Bonds are high-risk financial assets that allow a company to raise funds. Borrowers take out fixed-term loans from private investors. Bonds are usually bought at face value or with principal, which is refunded after a period of time (called the maturity period). A fixed or variable rate of interest is exchanged for periodic interest on a portion of the principle.
Individual bondholders have filed a claim against the organization’s debt fund. When the bond matures, the borrower must pay the defaulters the full face amount of the bond. Bondholders have priority over other shareholders or creditors in the case of a company’s insolvency.
Bond Funds are nothing but one form of debts as much as similar to your home loan where you borrower money from bank and in return you pay interest with principle amount. When a state or city issue bonds to raise money for building infrastructure like constructing roads, dams, bridges, etc with a fixed maturity and assured return are called as Government Bonds.
Whereas corporate issues bond to raise money for expansion like purchasing companies, expanding presents geographically, introducing new products, etc with a fixed maturity and assured return are called as Corporate Bonds.
In other words, Bonds are fixed-income securities that represent an investor’s obligation to a borrower (typically corporate or governmental). A bond is a contract between a lender and a borrower that specifies the terms and quantities of the loan repayment. All of these entities issue bonds to fund various projects and activities, including infrastructure development. Bondholders are known as creditors or debt-holders.
What are Stocks and Bond Markets?
Bond market is also known as debt market. It is more or like similar to stock market. Fresh bonds / debts issued across are called as primary market and traded i.e.. Buying and selling of securities in secondary market. Similar to the stocks, bonds can be purchased by Institutional investors, Traders, Governments, Individuals. Mainly stocks include equities / shareholder of the corporate whereas bonds include bills, notes of the government or corporate.
There is no maturity date or fixed interest payment in stocks which makes stock market risky. In contrast bond funds pays interest on the funds and they have fixed maturity date. Considering other fixed income securities (likes Treasury bonds, Money Markets, Certificate of Deposits, etc.) Bond funds usually give you high yield fixed income.
Examples of Bonds
Taking above scenario now let us understand how to calculate yield to maturity value:
| Yield to Maturity Value|
|Interest rate||9%||Coupon Rate of the Bond|
|Par value||1,000.00||Par Value of Bond|
|Purchase price||800.00||Current Market Value of Bond|
|Capital gain||200.00||Discount Gain = Rs.1000 – Rs.200|
|Number of years to maturity||5||Maturity of Bond|
|Annualized capital gain (A)||40.00||Capital Gain (Rs.200) / No. of Years (5)|
|Annual interest (B)||90.00||Par Value (Rs.1000) * Coupon Rate (9%)|
|Total annualized return (C = A+ B)||130.00||Total Gain per year on Bond|
|Yield “D”||16.25%||Purchase Price (Rs.800) / Annual Return (Rs.130)|
|Yield “E”||13.54%||Annual Gain (Rs.130) / [ Par Value (Rs.1000) – Annual Capital Gain (Rs.40) ]|
|Yield to Maturity||14.90%||[ (Yield D + Yield E) / 2 ] i.e.. Average of D and E is the Yield to Maturity value|
Let us take the example to understand when and how to invest in Bond funds. Bond price is inversely proportional to Interest rate. When interest rate fall by 3-4 percent then bond price will gradually increase by 3-4 percent. Let us take the simple example to understand this concept.
Assuming bond is issued at par value Rs.1000/- and coupon rate is 10 percent paying Rs.100/- per annum. Now let us assume that interest rate increased by 20 percent paying 12 percent as a new coupon rate which looks quite attractive for investors. Now your bond price will decrease by 20 percent respectively, New calculated current yield price will be Rs.833/- (Rs.100 / 12%) which is equally incredible for the investors.
Basic concepts on Bond Funds
A bond is an interest certificate, issued by either private companies (known as corporate bonds) or by government agencies (known as Treasury Bonds, State Bonds, Government Bonds, etc.). Bonds pay a fixed interest on maturity date you can redeem or sell prior to maturity as well. Government bonds have no risk of defaulter, while corporate bonds carry the risk of defaulter on interest, principal, or both.
Coupon rate is the interest rate per annum. For example, If bond par value is Rs.1000/- and coupon rate is 15 percent that means you get Rs.150 interest per annum.
Bonds price keep on fluctuating in secondary market. For example, If bond par value is Rs.1000/-, and coupon rate of 15 percent and current market price of Rs.700/- that means bond has a current yield of 21% (Rs.150 / Rs.700). This is because any fluctuation in price doesn’t affect the interest payment (i.e.. Rs.150/-) upon maturity.
Yield to Maturity
It is a disposable return expected at the maturity of the bond. For example, Assume you buy ICICI Prudential Plan at Rs.1000/- par value with a 9% coupon (interest) rate maturing in 5 years, and the market price for the bond is Rs.800/-. The coupon rate is the annual interest rate payable on par value that is 9% on Rs.1000/- which is Rs.90/-.
The current yield of the bond is the interest divided by the current price of the bond, which in this case is Rs.90 / Rs.800, or 11.25%. On redemption after 5 years you realize Rs.200 as capital gain since you have purchased bond on discount at par value and yield to maturity value is 14.90%.
This tutorial lesson gives you the understanding that Bonds are best investment in fixed income category when interest rates are high and about the fall so that investors make profit from both sides of the coin that means high income with high interest rate and principal gain when the interest rates start decreasing. Vice versa Bonds are poor fixed income investment when interest rates are low and about to increase, giving investor principal loss with increase in interest rate if decided to sell off before maturity or bond term ends.
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Basics of Banking and Financial Services for Beginners
- Chapter 1: What is Bank and Role of Bank in Economic Development
- Chapter 2: Different Types of Financial Services Provided by Banks
- Chapter 3: Different Types of Banking and Financial Institutions
- Chapter 4: What is Retail Banking and Services provided by the Banks
- Chapter 5: What is Commercial Bank and Services offered by Banks
- Chapter 6: What is Private Banking and Services offered by Best Banks
- Chapter 7: What is Investment Banking and Services offered by Bankers
- Chapter 8: What is Investment? How to Start Systematic Investment Plan?
- Chapter 9: What is Fixed Income Securities Market?
- Currently Reading: What are Bond Funds? Difference between Stocks and Bonds
- Chapter 11: What is Stock Market? How to Invest in Stock Market?
- Chapter 12: What is a Mutual Funds? Types of Mutual Funds with Examples
- Chapter 13: What is Futures Trading? How to Trade in Future Contracts?
- Chapter 14: What is Options Trading? How does Options Trading Works?
- Chapter 15: Banking Quiz - Basics of Banking and Financial Services for Beginners
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