Having read about the basics of bonds and time value of money we should be in a good shape now to go into greater depths of bonds. There are several topics that we need to touch upon.
- Grades of Bonds
- Bond Ratings
- Bond Pricing
- Yield to maturity
- Reinvestment Risk
For now we will take up the first three topics while we keep the rest for our next post.
Terminology: In the basics of bonds we discussed about various terminologies like face value, maturity, coupon etc. Let’s now add some more to the list.
Current Price: When an investor purchases a bond he might not hold the bond until maturity. He might want to sell the bond and close his position much before the maturity date. He can do it in the secondary market. The price at which the bonds are currently traded in the secondary market is the current price of the bond. Mostly it is quoted as a percentage of the par value. Suppose the face value of the bond is Rs 1000/-. The current price of 98.5 would mean that the bond is currently trading at Rs 985/-.
Accrued Interest: We know that the coupons are mostly paid at regular intervals. But what happens if the current holder of a bond, say A, wants to sell the bond in between two coupon dates.
Suppose he received the last coupon 3 months back but sells the bond now. The new owner of the bond, say B, will get the next full coupon, even though A held the bond for half the period between two coupon dates. Hence, this must be factored in the price that B must pay to A. Hence, it is significantly important to calculate how much interest accrues on daily basis.
Clean Price: It is the price which has no accrued interest in it. The buyer although has to also pay the accrued interest but only the clean price is quoted in the market.
Dirty Price: It is the price actually paid by the buyer, i.e. clean price plus the accrued interest.
Suppose a bond with face value Rs 1000/- has an annual coupon rate of 8% and it is 6 months now from the last coupon date. Let’s say it is trading at 94. Then the actual price paid would be Rs 980/- (94% of 1000 + 4% of 1000).
Default: When the issuer fails to make an interest payment on the coupon payment date, the issuer is said to be defaulting.
Investment Grade Bonds: Those bonds which are issued by agencies having high credit ratings. These agencies are least likely to default.
High Yielding Bonds or Junk Bonds: These bonds have a much lower ratings than the investment grade bonds. There is a greater risk of default by the issuers of these bonds. Hence they offer high interest rates to make these bonds attractive to the investors.
Now we will look at different types of bonds based on different issuer.
- Government Bonds
- Corporate Bonds
- Municipal Bonds
We will not go much deeper into these categories but a point worth noting here is that the Government Bonds or the sovereign bonds have the highest ratingsas the governments have the least chances of defaulting.
Bond Ratings: There are different rating agencies that rate an issuer according to the likelihood of the issuer defaulting. Most developed countries are least likely to default and have a higher rating while governments of the third world have a lesser credit rating. Recently we had heard that S&P downgraded the US ratings. That means now there were a relatively greater chances of default by the US government than what were earlier, which were quite negligible.
Different agencies have different rating conventions. But the typical ratings range from AAA, AA, A to the likes of CCC, CC, C, D, with AAA being the highest of them all and D signifying that a default has occurred.
This was all for this second post on bonds. We will take rest of the topics in the coming posts. Really, talking on bonds can take a significant amount of time. 🙂