Today, we will try to understand what a bond is and try to demystify all the jargons that are thrown at you when you try to buy a bond.
A bond is simply an instrument used by corporations and the government to borrow money to invest in profitable avenues. The issuer promises to pay back interest and the borrowed amount at a pre-decided time.
Whenever I try to buy a bond, I am generally overwhelmed by the information that is thrown at me, and that generally puts people away from buying bonds altogether. Let's put an end to this aversion as bonds are a very important addition to your portfolio as discussed here. We, at Harmoney, have resolved to make bonds an accessible and well-understood financial instrument!
Bond Covenants
We will use the above example to explain the basic bond covenants and then delve into slightly involved ones
Face Value (or the Principal Amount) is the amount on which the interest payment is calculated. We receive the face value back on maturity. It is ₹10,00,000 in the above example
Coupon Rate is the interest received each year. It is 10.15% in the above example
Coupon Frequency is the periodicity at which the interest payment is made. A quarterly payout bond will make 4 interest payments in a year. It is quarterly in the above example
Maturity Date is the date on which you receive the principal along with the final interest payment. It is 20th Jan 2025
The next set of covenants are a layer above the vanilla bond structure we discussed earlier
Perpetual bonds are bonds that pay coupons in perpetuity i.e. forever. The above SBI bond is a perpetual bond meaning the issuer will pay 7.74% interest every year forever.
Callable bonds give the issuer a right to buy back a bond on the call date. It means that the issuer will pay the face value of the bond on the call date and buy back the bond. The above SBI bond has a call option attached to it, meaning it can buy back the bonds at face value on 9th September 2025
Bringing it Together
At the end of this, you should be able to figure out what and when are your expected cash flows from a given bond!
In the next post, we will delve deeper into what should we look at when we are buying a bond and try to understand the returns that a bond yields.
