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Bond With The Best
Bond investing was meant to be simple, right? And yet, a formidable array of bond investing terms leave many a would-be bond investor bewildered. We attempt to decode some commonly used bond vocabulary
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Bond investing was meant to be simple, right? And yet, a formidable array of bond investing terms leave many a would-be bond investor bewildered. We attempt to decode some commonly used bond vocabulary.
The credit rating of a bond stands out as its most advertised feature. Simply put, credit rating is a third-party stamp of approval that underscores the creditworthiness (or lack of it) of the debtor in question. CRISIL, ICRA and CARE are the chief agencies that issue ratings for Indian corporations. Bond ratings range from AAA (highest) to D (lowest), with D being an acronym for ‘Default’, the most dreaded term in all of bond-land.
While the Greeks might beg to differ; government bonds, rated ‘SOV’ or sovereign, are widely perceived as risk-free and hence supersede even AAA in terms of creditworthiness.
The thumb rule is, the higher a bond’s rating, the lower its coupon rate, and vice-versa. Post 2008, there have been questions raised on the objectivity of some global credit rating agencies since the industry follows an “issuer pays” revenue model; that is, bonds’ issuers pay credit rating agencies to rate them.
Call and Put Provisions
Some bonds have inbuilt ‘call’ provisions that permit their issuers to redeem them even prior to their maturity date. Intuitively, there is an ironic flipside to this. After all, when is a bond issuer most likely to exercise the call option? Correct answer: after interest rates have fallen, so that they can re-price their outstanding debt by issuing lower interest bonds and reduce their own interest expenses. Unfortunately, this would leave the investor with no option other than to buy a lower interest bond to substitute the previous, higher interest one. Due to this, callable bonds usually have higher coupons to compensate the investor. Bonds that cannot be recalled prior to their maturity date are also called ‘bullet bonds’. In contrast, some bonds have inbuilt ‘put’ provisions that permit investors to sell the bond back to their issuers if they suddenly need cash, or after interest rates have risen. These bonds carry lower coupon rates, as compensation for the disadvantaged issuer.
Maturity, Yields and YTM
The maturity date of a bond is “the day of reckoning” on which it becomes due for repayment by the issuer — if your bond has unluckily sunk to a ‘D’ rating by then, don’t hold your breath!
The yield on a bond is the annual rate of return that you would earn from it. Simply put, the annual coupon divided by the bond price. For instance, if you purchase a bond for Rs 105 that pays Rs 8 as annual coupon, the yield works out to 7.61 per cent; that is Rs 8 divided by Rs 105. This is why rising bond prices are synonymous with falling yields, and vice-versa. The YTM or yield to maturity of a bond is the annualised yield that you would realise if you held it until its maturity date. This is why the average YTMs for bond funds surge when bond prices fall.
The ‘credit spread’ is the difference between the yields of two bonds of similar maturities but different credit qualities. For instance, if the yield on the 10-year G-Sec (government bond) is 6.5 per cent, and the yield on a 10-year corporate bond is 7.5 per cent, the credit spread between them is 1 per cent or 100 basis points. Considering that rising yields are marked by falling bond prices, a widening credit spread isn’t good news for the bond. It could be an early signal that the corporate borrower is headed for troubled times. Similarly, the narrowing of spreads spells good news for bond holders.