What's In a Bond?

What is in a Bond?
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Chandana

Last updated October 10, 2013


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Bond Calculation

Of all, the fixed Income Instruments FD, Certificate of deposits, Commercial Papers ,PTC bonds have always been the center of focus be it Government or corporate bonds .

What is a bond? By definition bonds are debt obligations issued by government/Corporate entities. When you buy a bond, you are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of that period, the bond reaches its maturity date, and the full amount of your original investment is returned to you.

Tracking bonds can be about as thrilling as watching a chess match, whereas watching stocks can have some investors as excited as NFL fans during the Super Bowl. However, don't let the hype (or lack thereof) mislead you. Both stocks and bonds have their pros and cons. This article will explain the advantages of bonds and offer some reasons as to why you may want to include them in your portfolio. Those who just entering the investment scene are usually able to grasp the concepts underlying stocks and bonds. Essentially, the difference can be summed up in one phrase: debt versus equity. That is, bonds represent debt and stocks represent equity ownership.

This difference brings us to the first main advantage of bonds: In general, investing in debt is safer than investing in equity. The reason for this is the priority that debt holders have over shareholders. If a company goes bankrupt, debt holders are ahead of shareholders in the line to be paid. In a worst-case scenario, such as bankruptcy , the creditors (debt holders) usually get at least some of their money back, while shareholders often lose their entire investment. Second Advanatge is getting income in the form of coupons which is periodical. Other advantages include Tax benefits in Tax exempt bonds. Inflation adjusted return in inflation linked bonds.

The various notions in a bond are Coupon( same as periodic interest payments can be annual, semi-annual,inflation linked etc) YTM (yield to maturity is the discounting factor or the opportunity cost), Accrued interest (its the interest buyer owes to the seller and considered a outflow in bond calculation), Dirty Price(clean price + accrued interest used for Total consideration calculation).

Lets see a calculation for e.g Consider a Indian Government bond 8.15% GoI 2022 which is trading @ YTM of 8.20%

8.15%-Is called a coupon which is semi-annual

GOI-Government of India

Maturity-11-june-2022

YTM-yield to maturity (opportunity cost)

Price=CF1/(1+DF)+CF2/((1+DF)^2)+CF3/((1+DF)^3)+...+CF20/((1+DF)^20)

In simple words Price=PV(inflow)-PV(outflow). So in simple words I am getting 8.15% semi-annual which is fixed and if yields reduce I can get capital appreciation

Where is the risk in a bond?

If you noticed the price depends on one factor i.e YTM. Price is inversely related to YTM. Higher the YTM lower the price and vice-versa. Now how is YTM determined it depends on a lot of factors Macro-economic, Micro-economic factors , Demand and supply of  private/public debt, Government & political  scenarios and various others. So it all depends on YTM .

Another factor which is actually is a subset to YTM is maturity of bond (longer the maturity of bond  higher the risk of getting your principal back).

Can Bonds result in negative return?

Yes, they can return a negative return, say u bought the above bond @ 8.20% YTM on 30-nov-12 the dirty price is 103.5628  and u sell the bond on 1-june-13 @ 9%  YTM the dirty price is 98.7107 which results in a net loss of  4.6852% absolute.

In Simple words Return on bonds = Coupon + Price appreciation

There are various factors to keep in mind while investing in bond

1.View on interest rate

2.Holding capacity

3.Required return

The Bottom Line

Misconceptions about bonds abound, but the fact is that bonds can contribute an element of stability to almost any portfolio. Bonds are a safe and conservative investment. They provide a predictable stream of income when stocks perform poorly, and they are a great savings vehicles for when you don't want to put your money at risk.

Image Courtesy: y4yy.com

About the Author

Chandana is working as a Senior Content Writer in Simplilearn.com and handles variety of creative writing jobs. She has done M.A. in English Literature from Gauhati University. A PRINCE2 Foundation certified, she has a unique and refreshing style of writing which can engross the readers to devour each sentence of her write-ups.


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