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Module-16

Session-31
Introduction to Bond Analysis
31.1 What is Bond?
Bond is a financial instrument which pays a fixed amount of interest periodically to
the holder of record. It also repays a fixed amount of principal at the date of maturity.
Generally bonds are issued by the government, states, municipalities and corporations. Some
bonds do not pay interest, but all bonds require a repayment of principal. When an investor
buys a bond, he/she becomes a creditor of the issuer. However, the buyer does not gain any
kind of ownership rights to the issuer, unlike in the case of equities. On the other hand bond
holder has a greater claim on an issuers income than a shareholder in the case of financial
distress.
The important intrinsic features of bond are coupon, maturity, principal value, and the
type of ownership are. The coupon of a bond indicates the income that the bond investor will
receive over the life (or holding period) of the issue. This is known as interest income or
coupon income. The term to maturity specifies the date or the number of years before a bond
matures (or expires). The principal, or par value, of an issue represents the original value of
the obligation. This is generally stated in Rs1, 000 increments from Rs1, 000 to Rs. 25,000 or
more. Bonds also differ in terms of ownership. With a bearer bond, the holder, or bearer, is
the owner, so the issuer keeps no record of ownership. Interest from a bearer bond is obtained
by clipping coupons attached to the bonds and sending them to the issuer for payment. In
contrast, the issuers of registered bonds maintain records of owners and pay the interest
directly to them.

31.2 Types of Bond Market


Generally the bond markets are divided by the maturity of the bond.

Money Market This market deals with the short-term issues that mature within one
year

Notes This market comprises the intermediate-term issues that mature between one
and ten years

Bonds This market deals with the long-term obligations with maturity greater than
ten years
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All these bond markets vary across the countries on the basis of the term to maturity of the
instruments available in that market.

31.3 Types of Bonds


Along the dimension of security bonds can be classified into secured and secured
bonds. Secured (senior) bonds are backed by a legal claim on some specified property of the
issuer in the case of default. For example, mortgage bonds are secured by real estate assets;
equipment trust certificates etc. Unsecured bonds (debentures) are backed only by the
promise of the issuer to pay interest and principal on a timely basis. As such, they are secured
by the general credit of the issuer.
Bonds also can be classified into convertible and non-convertible depending upon
whether they carry a conversion feature or not. Convertible bonds are those which can be
converted into equity shares at the option of the bondholders. In this case the ratio of
conversion (the number of shares exchanged for the converted portion) or alternatively the
conversion price (the price at which equity shares are exchanged for the converted portion of
the debentures) and the period during which the conversion can be effected are specified at
the time of the issue. Convertible bonds can either fully convertible or partly convertible. In
the case of partly convertible bonds, the non-convertible portion will carry interest until it is
repaid as per the provisions in the indenture. Non-convertible bonds cannot be converted to
equity share.
The bonds are also categorized by their issuers. Bonds issued by the government are
termed as treasury bonds. For example, dated securities released by the government. These
bonds are normally issued for longer maturity. Municipal bonds are debt securities issued by
states, cities, counties and other governmental entities to finance capital projects, such as
building schools, highways or sewer systems, and to fund day-to-day obligations. Investors
who buy municipal bonds are in effect lending money to the bond issuer in exchange for a
promise of regular interest payments, usually semi-annually, and the return of the original
investment, or principal. The date when the issuer repays the principal, the bonds maturity
date, may be years in the future. Short-term bonds mature in one to three years, while longterm bonds generally will not mature for more than a decade. The bonds are issued by the
corporations are termed as corporate bonds. These bonds are traded in the secondary market
and the price of the bonds depends on the market interest rates ruling at the time of trading.
Some of the bonds are defined on the basis of interest rate structure also. In the case
of floating rate bonds interest rates are floated with some reference rate in the market. For
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example, a bond can be issued with a feature that the interest rate on this bond is 1 percent
above the bank rate. The rates of interest are always in tune with the market rates because of
this special feature of floating. Other type of bond available in the market is indexed bonds.
In these bonds the principal and coupon payments are linked to the market index like
inflation and price index. Index bonds are attractive to investors as they are safer than the
convention bonds in terms of real interest rate risk and inflation expectation risk. Indexed
bonds apart from providing safety to investors also provide a steady interest income from
investment while keeping the principal intact. Because both coupon and principal payments
of an indexed bond are adjusted for inflation, an investor can count on the steady purchasing
power provided by the coupon interest payment during the life of the bond. Further when an
indexed bond matures, its principal has the same purchasing power as when it was invested.
Junk bonds are high yield bonds issued by companies and are considered highly speculative
because of high risk of default.
Callable bonds give the right to the issuer to redeem the bond the bond prior to its
maturity to date at a specified call price. The bonds are beneficial to its issuer when the
coupon interest paid by the bond is higher than the prevailing interest rates. Basically the
company can issue the same bonds at a lower interest rate leading to lower cost of financing.
Puttable bonds can be redeemed prior to maturity at the initiative of the bondholder. These
bonds are more advantageous to the investors as they get an opportunity to redeem their
bonds when the prevailing market interest rate is more than the coupon interest on bonds.
This feature enables the investors to unlock their current investment and invest in more
profitable avenues.

