Bonds are considered to be complex because of some of the terminologies associated with this investment. But actually, they’re just simple investments in the debt market (To know about what is a bonds and debentures, refer to this interesting article). A new bond investor may get confused by some of the jargons associated with a bond investment. We bring you a brief list of the most important bond jargons that you should understand and evaluate while making your investment decision.
A coupon payment is the amount of annual interest that will be paid to the bond holder on an annual basis. The coupon payment per bond unit is:
Coupon Payment = Face Value of Bond X Coupon Rate of the Bond in %
This amount will be paid as per a pre-defined schedule – monthly, quarterly, bi-annually or annually until the date of maturity.
2. Face Value
Face value is the designated value per unit of a bond when the bond is issued by the bond issuer. Normally, in the Indian Bond market, the face value of a bond can range from as low as Rs 1000 to as high as Rs 1 Cr.
3. Market Value
The market value of a bond is the value at which the bond is currently being bought and sold in the market. This happens after the bond has been issued at the face value. The market value of a bond can be either at a premium or at a discount to the face value. The value depends on the overall economic conditions, bond issuer industry state and the bond issuer’s business condition.
4. Bond Issuer
The bond issuer is the bond issuing company or the borrower who sells bonds with the promise of regular interest payments and return of the principal amount on maturity. The bond holder is the lender who lends money to the bond issuer in exchange of a bond.
5. Payment Frequency
The payment frequency or payment schedule of bonds is the dates on which the interest in paid to bond holders by bond issuing companies. The payment frequency can vary from monthly, quarterly, bi-annually to annually. Some payment dates can be customised by the bond holder.
The bond issuing company agrees to pay back the principal amount of the bond to the bond holder on a pre-defined date. This is called the bond maturity date. Once the principal amount is returned, the bond holder stops receiving the interest payments as well.
7. Yield to Maturity (YTM)
Yield to maturity is the effective returns that an investor gets by investing in a bond and then holding it till maturity. Simply put, the yield, measured in %, is the interest rate at which an investor invests money in the bond to generate the cash flows from the bond till it matures.
Say, an investor invests Rs 1005 (market value) in a bond. The various parameters of the bond are:
Face Value per unit = Rs 1000 ; Coupon Rate = 10% ; Payment Schedule = 5 years on 31st April.
The payments that the investor will receive are :
Rs 100 on 31st April every year till the next five years. On maturity on the 5th year, investor gets back the face value = Rs 1000.
Then his effective returns or yield to maturity will be 13.07% approximately.
The effective annual returns helps in making a realistic comparison of different rate of returns of bonds. For example, if a bond receives quarterly payment of interest, then due to compounding the effective annual returns will be higher than the actual interest returns.
A bond rating is the grade given to a bond depending on its credit worthiness. The ratings can vary from AAA to AA to A and further down. AAA is considered the highest rating and bonds with this rating are generally considered the safest.
Any bond that has credit ratings of BBB and above are labelled as investment grade bonds or safe bonds in India. This rating is given to the company (bond issuer) by rating agencies on the basis of various financials factors of the bond issuer. Some of the most commonly considered factors are the issuer’s previous financial strength or ability to repay the principal and interest on time.
While bonds are a very simple investment option, having a better understanding of the financial terms associated with them will make you more confident about your investment decisions.