Bonds, James Bonds....

BONDS
Part - 1
Introduction :
A well-known phrase “Bond”… James Bond !!! the most thrilling style, name and popularity on silver screen. Yes we are following this BOND theme since decades, but apart from the character and spice on screen there is an entirely different world behind this word. Some of the education drivers intentionally kept us away from it. There is huge depth behind this word, very first thing; why is it so important to know about bonds? the answer may (vary) have different views, but simply if we are talking in terms of money and (planning of) wealth then certainly it is not comprehensive to check all the aspects of the subject.

Debt Market / Debt Papers meaning & Concept :
When we are talking about wealth there has to be an asset allocation, and with the boom of equity we also have boon of Debt market. Debt market is a world of debt papers, also called as bond papers. If we understand the concept of bond papers then it will not only shelter our wealth but also enrich it. We have learnt one elementary law of thermodynamics, “Energy can neither be created nor can be destroyed, it can only change its forms”. Here knowing more about bonds or debt market is like knowing the other form of asset and different language of money. Now let’s try to understand the new form of money and Debt Market.
Debt, word itself suggests its meaning, ie liability or obligation. Suppose A borrows from B, then three things are discussed and decided.
1. what is the amount to be borrowed,
2. For what period it will be borrowed
3. And most important thing is @ what interest will be borrowed.
With the survey of market A and B mutually decides the rate @ which B will lend the money to A. Lets study a simple example, If A borrows Rs. 100/- from B for 3 years @ 8% interest, interprets B will lend Rs.100/- to A on day one, at end of one year A will return @ 8% of principle amount which is Rs. 100/-, 8% * (100) = Rs. 8/- to B, similarly at end of second year again he will return Rs. 8/- to B and at end of third year, A will return Rs. 8/- of interest and the basic principle amount Rs. 100/-, which is 8 + 100 = Rs. 108/-.
In return of aforesaid transactions A will issue a (Bond) paper to B as a security, on which there will be declaration of all the above three conditions. Here we will further elaborate the concepts :
1. Rs. 100/- Borrowed is called - Face Value
2. 3 years period of borrowing is called - Tenure and
3. Rate at which borrowed ie 8% is called - Coupon
Table 1.
Face Value 100 rs
Tenure 3 yrs
Coupon 8%

This paper is called as Bond Paper or Debt Paper. A will borrow Rs.100/- from B, and will give a paper in return as security, also called a Debt Paper. Any one can issue bond paper, when such Bonds are issued by Government they are called as Gsec (Government Securities), and when Commercial institutions like Tata or Birla issue papers they are called as Commercial Papers and when bank issue such papers it is called as Bonds.
Meaning and Concept of Coupons : -
Alike the word debt the Coupon itself suggests the meaning of coupon. In olden days there was a practice to paste stickers on Bond Papers, in our above example A will issue a bond paper with three stickers called as coupons to B. At end of first year B will return one Sticker to A and in return he (A) will pay Rs.8/- to B, similarly at end of second year A will again pay Rs. 8/- to B and will return second sticker and so on. These stickers are called as coupon and this terminology is still in practice while dealing in Bond Papers. In present days of advance technology there is no issue of bonds in physical forms but terminology of coupon is still prevailing.
Trading of Bond Papers in Security Market:
These bond papers can be traded in Security Market, named as Debt market. In accordance with the Securities Regulation Contract act of 1956 there are various instruments which come under the definition of securities, and one of them is Bond. Bond market comes under regulation of SEBI (Securities and Exchange Board of India) where as Gov-sec or Gilt comes under regulation of RBI (Reserve Bank of India).
Case Study – Present Value of Future Cash Flow : -
Further in our above example, with survey of market A agrees to issue bond paper with face value of Rs. 100/- for tenure of 3 years @ coupon of 8% and B agrees to invest in that paper by lending Rs.100 to A. At a latter date interest rates of market for lending and borrowing may fluctuate and when such fluctuation takes place it affects the transaction of A and B both. This is the most crucial part for trading in Bonds, We will further elaborate the aforesaid example to understand the effects such fluctuations.
To understand this mathematics of Bond it is essential to understand the definition of Bond in terms of the sum of the present value of future cash flows. And if we understand this definition then it will be simple for us to understand meaning of Bond Market. It is widely said that in finance many times the words explains better than actions. Here we will study an example to understand the above definition of bond from right hand side to left hand side.
Table 2.
From right to left
<--------<-------------<------------ <----------------<---------------<--------
Years 0 1 2 3
-100
PV1 7.41 8 FV1
PV2 6.86 8 FV2
PV3 85.73 108 FV3

