Individual investors were finding it increasingly difficult to comprehend the bond market and its long-term significance. After all, it's not the investors' fault. Investors take the equity route because their knowledge about fixed income securities is usually limited to Fixed Deposits, in general. But now, the things have changed & its the change has been for better. That is, It's no longer a question of selecting between the two.
Smart investors avoid putting their entire portfolio in one place. They diversify their investments in different asset classes to maintain a well - balanced portfolio for the short & long term goals.Let us now understand the same in detail for a better understanding -
What are Bonds ?
A bond is a loan made to the bond issuer by the bond purchaser, or bondholder. When governments, corporations, and municipalities want funds, they issue bonds. An investor who purchases a government bond is effectively lending money to the government. When an investor purchases a corporate bond, he or she is effectively lending money to the company. A bond, like a loan, pays interest on a regular basis and repays the principal amount at the maturity date.
For Example - If Ms. Pooja buys ABC bond which has a face value of Rs.1000 & the coupon rate as 10%, then she will get Rs.100 per year as her coupon payments. Here, in this example Ms. Pooja has bought the bond on par.i.e., exactly equal to the face value amount. However, sometimes a bond is purchased for more than its face value (premium) or less than its face value (discount), which will change the yield i.e., total return of an investor earns on the bond.
What are the basic terms used in Bond Market?
The basic terms used in bond Market are -
1. Price of the Bond - Bond price is the present value of the bond that an investor is willing to pay. The higher a bond's price, the lower its yield. That's because an investor buying the bond has to pay more for the same return.The higher a bond's price, the lower its yield. That's because an investor buying the bond has to pay more for the same return.
2. Coupon Rate - This is the periodic interest rate paid to the purchasers by the issuers on the bond's face value.
3. Face Value - Also called par value, it is the price that the bond issuer pays at the time of the bond’s maturity. For Example - In the above example, Ms. Pooja bought a bond which had a face value of Rs. 1000.That is, the bond was bought at par. Similarly, if the Bond Prices at the time of purchase was Rs. 1200, then the bond would have been bought at Premium & if the same bond was bought at Rs. 900 then the bond would have been bought at Discount. Buying a bond at par, premium & discount depends largely upon the market conditions (economy) & the factors such as demand & supply for the bond.
4. Bond Yield - This is the expected earnings realized over some time, represented by a percentage. For Example Ms. Pooja earned an Bond yield of 9% p.a. for a period of 3 years.
5. Yield to Maturity - This is the total return anticipated on a bond if it is held until its maturity.
Why do investors invest in Bonds ?
Few of the reasons for which investors prefer bond markets or purchasing a bond are -
1. Preservation of Capital - Bonds, unlike stocks, are required to repay principal at a specific date, or maturity. Bonds are attractive to investors who do not want to risk losing money and who must meet a liability at a specific point in the future. Bonds also have the advantage of paying a fixed rate of interest, which is generally greater than short-term savings rates..
2. Steady Income - The majority of bonds provide a "fixed" income to the investor. The bond issuer provides the bondholder an interest payment on a regular basis, whether quarterly, twice a year, or annually, which can be spent or reinvested in other bonds. Dividend payments from stocks can also offer income, although dividends are typically less than bond coupon payments, and corporations can choose whether or not to pay dividends, whereas bond issuers are required to make coupon payments.
3. Diversification - Bonds, when included in an investing portfolio, can help to diversify it. To decrease the risk of low, or even negative, returns on their portfolios, many investors diversify over a wide range of assets, from equities and bonds to commodities and alternative investments.
4. Potential benefits during an economy slowdown - For a variety of reasons, bonds can help safeguard investors from an economic downturn. A bond's price is determined by how much investors value the income it produces. The majority of bonds pay a fixed income that does not fluctuate. When the price of goods and services rises, a circumstance known as inflation, the fixed income of a bond becomes less appealing since the income buys fewer goods and services. Slower economic growth, on the other hand, usually means lower inflation, making bond income more appealing.
What's the relationship between bond prices and bond yields?
The yield and bond price have an important but inverse relationship. When the bond price is lower than the face value, the bond yield is higher than the coupon rate. When the bond price is higher than the face value, the bond yield is lower than the coupon rate. So, the bond yield calculation depends on the price of the bond and the coupon rate of the bond. If the bond price falls, the yield rises, and if the bond price rises, the yield falls. Let us understand the same with an example -
Ms. Pooja bought a 10 year bond with a price of Rs. 5000 & a coupon payment of Rs. 200. The yield on the bond is calculated as -
Yield = interest on bond / market price of the bond x 100
= 200 / 5000 x 100
Further, Let's assume the bond's price rises from Rs. 5000 to Rs. 5500 as a result of strong investor demand. As a result, the bond currently trades at a 10% premium to the issue price. The coupon amount, however, remains same at Rs 200.
Now the yield changes to (200/5500) x 100% = 3.64%
As a result, the bond price has increased, lowering the yield on the bond. Similarly when bond prices decreases, the bond yields tend to increase.
Aside from elements like demand and supply, there are a slew of others that can help us figure out how bond markets behave. What happens to their prices or yields, and so much more. But as a beginner, if you want to start invest in bond markets, one can explore this options by investing in Debt Mutual Funds to lower the risk. Lastly, understanding a financial instrument is important before you actually start investing in it so as to be aware of the risks associated with it & get the most out of the product you've been investing.
Happy Investing !
- Team IFA