Bonds: Price vs Interest, Features, and Types

Last Updated on Nov 29, 2022 by Aradhana Gotur

What is a bond? 

According to Wikipedia, a bond is a type of security under which the issuer owes the holder a debt and is obliged – depending on the terms – to repay the principal of the bond at the maturity date as well as interest over a specified amount of time.

But in layman’s terms bond is nothing but a loan from a lender (investor) to a borrower (issuer) such as a company or a government.

A bond is also considered a less risky asset to invest when compared to equity and real estate, as the certainty of cashflows can be predicted well in advance, unlike real estate and equity assets. Bonds offer an assured return to its investor. While other assets do not give an assured return and are much more likely to default, bonds are one of the safest investments in financial products. 

Commonly used terms

Before getting any deep into bonds, we must know some commonly used terms in the bond world.

Coupon rate – This is the cash flow an investor expects to receive while holding a bond. This rate is stated in the bond document, known as bond indenture. The coupon rate can be fixed or floating, but generally, it is fixed on the bond indenture, and remains the same until maturity. 

Maturity –  It refers to the date on which the issuer of the bond is obligated to repay the bond holder’s outstanding principal amount. 

Par value – It is also known as face value, i.e. the amount of principal that the issuer agrees to repay to the bondholder at the maturity date. 

Bond Indenture – It refers to nothing but the legal contract between the issuer and the holder (lender and borrower). This document carries all the necessary information regarding the bond, like its maturity, coupon rate, covenants, etc. The Bond Indenture has all the essential information that is important for the bond issuer to disclose and crucial for the bondholder to know before investing. 

Bond yield – It refers to the annual rate of return on a bond, expressed as a percentage of bondholders’ invested capital. Bond yield is the same as a coupon rate when the bond is issued at par value, but when the bond is issued at a discount or at a premium, the Bond Yield is more and less than the coupon rate, respectively. 

If the bond yield is less than the coupon rate, that means the bond is quoting at a premium, and if the bond yield is more than the coupon rate, then the bond is quoting at a discount. 

For example, Ram, an investor, purchases an Rs. 1,000 bond with a coupon of 10% at a discount of Rs.800, and Sham purchases the same bond at the par value of Rs. 1,000. Both Ram and Sham would receive Rs. 100 interest at the end of the year, while the Bond Yield of Ram is 12.5% more than the coupon rate, and the bond yield of Sham is the same as the coupon rate. 

Till now, we have understood that in a bond, the bondholder gives out a loan to the bond issuer for some interest, but how is the interest calculated for the bond? 

Components of bond interest 

For the loan given by an investor, he receives a return in the form of Bond Yield or YTM ( Yield to Maturity). This Bond Yield consists of –

1. A Risk-free rate of return or Treasury rate: Risk-Free Rate(RFR) of return refers to the rate of return of an investment with no potential risk. For example, Government Treasury Bills, Government bonds, etc.

For the investors who want to play it very safe, they have the option of investing in risk-free, as even in the worst-case scenario if the government has a shortage of funds and isn’t able to pay back the principal or the interest so it can easily borrow from the central bank to pay off the lenders.

2. Yield Spread: It refers to the extra benefit that an investor receives because of the potential risk they bear. This risk varies from company to company. The higher the yield of the bond, the greater the risk the bondholder would take. 

The Yield spread of a company primarily depends on two kinds of risk-

1. Credit risk: It refers to the risk of default. It is the kind of risk the company bears due to which it might not be able to perform at the desired level of output. For instance, a strike by employees or a fire in the factory or any other reason which impacts the ability of the company to earn consistent profits drops, leading to an increase in the risk of generating profits in future and would result in a higher risk spread.

2. Liquidity risk: It refers to the risk that the investor faces due to lower liquidity of the security in the market. Not being able to sell the security at the quoted price leads to an add-on premium for liquidity. Highly liquid security would carry a low or negligible liquidity rate with itself. 

Liquidity rate refers to the loss in the value of an investment which occurs due to the sale of the asset. For example, a low liquid asset would be cash and cash equivalents, CDs and US treasury, as you can sell these assets at any time and realise the entire or approximately the full amount. 

A highly liquid asset would be Real Estate, Art and antiques. These assets require higher capital to invest, and some of the purchases also have a lengthy procedure to find buyers and perform legal activities to complete the sale. 

Since the investor bears both risks, they expect a return compensation including these risks on his investments.

Together, RFR and Yield Spread decide the rate at which the market expects its return, called market rate or Bond Yield.

Bond Yield = Risk-free rate + Yield spread

Interest rates vs bond prices 

The prices of the bond fluctuates in the real world as per the prevailing interest rates in the market. 

	Coupon rate	Current interest rate in the market	Market value of bond	Premium/(Discount)
Issued at par	10%	10%	1000	–
Issued at premium	10%	9%	1100	100
Issued at a discount	10%	11%	900	(100)

How do bond prices change?  

