The sheer adrenaline rush which you may get while trading or investing on Equity share market may be missing while investing on the bond markets, probably that may be one the reasons why people end up neglecting the bond markets. Another reason behind the mad rush of Equity investing are the stories of people becoming rich on an overnight basis during the bull run. However, equally horrible are the stories of people becoming paupers owing to poor stock selections. Bond markets may not offer this level of volatility and excitement, but these characteristics of bonds make every financial advisor to swear and recommend in every investor’s portfolio.
What are Bonds
Literally speaking, Bonds in financial markets reflect a bond or an agreement between a borrower and a lender whereby the borrower agrees to repay the borrowed amount to the lender along with a periodic payment of interest. The lender is hence aware of the cash flows which he shall get from the borrower owing to the amount lent to the borrower. Bonds, just like shares, may be listed on a stock exchange where the initial lender may sell the bond to other investors.
The following terms are worth mentioning with regards to Bonds :
Coupon : is the interest payments on bonds. I
Principal or Nominal amount is the initial amount borrowed by the Borrower
Bond Price – refers to the current price at which a bond is quoted on an exchange.
Bond Yield – refers to current coupon amount on the bond divided by the current bond price.
Let me explain the above terms by way of an example. Company XYZ issues bonds of Rs. 10,000 each paying 10% interest on an annual basis. In this bond, Rs. 10,000 is the Principal of the bond. The coupon on the bond is Rs. 1000 (10% of Rs. 10,000). If after a couple of months, the bonds are available to buy on a stock exchange and are priced at Rs. 12,000, then the bond yield is Rs. 1000/ Rs. 12,000 x 100 = 8.33%.
Bond Prices & Bond Yield
You may notice that the bond yield is different from the rate of interest on the bond. This bond yield is primarily dependent on the bond price. If the bond prices goes up, the bond yield go down and viceversa. But an important question is why do bond prices go up or down ?
Relationship between Bond Prices & Interest Rates in the Economies
Before investing into a bond, an investor would like to see how much is the yield coming out of that bond. In the above example, if the bonds of Company are yielding 8.33%, investors would like to compare such yield with other options available in the financial market. For example, if the risk free interest rate prevailing in the Economy is increases from 8% to 9% and the above bond is providing 8.33% rate, the investors would no longer have an incentive to hold this bond which is providing less return in comparison with the other less riskier options in the market which are giving a yield of 9%. This will result in people selling the bonds of XYZ yielding 8.33%, reducing their bond prices from Rs. 12,000 to Rs. 10,500. At this moment, the yield on the bond of Company XYZ would go up from 8.33% to 9.5% (1000/10500 x 100). It is important to note that irrespective of price & yield, the interest coupon being paid out by the bonds of Company XYZ will remain at Rs. 1,000.
Moving on, if the risk free interest rate in the economy decreases from 9% to 7%, the bonds of Company XYZ would now attract more investor attention as these bonds are available with a yield of 9.5% (compared to interest free rate of 7%). This would force investors to buy the bonds of XYZ, pushing the bond prices from Rs. 10,500 to Rs. 13,000. At this moment, the yield on XYZ bond would reduce to 7.7% (Rs. 1000 / 13000 x 100).
Hence you may notice that the bond prices are inversely proportionate to the risk free interest rates prevailing in the economy. And, if the bond prices go up, the bond yields go down.
Is High Yield & High Bond Prices Good ?
You might be wondering that High bond yields and High bond prices can not co-exist due to the inverse relationship. So which is good for an investor – high yields or high bond prices ?
It all depends upon how investors perceive it. If an investor bought the bonds of XYZ when it was quoting at Rs. 10,000, he would be enjoying a yield of 10% providing him a long term regular coupon of Rs. 1000 over his Rs. 10,000 deposit. If the bond prices go up to Rs. 13,000, while the bond yield may now look as 7.7%, the investor is enjoying a capital gain on his bond holding whereby his initial investment of Rs. 10,000 has now appreciated to Rs. 13,000. The investor can cash out of his holding making a gain of Rs. 3000 or 30% ! Alternatively, the investor may continue holding on to these bonds which are not providing him 10% annul return on his initial investment.
Other factors influencing Bond Prices
While the underlying interest rate prevailing in the economy is one of the strongest influencer of bond prices, two other important factors which affect bond prices are as follows :
- Duration of the bond : The duration of a bond can be from a few weeks to several years (over 30 years in some cases). If a bond is of a shorter maturity, there is less uncertainty in with the underlying bond. This is because in the short term the financial forecasting is more reliance on the health of the Bond issuing company. Hence prices of bonds with short maturity would be less volatile. Conversely, long duration bonds have more uncertainty and hence are more volatile and sensitive to factors which affect a bond.
- Credibility of the Issuer : Bond is just a loan and the pricing of a loan very much depends upon credibility of the borrower. The more credible a borrower is, the more closer would its price be to the risk free bonds quoting in the economy. The riskier the borrower, the higher this difference would be. The difference between the bond yield and the risk free interest rate in the economy is called ‘Spread‘. You can see this for yourself by seeing a few bond or fixed deposit issuances by companies. Generally Real Estate companies are considered more riskier than stable companies like blue chip banks. Hence in order to attract public deposits, they have to offer significantly higher interest rates to incentivise the investors in comparison to the interest rates being offered by the banks.
Looking into the above characteristics of bonds, you may realise that the biggest factor affecting the bond prices are the interest rates prevailing the in the economy. From a retail investor’s perspective, it may be difficult to keep a track on the other factors affecting the bond (such as credibility of the bond issuing company). However, it may be easier for such investors to understand if the interest rates are at their peak or troughs. If interest rates are at their peaks (as in year 2012), buy Bonds. This would enable investors to buy bonds at a cheaper price and at a higher yield. Investors can continue holding the bonds as they would provide a good yield over investment. If the interest rates are at their trough, investors can sell Bonds as the bond prices would have reached their maximum and then make a good capital gain.
6 Replies to “Making Money Out of Bonds”
very informative.learnt a lot after reading it. kudos for excellent post.
Thanks for your appreciation. Hopefully I can continue to write such articles in future.
simple & informative….
Very informative, especially from a retail investors perspective.
One doubt though: Once the duration of the bond is over does the borrower return to the lender the Principal amount or whatever is the Bond Price at that time?
Thanks Anirban. Generally after at the maturity of the bond, the borrower returns the principal amount to the Lender. As the bond approaches maturity, the bond prices comes closer to the actual worth of the bond. On the maturity date, bond price should be equal to the redemption amount of the Bond.
Hope that answers your query.