31.4 Types of Bonds in India


(1) Money Market Instruments
(A) Treasury Bills

Represent short-term obligations of the Government

Maturity Period: 91 Days, 182 Days and 365 days

They dont carry any explicit coupon rate

They are sold at a discount and redeemed at par value

There is a very active secondary market for this

(B) Certificate of Deposits

Represents a negotiable receipt of funds deposited in a bank for a fixed period

They are sold at a discount and redeemed at par value


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There is a very active secondary market for this

(C) Commercial Paper

Represents the short-term unsecured promissory notes issued by firms

They are sold at a discount and redeemed at par value

There is not active secondary market for this

(2) Government Securities and Govt. Guaranteed Bonds

Issued by RBI on behalf of GOI and State Governments

Interest payments are semi annually

They are essentially medium to long-term bonds

(3) Corporate Bonds

Issued by corporations, banks, public sector units

Issued on the basis of maturity: (i) Short Term Maturity: - Security with maturity
period less than one year, (ii) Medium Term: - Security with maturity period between
1year and 5 year, (iii) Long Term Maturity: -Such securities have maturity period
more than 5 years, (iv) Perpetual: - Security with no maturity. Currently, in India
Banks issue perpetual bond.

It can also be issued on the basis of coupon: (i) Fixed Rate Bonds:-have a coupon that
remains constant throughout the life of the bond, (ii) Floating Rate Bonds: - Coupon
rates are reset periodically based on benchmark rate, (iii) Zero-coupon Bonds no
coupons are paid. The bond is issued at a discount to its face value, at which it will be
redeemed. There are no intermittent payments of interest

Categorized on the basis on Option (i) Bond with call option: - This feature gives a
bond issuer the right, but not the obligation, to redeem his issue of bonds before the
bond's maturity at predetermined price and date, (ii) Bond with put option: - This
feature gives bondholders the right but not the obligation to sell their bonds back to
the issuer at a predetermined price and date. These bonds generally protect investors
from interest rate risk.

These are classified on the basis of redemption: (i) Bonds with single redemption: - In
this case principal amount of bond is paid at the time of maturity only, (ii) Amortising
Bonds: - A bond, in which payment made by the borrower over the life of the bond,
includes both interest and principal, is called an amortizing bond.

Table 31.1 Participants and products in Debt Market in India


Issuer

Instruments

Maturity

Investors

Central
Bank

T-Bills

91/364 days

RBI

State
Government

Dated
Securities

5-13 Years

Banks, Insurance Companies,


Provident Funds

PSUs

Bonds

5-10 Years

Banks, Corporates, Mutual Funds,


Individuals

Corpoartes

Debentures

1-12 Years

Banks, Mutual Funds, Individuals


etc/

Commercial
Banks

Certificate
of Deposits

15 days to 1 Year For


FIs it is 1 to 10 Year

Banks, Mutual Funds, Individuals


etc/

31.5

Indenture Provisions of Bond

It is the contract between the issuer and the bond holders specifying the issuers legal
requirements. A trustee acting on behalf of the bond holders ensures that all the indenture
provisions are met including the timely payment of interest and principal.