Sum 100.00

B invests Rs. 100/- in bond paper issued by A. In simple language B lends Rs. 100/- to A,
In aforesaid table 2
Row 1 : indicates number of years
PV1 : Present value at the end of 1st year
PV2 : Present value at the end of 2nd year
PV3 : Present value at the end of 3rd year
FV1 : Future cash flow at the end of 1st Year
FV2 : Future cash flow at the end of 2nd year
FV3 : Future cash flow at the end of 3rd year

When B lends money to A it is -100 shown in column 2, row 2. On day one, year is 0, at end of first year B will get Rs. 8/- ie is in column 3 row 3 which is the future value B will get denoted as FV1 Future cash flow after 1 year. Similarly after 2nd year B will get again Rs. 8/- FV2 Future cash flow after 2nd year and Rs. 108/- FV3 Future cash flow of after 3rd year.(0,1,2,3 are the number of years, 8, 8 and 108 are the future cash flows and 7.41,6.86 and 85.73 are the present values of respective future cash flows and 100 is the sum).
Further, if 8% is the interest in market, to get Rs.8/- at this rate for one year we need to invest Rs. 7.41. So that interest on Rs7.41 @ 8% we will get Rs. 0.59 which gives us total of Rs. 8/-. That means Rs. 7.41 is the present value of Rs.8 (after one year) @ 8%, which is 1st year cash flow. Similarly to get Rs.8 after 2 years, we need to invest Rs.6.86 @8% for two years, which shows Rs.6.86 is the present value of Rs.8 @ 8% ie 2nd year cash flow. Similarly Rs.85.73 is the present value of third future cash flow @ 8%. Adding all the present values, 7.41 + 6.86 + 85.73 = Rs.100/- this is how we calculated the current price of bond. The price of bond paper which is with B is Rs.100. It means on day zero neither borrower nor lender is in profit or loss.
Case Study where there is fluctuation in Interest on Higher side: -

Now, if the market rate of interest fluctuates then there are only two possibilities, either market rates will be higher than coupon or lower than coupon. Take a case if market rates are higher than the coupon. For example B lends Rs. 100 to A @ 8% and if interest rate goes up, B would not have opportunity to encash the higher cash flows, as his money is already blocked with A. He could have lent the same amount to other person with higher interest rate and get higher future cash flows. To understand this concept better, consider that market rates rises to 9%.
Table 3.

