2. Every one know about the stock market .
Stocks look exciting. Buying at low price and
sell at high price may be an interesting job.
Every day you watch TV and read news
paper to get an idea about the bonds
New investors get the help of advisors.
For many others stock market is a scary
jungle. They have no idea where to invest
and how to start. They follow the stories of
windfall profits from market bulls
3. Diversification - “ Do not put
all your eggs in one basket”
Investors need to diversify their
investments in various assets classes
to reduce risk. In bull market investors
are excited by the stock rally and ignore
bonds. Only in market crash thinks
about the bonds.
In coming chapters we are going to
discuss bonds and its relation ship with
stock market.
After reading the full chapter you can decide whether you need to
include bonds in your portfolio
4. What are bonds ?
Sure ,everyone borrowed money
at least once in their life.
Remember you asked pocket
money from your parents to buy
candy
Like this Companies and
Government also need money to
run their business
Here we can see one giving (
lending ) money other receiving
(borrow ) it .
Assume here you are the
lender and Government is
the borrower . As you are
giving hard earned money
to Government you will
expect a return. That is
called interest or coupon.
Next slide
5. What is a coupon ?
say you buy a bond with a face value of
Rs.1,000, a coupon of 8%, and a maturity of 10
years. This means you'll receive a total of Rs. 80
(Rs. 1,000*8%) of interest per year for the next
10 years.
Actually, because most bonds pay interest semi-
annually, you'll receive two payments of Rs. 40 a
year for 10 years. When the bond matures after a
decade, you'll get your Rs. 1,000 back.
6. Who should invest in
bonds?
1. Retired persons : They are living on fixed
income. If he is losing his investment he
may not able to pay his bills.
2. Shorter time horizons : Lets say a young
executive planning for higher education in
next 3 years. His time horizon is low. He
cannot afford losing big.
7. How to deal with bonds ?
We already discussed coupon rate . Now we need comes
maturity. The maturity date is the date in the future on
which the investor's principal will be repaid. Maturities can
range from as little as one day to as long as 30 years
So you decided to buy Rs. 100 bond with a coupon rate of
8% paying semi annually expiring at 2020.
This means you will get Rs.4 every 6 months. And you will
get full Rs. 100 in 2020.
8. How interest rates effect
bonds ?
Now you must realize Rs. 100 bond can be traded
at Rs. 90 or Rs. 110. How this happens .
Lets check
Think about a situation bank interest rates rises to
10% in the country. Now you don’t buy bond
paying Rs. 100 because you will get only 8% in
bonds. So you will try to get bonds with lower price
If interest rates comes down demand for bonds
will be high and thus price of the bond will rise.
9. Bond yields
Now lets dog the term bond yield. In our example we are talking about a bond
with a face value of Rs.100. This bond price can be Rs. 110 or Rs. 90 depends
on interest rate expectation . Those who purchasing bond in above prices will
all get same 8% interest rate. But yield will be different . How?
Watch excel sheet for calculations
10. Bond yields
Those purchasing bonds with lower
price will get higher yield
Eg : Person buying bond for Rs.90 will
get same coupon rate of Rs.8 . He is
effectively getting 8.89% interest.
His yield will be high comparing with
those who are purchasing same bond
at par or premium rate
11. Yield to Maturity (YTM)
Yield to maturity accounts for the present value of
a bond’s future coupon payments.
YTM is the interest rate an investor would earn by
investing every coupon payment from the bond at
a constant interest rate until the bond’s maturity
date.
The present value of all of these future cash flows
equals the bond’s market price.
Calculation
12. Pricing the bond
Now it is very important part
We understood that when bank interest goes up
price of the bond will come down and bond yield
will rise .
Now we are going to calculate the price of the
bond in given interest arte expectation
Assume RBI rises interest rate to 9%
Bond coupon is only 8%
Of course you and me ask for 9% .
Now the demand for the bond will come down and
price will fall then yield will rise.
Calculation
13. Credit/Default Risk
Credit or default risk is the risk that interest and principal payments due on the
obligation will not be made as required.
Prepayment Risk
Prepayment risk is the risk that a given bond issue will be paid off earlier than
expected, normally through a call provision. This can be bad news for investors,
because the company only has an incentive to repay the obligation early when
interest rates have declined substantially. Instead of continuing to hold a high interest
investment, investors are left to reinvest funds in a lower interest rate environment.
Interest Rate Risk
Interest rate risk is the risk that interest rates will change significantly from what the
investor expected. If interest rates significantly decline, the investor faces the
possibility of prepayment. If interest rates increase, the investor will be stuck with an
instrument yielding below market rates.
Risk of Bonds
14. The most commonly cited bond
rating agencies are Standard &
Poor's, Moody's and Fitch. These
agencies rate a company's ability to
repay its obligations.
In India CRISIL is the authorized
agency for credit rating
Bond Ratings
