Okay, give me and yourself a chance and read through. Even when it looks like you can’t take it anymore, keep going. It is just a little bit of knowledge, won’t do much harm 😉
There is one thing that confuses a lot of people, yet a few ask.
You borrow money from bank and it is called “debt”. So education loan, house loan, car loan etc is all debt. “Repaying the debt” is something we strive for. Being “debt free” is celebrated.
And then there is investing into debt. For example “debt mutual fund”. Then there is a certain “debt-equity ratio” in your investments.
How can you “be in debt” and “invest in debt” too? So is debt a good thing or a bad thing?
I think nothing explains the other aspect of debt better than Bonds. As an investment instrument, I find them complicated in their process of buying and selling. But the underlying concept is very simple.
When you borrow money, you pay interest and you are IN debt.
When you lend money, you earn interest and you are INVESTED in debt.
The written promise you get to receive your money back after some time with all the terms of the loan is a bond.
It really is that simple.
Just like you and I borrow money for things we need, like education, house or car, the government also need money for comparatively bigger pursuits – building roads, rail, bridges and other infrastructure. Similarly companies need money to grow their businesses.
Just like we go to banks looking for money, the government and companies come to us looking for money they need, via RBI. (So they basically go to RBI asking for money. Since these request run in some thousand of crores, RBI decides to arrange for some part of the loan from retail investors like you and I )
And then they promise us to repay the money after some time with some interest.
Bonds are nothing but a promissory note to pay certain amount of money on a certain date.
Now you can decide to keep the bond (promissory note) till that certain date or you can decide to sell it to someone else. The bond may sell at the higher or lower rate than your buy price depending on some factors like time to maturity, interest rates in market etc.
Elements of a bond
Now you are lending your money. You want everything in written – how much you are giving, how much you will receive, after how long and how much interest payment is the borrower going to pay you.
The borrower issues a promissory note to you, so the borrower is the bond issuer.
- Face Value : This is what the bond will be worth at maturity. For example, the issuer promises to pay Rs 1000 on 2nd April 2021. This Rs 1000 is the face value.
- Coupon rate : The interest at which the issuer borrows money from you. The coupon is a fixed rate and is calculated on face value of the bond.
- Payment Frequency (Coupon date) : How the interest will be paid – yearly, half yearly etc and on which date.
- Maturity Date : The date on which the issuer promises to return the loan. Say for example the maturity date for the bond you bought is 2nd April 2021. So the issuer has borrowed money from you for 2 years.
How this works
Government of India wants money. They issue a Rs 1000 bond at 8% coupon with maturity on 2nd April 2021 and half yearly payments.
Face Value : 1000
Coupon Rate : 8%
Interest payment : Rs 80
Frequency : Half yearly
Maturity Date : 2nd April 2021
Now say you wanted to invest Rs 10,000, so you will buy 10000/1000 = 10 bonds.
“What? You said Rs 1000 is the maturity value, why are we buying at Rs 1000?” That’s because the Principal is what will be paid to you at maturity right? The interest earning will come half yearly to you.
At the time of issue, face value of the bond is equal to price of the bond. This is also called par value.
Now the good thing with bonds, as against say fixed deposit with bank is that you can actually sell a bond to someone. The fixed deposit is not transferable.
Also, a thing to remember is that coupon rate is fixed. The Rs 80 coupon rate for a bond will stay at that till maturity.
Now, the Reserve Bank of India decided to increase the interest rates to say 9%. Meaning now, a Rs 1000 bond is available in the market at 9% interest, Rs 90 per year. So why would anyone buy a bond from you that gives Rs 80 per year for the same price?
The buyer thinks I can lend Rs 1000 for Rs 90 per year. But if the bond is going to pay me Rs 80 per year, I have to get it at a discount.
The coupon rate is fixed at Rs 80 per year for your bond, so you have to set a price such that you match the market yield of 9%. Meaning, 9% of your new price should be Rs 80.
80/9% = Rs 888.88
Now, your bond is yielding 9% at current price.
Similarly, if the RBI reduces rate to say 7%. Now Rs 1000 bond is giving Rs 70 per year while your bond is giving Rs 80. So you want to demand a premium for the awesome bond you are selling.
It’s simple now, 7% (new market rate) of your new price has to give Rs 80 (fixed coupon rate) . So your new price will be 80/7% = Rs 1142.
The buyer is ready to pay a premium (meaning pay more) for better return.
Do all bonds have coupon?
There are zero-coupon bonds also. No interest payment.
These bonds are issued at deep discounts from face value. So a Rs 1000 five-years zero-coupon bond issued at 20% discount basically means that you can buy the bond for Rs 800 and after five years you will be paid Rs 1000. There is no coupon and the discount is basically your return. Since there is no coupon, there is no interest payments. The zero coupon bonds pay at maturity.
Off course, the bond instrument is not so simple. Like I said actually buying a bond is more complicated than the theory.
Where do they fit in investor’s life?
Bonds are a debt instrument – they are a mode for you to invest in debt. When you invest in debt mutual funds that invest in bonds, this is where your money goes. Should you invest in bonds or bond funds? That depends on a lot of factors, most important being your ability and knowledge to research, understand, invest and track your investments. It also depends on the liquidity you want. And a lot of other factors. There is no right or wrong here.
Important is this, and it stands true for any investment. The instrument you decide to invest in is the third decision. The first is figure out why do you want to invest. Then how much risk can you take. Then decide the instrument.
For a retired couple looking for fixed income, a zero coupon bond does not make sense. They want money regularly, not after 2 or 5 or 10 years. For me today, why not? For my retirement, I want to invest some money in debt. A zero coupon bond make sense for me because I want to keep this money away for next 20 years!
Some reality check. You can keep some money away only when you have rest of everything covered. The emergency money, the vacation money, everything. I see people with some decent financial strength directly investing in bonds. I am not directly invested in bonds currently. My personal target is to put money in bonds after I have at least Rs 25 lakh in Mutual funds.
I don’t know a definite right or wrong here. Please speak with your advisor and gain more knowledge. I share what I study for my personal finance. You do your own due diligence before making any move.
In Summary, some important points
- Coupon rate is the return calculated on Face Value. Yield is the return calculated on Market Value.
- As we saw, interest rates are inversely proportional to bond prices.
- You can make more than coupon rate on the bond by selling the bond at higher value than your buy price. This happens when interest rates fall. But you can also incur losses when the interest rates rises.
- If you continue to hold the bond till maturity, you get the face value on maturity date.
- There is less liquidity in bond market. Meaning, you may not be able to sell the bond easily and release the money for use if required. If you want liquidity, mutual funds is the route for you.
If you reached here, feel so proud that it bring smile to your face 🙂
You are bond, James Bond!
Also published on Medium.