Face Value 100
Tenure 3
Coupon 8%
Market Rate 9%

Years 0 1 2 3
-100
PV1 7.34 8 FV1
PV2 6.73 8 FV2
PV3 83.40 108 FV3

Sum 97.47

In the above table, considering the same example of Bond paper issued by A of face value Rs. 100/- @ 8% for three years, where B will get the future cash flows of 8, 8 and 108 in three years respectively. If interest rates increases to 9%, then we can see that the present values of respective cash flows are reduced, resulting in the reduction of the sum of bond price. This means with increase in Market rate the Bond prices decreases.
Logically, when market rate and coupon was same, to get cash flow of Rs.8/- after one year we need to invest only 7.41 (Table 2) today. In above Table 3 we need to invest Rs. 7.34 today to achieve Rs. 8 in one year @9%.
Mathematically: In school, we learnt formula of Compound interest FV = PV (1+R) * N, where FV is future value, PV is present value, R is rate of interest, and N is Number of years. To find PV we can adjust formula as PV = FV / (1+R)*N. In the above formula R is inversely related to PV, if value of R is increased then the value of total ratio decreases. In above example the value of R is increased from 8% to 9% resulting in the decrease of total value of ratio from 7.41 to 7.34.
Sentimental: As B has already blocked the amount Rs. 100/- @ 8%. and market rates goes to 9% then emotionally he is negative on his investments, with the result no one will wish to buy that bond paper from B. This will Shrink the demand of bond price due to sentimental price of bond paper.
If market rates are falling then same three reasons will act in opposite way resulting in the increase of bond price.
So, we can state that bond prices are inversely proportional to the market rates, if market interest rates are rising, bond price will fall and vice versa This is called inverse relation between bond price and market interest rates.


Case study of Long Term & Short term Bond Papers

Just knowing relation is not enough, knowing implementation of it is also important…
Now, we have understood the relation between market interest rates and bond price. Let us try to understand what happens with long term bond paper. If B invest in bond paper issued by A for three years and invests same with C for five years @ 8% coupon. If interest rate falls,…?
According to the inverse relation, with fall in market interest rates, there will be rise in bond price. In above case the bond price of A and B, will rise. Now at what rate this increment happens is questioning If market interest rate becomes 7%.
Table 4.

Three years Five years
FV 100 FV 100
Tenure 3 Tenor 5
Coupon 8% Coupon 8%
Market Rate 7% Market Rate 7%

Years 0 1 2 3 Years 0 1 2 3 4 5
-100 -100
PV1 7.476636 8 PV1 7.476635514 8
PV2 6.98751 8 PV2 6.987509826 8
PV3 88.16017 108 PV3 6.530383015 8
102.6243 PV4 6.103161696 8
PV5 77.00250738 108
104.1001974


From the above two tables we can conclude that if B invest in A for three years, B will get the investment back after three years which if B reinvests he will get cash flows @ 7% instead of 8%. Where if B invests with C for five years then for five cash flows B will get higher rates than that of market.(where market interest rate has fallen.) so we can say as market interest rates are falling five years bond rate is rising more than three years bonds. And vice versa if market interest rates are rising then the five year bond will fall more than three year bond. To summarize we can make new statement here that “Long term bonds are more sensitive to market interest rates”.
For Bonds we saw two important relations, First one is “Bond prices are inversely proportionate to market price” and second one is “Long term bonds are more sensitive to the market interest rates”. The knowledge without implementation is of no use.
In day to day life all of us are fighting with inflation, RBI hiked interest rates consecutively for 13 times. Rupee is all time low at Rs.54 against US dollars. IIP numbers are minus for the quarter, growth rate is hard to achieve. We know to make it steady and ease the pressure RBI may lose some bps (basis points, 100 basis point = 1%) in near future. And if interest rates falls then bond price will rise, and according to the second relation long term bond paper will be more aggressive in raising its price. In last decade we have seen that one time one asset performs, and this is the time for long terms bond papers or GILT funds, in last 1 month these gilt funds have delivered ~ 4% returns, means annually almost 40% returns. Getting 40% returns may look unrealistic but the time when we are getting slaughtered in equity, there is a bull in bonds, all set for the run, ready with freshness, and still we are side lining. It is our tendency now a day, when crowd makes noise, we take the chance but this is the time where the silence is speaking louder than anything and welcoming us for the new rally.
So, when equity is in trouble and if we can understand this form of asset, then we can change the type of our investment and still make some handsome returns on it.
This is why knowing BONDS is important. Just make your doubts clear, Study regularly, track your investments, love your money clear your doubts and do not listen to so called Market Guru. Let us study regularly, read Financial paper, track RBI’s movements and decide the investment strategy. Just remember the law of thermodynamics and enjoy the gains. Till then rock the study’s and rule the investments.

Shivani Dani
Financial Consultant Stock Analyst & Columnist
Beta Money Management Services
+91-98601-33860
+91-95793-22224