
Discount, premium or at par: If you want your money back before maturity you can sell them in the bond market. Here you might not get the same price for your bond at which you bought it at. The price will either be higher than the face value (at a premium) or could be lower than face value (at a discount) or at face value (at par).
Think of it logically, if you bought a bond 5 years back at 10% coupon but current interest rates on fixed deposits are 11%. Your bond is less attractive because of lower interest on it. To attract people to buy it you’ll have to sell it at a lower price i.e. at a discount.
So when investors buy bonds from the bond market they don’t always buy them at face value, they may buy it at a discount or premium. But, whatever the price of the bond, the coupon is always calculated at the Face Value. Only the yield of the bond changes.
Yield: Yield is the rate of return on a bond.
It is calculated as follows: Coupon amount received per year/ Price at which you bought the bond * 100
Example: A 10-year government bond with a face value of Rs. 1000 and coupon rate of 10% is issued by the government. The coupon amount is Rs. 100.
- Situation 1: You buy the bond at Rs. 1000 which is at face value or par
Yield = Rs. 100 / Rs. 1000 * 100 = 10%
Here the yield is the same as coupon rate because you bought the bond at face value
- Situation 2: You buy the bond at Rs. 800 which is at a discount because it is less than the face value Rs. 1000. The coupon will still be Rs. 100 as it is still calculated on the face value of Rs. 1000. But your yield or rate of return will be-
Yield = Rs. 100/Rs.800*100 = 12.5%.
Here the yield is higher than the coupon rate.
- Situation 3: You buy the bond at Rs. 1100 which is at a premium because it is more than face value Rs. 1000. The coupon will still be Rs. 100 as it is still calculated at the face value of Rs. 1000. But your yield or rate of return will be-
Yield = Rs. 100/Rs.1100*100 = 9.09%
That’s why you can conclude that higher the price of a bond, lower is its yield.
Yield To Maturity: The total return anticipated on a bond if it is held till maturity. There are different ways to calculate this, check out this Investopedia explanation.
That was all about the complex bond market. If you still have more questions on bonds, comment and let us know.