Interest rates are inversely proportional to the market value of the bond. If the interest rates rise, the value of the bond falls because there are other bonds available in the market with higher interest rates. So, the bond would quote at a discount with the amount of difference to which the interest rates have risen and vice versa.

A bond quoting at a discount/premium would not get much affected by the total yield for the bond because if the interest rates decrease, the new investor has already paid a premium for the higher interest rates which he is going to receive. If the interest rates go down, then also the new investor has purchased the bond at a discount so the total bond yield would not get much affected by the bond quoting at a premium or a discount.

When interest rates in the market go up, we’ve read that the bond prices go down and quote at a discount. This happens because when interest rates go up in the market, there are better opportunities in the market for the investors to put in their money so the investors tend to shift their investments from the lower yielding investments to higher return-yielding investments. Due to this shift, the bond prices go down.

When interest rates in the market go down, investors tend to shift their investments from lower-yielding coupon bonds to higher-yielding coupons. It is followed by a rise in the prices of the bonds available in the market at higher coupon rates than the new market interest rates, leading to the bond quoting at a premium and charging a price higher than its par value. 

If YTM is greater than the coupon rate, then the bond would quote at a discount. If YTM is less than the coupon rate, then the bond would quote at a premium. Even a discounted bond can be overvalued, and a premium bond can be undervalued. 

Types of bonds 

Now, let’s read more about the various types of bonds available in the market with various redemption methods according to the needs of the bondholders.

1. Zero coupon bond – This is also known as an accrual bond, a type of security which does not pay any interest to the bondholder but is traded at a heavy discount in the market. The bondholder gets its profits when the bond is redeemed at the par value at maturity.

For example, for a bond with a par value of Rs.1,000, issued at a discount, quoting at Rs. 800, the bondholder would now get no interest payments, but the difference amount of Rs. 200 would be the profit for the bondholder.

2. Bullet bond – A bullet bond is a type of bond wherein the payment is made in one lump sum on the maturity date rather than amortised over its lifetime. It is generally considered riskier to its issuer than an amortising bond because it obliges the issuer to repay the entire amount on a single date rather than in a series of smaller repayments over time.

For example, a 3-yr Rs. 1,000 bond with a coupon of 10% was issued. The payments made would be Rs. 100 as an interest at the end of 1st year, 2nd year and the 3rd year, along with the 1000 principal.

3. Amortising bond– It is the type of bond in which the principal is paid along with the interest payment. For example, in a car loan, the EMI payment of the loan is a mix of the principal amount and the interest payment made towards that principal.

4. Partially amortising bond– They are similar to amortising bonds; they also make fixed periodic payments until maturity, but a certain sum of principal is paid till the maturity date. The remaining principal is made through a balloon payment on the maturity date.

For example, for a 3-yr Rs. 1,000 bond with a coupon rate of 10%, the bondholder would receive Rs. 300 (Rs. 100 interest and Rs. 200 principal) at the end of 1st year. At the end of 2nd year, the bondholder would receive Rs. 300 (Rs. 100 interest and Rs. 200 principal). At the end of 3rd year, the bondholder would receive Rs. 700 ( Rs. 100 interest and Rs. 600 principal).

5. Callable bond – It is also called a redeemable bond. A callable bond is a bond in which the issuer has the option to redeem the bond before its maturity. It allows the company to pay off its debt early. Generally, companies exercise this option when the interest rates in the market fall and they can avail debt at a cheaper cost now. Due to this callability option, the issuer pays the bondholders a slightly higher interest rate.

For example, a company issues a 5-yrs callable bond at 10% p.a, and after 3-yrs, the interest rates fall in the market so the company can pay off its bondholders by issuing a new bond at 7% interest rate and return the money to the previous bondholders.

6. Puttable bond –  This bond gives the bondholder the special power of forcing the bond issuer to purchase the security before the maturity date. The repurchase price is set beforehand and is generally the par value of the asset.

For example, a bondholder with a 10-yr bond issued at a coupon of 7%, when the interest rates in the market increase then the bondholder would ask the issuer to repurchase the bond and then invest the amount in a new bond with a higher interest return yielding bonds.

7. Convertible bonds – It is a fixed-income bond with the option given to the shareholder to convert the bond into a predetermined number of common stocks or equity shares.

For example, a bondholder with a 10-yr Rs. 1,000 bond issued at a 10% interest rate would have the power to convert the bond into common stocks of the company as per the conversion rate mentioned in the bond indenture. 

Suppose the conversion ratio mentioned is 20:2, which is for every Rs. 20 invested. The bondholder can convert their bond into 2 shares. Suppose the stock price is Rs. 22 then the investor can convert his bond into common stock as they would be getting 50 shares worth Rs. 22 each, which is Rs. 100 more than the bond value as a profit. The bondholder would not exercise this option when the stock price is trading below Rs. 20, as that would be a loss for the investor.