Understanding Bonds – Part 2

After the introduction of the basic concept of the bonds, today we are trying to explore characteristics of a bonds.

Face Value / Par Value:

The face value is also known as the par value or principal. It is the amount of money a bond holder will get back once a bond matures. Corporate bonds normally have a par value of Rs 1,000, but this amount can be much greater for government bonds. Now the confusing part is that the price of the bond. A newly issued bond usually sells at par value. After issuing, its price would be fluctuates due to many economic conditions till the maturity date. If it trades above the face value, it is said to be in premium and when it trades below from the face value, it is said to be in discount.

Maturity Date:

The maturity date is the date on which the investor will get back face value or par value from the issuer. In general, maturity date can be range from one day to 30 years or even more than 30 years depend on the bond’s term and condition. Obviously a bond that matures in one year is much more predictable and less risky than a bond that matures in 20 years. So the longer the time to maturity, the higher the interest rate. If all things are being equal, a longer term bond will fluctuate more than a shorter term bond.

Coupon rate or Interest rate:

Coupon rates or interest rates both are same. It is the amount the bondholder will receive as interest payments till maturity date as per predefined condition maintained in the bond. Most bonds pay interest in every six months, but many pay also monthly, quarterly or annually. The coupon is expressed as a percentage of the par value or face value. For example if a bond pays a coupon of 10% and its par value is Rs 1,000, then it will pay Rs 100 of interest in a year.

If coupon rate fix till the maturity then this bond is called as fixed coupon bonds. When the interest rate (coupon rate) is linked to the market rates through an index then it is known as floating rate bonds.

Issuer:

It is the most important factor to know ‘Who is the issuer of the bond?’.The issuer of a bond is a crucial factor to consider before purchase any bond. First check the issuer's stability and credit for getting paid back coupon and face value. For example, the Indian government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small. That is the reason Indian government securities are known as risk free assets. The reason behind this is that a government will always be able to bring in future revenue through taxation. If the issuer is non govt organisation, it must continue to make profits, which should be more than guaranteed coupon and face value.

There are also a bond rating agencies which helps investors determine a company's credit risk at the time of purchasing bond. Blue chip firms have a high rating, while risky companies have a low rating. There are many popular rating agencies. Few of them are Moody, Standard and Poor , Crisil and Fitch Ratings.

If the company falls below a certain credit rating, its grade changes from investment quality to junk status. Junk bonds are the bonds whose issuer companies in some sort of financial difficulty. Because they are so risky, they have to offer much higher yields than any other debt. So every time investor should not be in trap of higher coupon rate from these type of junk bond companies. It is better to be avoid such type of bond.

In next part of the bond series we will discuss about bond yield, price in more detail.

Regards,

Arvind Trivedi

Certified Financial Planner