Today, we will try to look at the variables we should look at while buying a bond. We will try to explain the price of a bond and its primary drivers. We will use the below bond as a reference
If you are not familiar with bonds, I will strongly recommend you to read this before continuing
What is a bond yield?
Bonds are generally quoted in yield terms. The yield of a bond is the returns you lock if you buy a bond. So if you buy a bond maturing in January 2028 at a yield of 9.32%, it means you have locked in a 9.32% p.a. return till January 2028.
What is a bond price?
This is the amount you pay for buying the bond. Yield and Price are tightly coupled, setting up one fixes the other.
Bond price is the present value of all the payouts that are expected in the future. The present value of a payout is the value of that payout if it was made today.
₹100 today is worth more than ₹100 one year later. If the yield of the bond is 9.32% ₹100 today will be worth ₹109.32 in a year. This is how we can calculate the present value of all the payouts and add it up to get the bond price.
Relationship between bond yield and bond price
Yield and price move in opposite directions. When the yields are high, the price will be predictably lower because yield is simply the returns.
Basically, when the yields rise, the present value of future cash flows will be lesser and the prices will drop
Interpreting Yields
How do you know if 9.32% is a good yield or not for the bond? How do you know if it is safe to buy a bond that is going to make you a couple of extra percentage points? The trick is to look under the hood. We will explain the primary drivers of the yield here
Length of the bond
When do I get the money back? is the first question we tend to ask. The longer the length, the more will be the returns I would expect. So longer length bonds will have higher yields.
So if you are given a UP Power Corporation Bond that matures in 2025 you would expect that it will yield lesser than 9.32%. If that is not the case, you should ask the question why!
Government Yields
What is the government giving for a similar length? should be next in line. We should know how much are the Government of India Bonds maturing at a similar time returning.
Let's say the GOI bonds return around 6%, then the difference in yield is the credit risk we are taking when you buy the bond. So, if you buy the above bond, the 3.32% extra you make is your compensation for taking the credit risk.
If someone quotes a yield less than the GOI bond of a similar length, you should ask the question why!
Issuer
Will the issuer company be around till the bond matures? is the most important question that you need to ask. If there is slightest of doubt around the survival of a company during the tenure, one should avoid the bond.
Credit Risk is the risk you bear when you invest in a bond issued by non-government entities. This is the most important risk component for a bond and being on the wrong side of this risk might end up in capital loss.
Secured by Assets
Are there assets kept aside for contingency? is yet another important question that needs to be addressed.
If a bond is backed by the issuing company assets, it is referred to as secured and it has a much lower default risk. This means that a secured bond from an issuer will be quoted at a much lower yield as compared to its unsecured counterpart.
Bringing it Together
Once you have found the bond with the covenants matching your requirements. You need to ask the right questions before sealing the deal.
These are the questions that should be at the top of your list
- When do I get the money back?
- What is the government giving for a similar length?
- Will the issuer company be around till the bond matures?
- Are there assets kept aside for contingency?
Too excited to buy your first bond and ask the above question? Give it a shot here
