211) Fixed Income Securities - Bonds Basics

A bond is a debt security, similar to an I.O.U (I Owe yoU) .When you purchase a bond; you are lending money to the issuer which may be a government, municipality, corporation, federal agency, corporate or other entity. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to pay back the face value of the bond or the principal when it “matures,” or comes due.

Among the types of bonds you can choose from are: government securities, municipal bonds, corporate bonds, mortgage and asset—backed securities and foreign government bonds.

Types of Bonds

Zero coupon bonds do not pay any interest. They are issued at a substantial discount to par value. The bond holder receives the full principal amount on the redemption date. Zero coupon bonds may be created from fixed rate bonds by a financial institutions separating "stripping off" the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond are allowed to trade independently.

Government Securities is a bond where government is the issuer or borrower. It is the safest form of bond as it is extremely unlikely that the government defaults (unless the economy is as bad as that of Pakistan). Government issues bonds to raise money for funding infrastructure development, support subsidies or several other initiatives. For example government of India has recently started issuing fertilizer and oil bonds to Public Sector companies to fund subsidies on fertilizers and oils.

Municipal Bond is a bond issued by a state, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

Corporate Bond is a bond issued by corporate i.e. public or private companies to the investors. The company borrows money from investors and promise to pay interest at regular interval. The interest rates on such bonds are high compared to government bonds because the probability of government defaulting on interest payments is low compared to that of corporate. Hence, corporate bonds have high risk and hence require higher return.

High Yield Bonds are those bonds that are rated below investment grade (lower than BBB-) by the credit rating agencies. I will talk in details about rating agencies and bond rating. As these bonds are more risky than investment grade bonds, investors usually expect to earn a higher yield. These bonds are also known as Junk Bonds.

Inflation linked bonds are bonds where the principal amount and interest payments are indexed to inflation. The interest rate is usually lower than that of fixed rate bonds with a comparable maturity. Though, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked bonds in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.

Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.

Asset-backed Securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and  also collateralized debt obligations (CDOs).

Subordinated Bonds are those that have a lower priority than other bonds of the issuer in case of liquidation/winding up. In case of bankruptcy, there is a hierarchy of creditors. First and foremost the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After these senior bonds have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Thus, subordinated bonds generally have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first; the subordinated tranches are paid later.

Perpetual Bonds are generally called perpetuities. They have no maturity date.

Bearer Bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate that is the bearer can claim the value of the bond. Usually they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risk prone because they can be lost or stolen.

Registered Bond is a bond whose ownership and any subsequent purchaser are recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner only.

Fixed Rate Bonds have a coupon (interest) that remains constant throughout the life of the bond.

Floating rate notes (FRNs) have a coupon which is linked to an index. Common indices include: money market indices, such as LIBOR or Euribor, and CPI (the Consumer Price Index). Coupon examples: 3 month USD LIBOR + 0.20%, or twelve month CPI + 1.50%. FRN coupons reset periodically, usually every one or three months. In assumption, any Index could be used as the basis for the coupon of an FRN, so long as the issuer and the buyer can agree to terms.

Features of Bonds

The most important features of a bond are:

Principal or face amount -It is the amount on which the issuer pays interest, and which has to be repaid at the end.

Issue price - It is the price at which investors buy the bonds when they are first issued, which will normally be approximately equal to the principal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.

Maturity date -It is the date on which the issuer has to repay the principal amount. As long as all payments have been made, the issuer has no more compulsions to the bond holders after the maturity date. The length of time until the maturity date is called as the term or tenure or maturity of a bond. The maturity can be any length of time, though debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to 30 years. Few bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in Euros for bonds with a maturity of fifty years.

In the market for government securities, there are three groups of bond maturities: 

• Short term (bills): maturities up to 1 year;

• Medium term (notes): maturities between 1 and 10 years;

• Long term (bonds): maturities greater than 10 years.