31.6 Calculation of Bond Return


HPR i, t =
where:

Pi, t +1 + Int i, t
Pi, t

HPRi,t = the holding period for bond i during the period t


Pi,t+1 = the market price of bond i at the end of period t
Pi,t = the market price of bond i at the beginning of period t
Inti,t = the interest payments on bond i during period t
The holding period yield (HPY) is: HPY = HPR - 1

31.7 Interpretation of Bond Quotes

Quoted on basis of yield or price

Price quotes are percentage of par


Example: 98 1/2 is not $98.50 but 98.5% of par
A municipal Rs. 5,000 bond quoted at 98 1/2 would be Rs. 4,925

Corporate Bond Quotes

Notations used in bond quotations

cv = convertible

zr = zero coupon

dc = deep discount (at time of issue)

Accrued interest must be added to price quoted

Questions and Answers


Q1: What are the different types of Bond Market?
Ans. Types of Bond Market: Bond market is divided by maturity

Money Market - short-term issues that mature within one year

Notes - intermediate-term issues that mature between one and ten years

Bonds - long-term obligations with maturity greater than ten years

Types of Bonds in India


(a) Money Market Instruments
i.

Treasury Bills

Represent short-term obligations of the Government

Maturity Period: 91 Days, 182 Days and 365 days

They dont carry any explicit coupon rate

They are sold at a discount and redeemed at par value

There is a very active secondary market for this


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ii.

iii.

Certificate of Deposits

Represents a negotiable receipt of funds deposited in a bank for a fixed period

They are sold at a discount and redeemed at par value

There is a very active secondary market for this

Commercial Paper

Represents the short-term unsecured promissory notes issued by firms

They are sold at a discount and redeemed at par value

There is not active secondary market for this

(b) Government Securities and Govt. Guaranteed Bonds

Issued by RBI on behalf of GOI and State Governments

Interest payments are semi annually

They are essentially medium to long-term bonds

(c) Corporate Bonds

Straight Bond (Plain Vanilla Bond)

Zero Coupon Bond

Floating Rate Bond

Bonds with Embedded Options

Commodity-Linked Bonds

Q2: How to calculate Rates of Return on a Bond Portfolio.


Ans. Holding Period Return (HPR) = Holding Period Yield (HPY) + 1
HPR i, t =
Where,

Pi, t +1 + Int i, t
Pi, t

HPRi,t = the holding period for bond i during the period t


Pi,t+1 = the market price of bond i at the end of period t
Pi,t = the market price of bond i at the beginning of period t
Inti,t = the interest payments on bond i during period t

Q3: Write short note on Floating Rate Notes.


Ans. Floating Rate Notes (FRN) is a bond issued for medium to long-term which pays
coupons that are pegged to a level of certain floating index which is called reference
index. FRN A note with a variable interest rate. Features of Floating rate Notes:

Reference Index

Quoted margin to Reference Rate (default risk premium)

Reset Frequency (Period of Coupon Payment)

Observation Date (for Index)

Maturity Date

Q4: Explain the intrinsic features of a Bond.


Ans. Intrinsic Features:

Coupon: Indicates the income that the bond investor will receive over the life of the
issue.

Term to Maturity: The date or the number of years before a bond matures.

Term Bond: Single Maturity Date

Serial Obligation Bond: Series of Maturity Dates

Principal or Par value: It is the original value of obligation

Types of Ownership

Bearer Bond

Registered Bond

Types of Issues

Secured (Senior) Bond: Backed by a legal claim on some specified property


of the issuer in the case of default.

Unsecured Bond (Debentures): Backed by the promise of the issuer to pay


interest and principal on a timely basis.

Features Affecting a Bonds Maturity

Callable

Non callable

Deferred call