Saturday, May 25, 2013

what is Debt ? what is Bond ?

Debt Instruments are contracts in which one party lends money to another on pre determined terms with regards 1) Interest rate, 2) periodicity of interest and 3) tenure of debt after which principal is repayed.

Few common examples of Debt Instruments are Fixed Deposit, NSC, PPF, Bond, Debentures etc

'Bond' is the term used for debt instruments issued by government and 'Debentures' is the term used for instruments issued by corporates or private sector.

There are bonds which are listed on stock exchanges after issuance and are traded regularly on marked to market basis. Trading platform for government securities are NDM - 'Negotiated Dealing System' and WDM- 'Wholesale Debt Market' also called NEAT(National Exchange for Automated Trading) on BSE and NSE.



Terms used in Bonds

Principal : Principal is the actual amount lent or invested or Face value of the bond.

Maturity : Maturity is the length of time until principal amount of bond must be repaid.

Coupon : Is the amount of Interest paid per year expressed as a percentage of the face value of the bond. It is mostly paid semi annually (It is called coupon as intially each bond used to have coupons attached to the bonds and holders receive the interest by stripping off the coupons and redeming them)



Different kinds of bonds

Coupon Bond : Debt obligation of semiannual interest payments generally called bearer bond or vanilla bond

Zero Coupon Bond: This bonds do not pay interest but are issued at deep discount to the face value. this are also known as deep discount bonds

Floating Rate Bond : Bond with variable interest rate is called floating rate bond. The adjustments are tied to certain money market instruments and are set every six months.

Callable Bond : Bond that can be redeemed by the issuer prior to its maturity.

Putable Bond : Bond holder can force the issuer to repurchase the bond before maturity.

Convertible Bond : Bond which can be converted to companys equity at predetermined date at the discretion of the bond holder.

Amortizing Bond: A class of debt in which a portion of principal amount is paid along with periodic interest.



DEBT INVESTMENTS THUMB RULE :
Price of Bond is inversely proportional to the interest rate.

Lets look at an example. A 10 year GOI (Government of India) bond offering 7% fixed coupon has been auctioned today with face value of Rs. 100. We assume we bought it on issue and this bond gets listed on exchanges at Rs. 100. Aftere 3 months due to monetary measures taken by RBI the interest rate in market falles by one percentage to 6%.

As the bond is marked to market and traded. it has to be valued every day. so market price post interest rate cut will go up as the bond carries a higher coupon rate then prevailing market interest rate. However if the interest rate would move upward the same bond would be traded at discount price. therefore we follow the first thumb rule of interest rate and current price of a bond move in opposite direction.

Now the question is how much % price of a bond change due to changes in interest rate. in above case 1% rate cut in interest rate will affect all future cash flows to be received from this bond to the remaining tenor. We can then say that all future coupons will be re-invested at a lower interest rate and resulting in fall in YTM on the day of valuation.

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