Coupon -Coupon is the interest payment that the issuer pays to the bond holders. Generally coupon rate is fixed throughout the life of the bond. It can also vary with a money market index, like LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.

Indentures and Covenants - An indenture is a formal debt agreement that creates the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants state the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the central and state securities and commercial laws apply to the enforcement of these agreements, which are interpreted by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document usually requiring approval by a majority (or super-majority) vote of the bondholders.

Coupon date- These are the dates on which the issuer pays the coupon to the bond holders. In the India most bonds are semi-annual, which means that they pay a coupon every six months.

We will now discuss Government bonds in great detail in rest of the article.

Government Bond

A Government security is a tradable security issued by the Central Government or the State Governments, acknowledging the Government’s debt obligation. Such securities can be short term (usually called Treasury Bills, with original maturities of less than 1 year) or long term (usually called Government bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both Treasury Bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). Government securities carry practically no risk of default and, hence, are called risk-free instruments. Government of India also issue savings instruments (Savings Bonds, National Saving Certificates (NSCs), etc.) or special securities (Oil bonds, FCI bonds, fertilizer bonds, power bonds, etc.) but they are usually not fully tradable and are not eligible for meeting the SLR requirement.

One of the world’s largest and most liquid bond markets is comprised of debt securities issued by the U.S. Treasury, by U.S. government agencies and by U.S government-sponsored enterprises.

Treasury Bills (T-Bills)

Treasury Bills, which are money market instruments, are short term debt instruments issued by the Government of India and are presently issued in three tenors, viz., 91 day, 182 day and 364 day. Treasury Bills are zero coupon securities and pay no coupon. They are issued at a discount and redeemed at the face value at maturity. The return to the investors is, therefore, the difference between the maturity value or face value (i.e., Rs.100) and the issue price.

For example, a 91 day Treasury Bill of Rs.100/- (face value) may be issued at a discount of say, Rs.1.80, that is Rs.98.20 and redeemed at the face value of Rs.100. Thus, the buyer will pay Rs. 98.2 today for 1 unit of Treasury Bill worth Rs. 100. After 91 days he will get Rs. 100. Hence, his return would be:

(100-98.2)/98.2 = 1.83% for 91 days period

  = 1.83*4 for 1 year (Simple Interest payment i.e. 365/91 ~ 4 periods)

  = 7.32% per annum simple interest rate.

Treasury Bills are issued through auctions conducted by the Reserve Bank of India usually every Wednesday and payments for the Treasury Bills purchased have to be made on the following Friday. The Treasury Bills of 182 days and 364 days' tenure are issued on alternate Wednesdays, that is, Treasury Bills of 364 day tenure are issued on the Wednesday preceding the reporting Friday while Treasury Bills of 182 days tenure are issued on the Wednesday prior to a non-reporting Friday. Currently, the notified amount for issuance of 91 day and 182 day Treasury Bills is Rs.500 crore each whereas the notified amount for issuance of 364 day Bill is higher at Rs.1000 crore.

An annual calendar of T-Bill issuances for the following financial year is released by the Reserve Bank of India in the last week of March. The Reserve Bank of India also announces the issue details of Treasury bills by way of press release every week.

Dated Government Securities

Dated Government securities are longer term securities and carry a fixed or floating coupon (interest rate) paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated securities can be up to 30 years. The Public Debt Office (PDO) of the RBI acts as the registry / depository of

Government securities and deals with the issue, interest payment and repayment of principal at maturity. Most of the dated securities are fixed coupon securities. The nomenclature of a typical dated fixed coupon Government security has the following features - coupon, name of the issuer, maturity and face value. For example, 7.49% GOI 2017 would have the following features:

Date of Issue    : April 16, 2007

Date of Maturity   : April 16, 2017

Coupon     : 7.49% paid on face value

Coupon Payment Dates   : Half-yearly (October16 and April 16) every year

Minimum Amount of issue/ sale  : Rs.10,000

Dated securities may be of the following types:

1. Fixed Rate Bonds

2. Floating Rate Bonds

3. Zero Coupon Bonds

4. Capital Indexed Bond

5. Bonds with Call/Put Options

State Development Loans (SDLs)

State Governments also raise loans from the market. SDLs are dated securities issued through an auction similar to the auctions conducted for dated securities issued by the Central Government. Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Like dated securities issued by the Central Government, SDLs issued by the State Governments qualify for SLR. They are also eligible as collaterals for borrowing through market repo as well as borrowing by eligible entities from the RBI under the Liquidity Adjustment Facility (LAF).

How are the Government Securities issued?

Government securities are issued through auctions conducted by the RBI. Auctions are conducted on the electronic platform called the Public Debt Office – Negotiated Dealing System (PDO-NDS). Commercial banks, scheduled urban cooperative banks, Primary Dealers, insurance companies and provident funds, who maintain funds account (current account) and securities accounts (SGL account) with RBI, are members of this electronic platform. All members of PDO-NDS can place their bids in the auction through this electronic platform. All non-NDS members including non-scheduled urban co-operative banks can participate in the primary auction through scheduled commercial banks or Primary Dealers. For this purpose, the urban co-operative banks need to open a securities account with a bank / Primary Dealer – such an account is called a Gilt Account. A Gilt Account is a dematerialized account maintained by a scheduled commercial bank or Primary Dealer for its constituent (e.g., a non-scheduled urban co-operative bank).

The RBI, in consultation with the Government of India, issues an indicative half-yearly auction calendar which contains information about the amount of borrowing, the tenor of security and the likely period during which auctions will be held. A Notification and a Press Communiqué giving exact particulars of the securities, viz., name, amount, type of issue and procedure of auction are issued by the Government of India about a week prior to the actual date of auction.

Types of Auction

With the introduction of auctions, the rate of interest (coupon rate) gets fixed through a market based price discovery process. An auction may either be yield based or price based.

Yield Based Auction

A yield based auction is generally conducted when a new Government security is issued. Investors bid in yield terms up to two decimal places (for example, 7.85 per cent, 7.87 per cent, etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield corresponding to the notified amount of the auction. The cut-off yield is taken as the coupon rate for the security. Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than the cut-off yield are rejected. An illustrative example of the yield based auction is given below:

Yield based auction of a new security

• Maturity Date: September 8, 2018

• Coupon: It is determined in the auction (8.22% as shown in the illustration below)

• Auction date: September 5, 2008

• Auction settlement date: September 8, 2008

• Notified Amount: Rs.1000 crore

The issuer would get the notified amount by accepting bids up to 5. Since the bid number 6 also is at the same yield, bid numbers 5 and 6 would get allotment pro-rata so that the notified amount is not exceeded. In the above case each would get Rs. 50 Crore. Bid numbers 7 and 8 are rejected as the yields are higher than the cut-off yield.

Price Based Auction
A price based auction is conducted when Government of India re-issues securities already issued earlier. Bidders quote in terms of price per Rs.100 of face value of the security (e.g., Rs.101.02, Rs.100.95, Rs.99.80, etc., per Rs.100/-). Bids are arranged in descending order and the successful bidders are those who have bid at or above the cut-off price. Bids which are below the cut-off price are rejected. An illustrative example of price based auction is given below:

Price based auction of an existing security 8.24% GS 2018
• Maturity Date: April 22, 2018
• Coupon: 8.24%
• Auction date: September 5, 2008
• Auction settlement date: September 8, 2008
• Notified Amount: Rs.1000 Crore 

The issuer would get the notified amount by accepting bids up to 5. Since the bid number 6 also is at the same yield, bid numbers 5 and 6 would get allotment in proportion so that the notified amount is not exceeded. In the above case each would get Rs. 50 Crore. Bid numbers 7 and 8 are rejected as the price quoted is less than the cut-off price.

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