The bond market is full of complex concepts, terminology, and acronyms. Let us help you break them down into simple terms:
ADDITIONAL TIER I BONDS (AT1 BONDS)
AT1 Bonds (also known as Perpetual Bonds or Perps) have been specifically very popular after the news of SEBI allowing temporary writing off Yes Bank AT1 bonds hit the market. Let us understand what these are:
It is a popular option among Banks to raise capital to meet their core capital (Tier1 capital) needs as instructed by RBI. However, this category carries considerable risk and hence pays high-interest rates to investors. As per BASEL III norms, theoretically, these bonds can be carried on till infinity. In reality, they come with a call option after 5 years or 10 years from the date of issuance.
Note: In case of winding up of the issuer, if any payment is to be made to Tier I capital holders, AT I bondholders are paid before equity holders. However, in case the Bank is getting merged with another Bank due to its non-viable business state, then AT1 Bonds can be written off fully while keeping the equity capital unaffected.
However, it has a two-fold risk:
Given these characteristics, AT1 bonds are also referred to as quasi-equity.
How RBI can take over the regulation of any bank?
There is an additional trigger in Indian regulations, called the ‘Point of Non-Viability Trigger’ (PONV).
This is the simplest of all the return metrics we are going to discuss here.
Absolute return measures the absolute increase in your portfolio.
Let’s say you invested Rs. 10,000 on 1st June 2008. The value of your portfolio becomes Rs. 15,000 on 1st June 2010. What do you think is the absolute return of your portfolio?
It is 50% calculated as follows –
Now, let’s say you invested Rs. 30,000 on 1st Jan 2009 and the value of your portfolio becomes Rs. Rs. 40,000 on 1st Feb 2009. What do you think the absolute increase in your portfolio is?
It’s about 33%!
When it comes to absolute return, the timeline doesn’t matter. What matters are only two variables – the investment amount and the current portfolio amount – that’s it!
Absolute return is rarely used as a formal return metric though you might see it on many mutual fund investment portals. But it doesn’t tell you how well your investment is doing when compared to, let’s say, an FD with an interest rate of 7% per annum!
This is the interest earned by an investor for a given period of time,
The bond issuer pays the bond holder a fixed interest on a predetermined schedule. However, if a bond were sold between its interest payment dates, the purchaser would have to pay the market price of the bond plus the appropriate fraction of the accrued coupon interest earned but not yet received by the party selling the bond.
Example: Hrishvi holds 1 Bond with face value of Rs 10 Lac and a coupon rate of 10% (payable annually). Every year Hrishvi receives Rs 1 Lac from the issuer on a specific date. Then, after 6 months from one such payment, Hrishvi sells this Bond to Kiara. Kiara then has to pay Rs 50 K as accrued interest to A along with the principal value of the Bond to A.
A debt security issued by entities such as corporations, governments or their agencies (Ex. statutory authorities). A bondholder is a creditor of the issuer and not a shareholder.
The bond issuer is the bond issuing company or the borrower who sells bonds with the promise of regular interest payments and return of the principal amount on maturity. The bond holder is the lender who lends money to the bond issuer in exchange of a bond.
CAGR is where time is of importance.
What do you mean when your bank’s relationship manager says that the bank fixed deposit will earn you 6% interest per annum for 5 years? (We assume you do not choose the interest pay-out option)
Here’s what exactly he means –
|Date||Value of FD||Interest|
|Total Interest Earned||33,823|
If you invest Rs. 1,00,000 in an FD which has a 6% interest rate per annum the above is how your money grows year on year.
As you can see, the interest component increases every year! It is not Rs. 6000 every year which is 6% of the invested amount.
If you remember your high school mathematics, I just helped you understand the difference between simple interest and compound interest.
In simple interest, the interest is calculated on the initial investment and the interest is constant as long as the investment amount is constant.
In compound interest, on the other hand, the interest is calculated on the investment corpus and interests accrued already. This creates a snow-ball effect!
Question – How much will be Rs. 1,00,000’s value if it is invested for 10 years at 6% simple interest and 6% compound interest?
|Date||Value (Simple Interest)||Value (Compound Interest)|
|Total Interest Earned||60,000||79,085|
This is what is referred to as ‘power of compounding!’
The gap between the total interest earned will only widen with time.
CAGR is best suited to calculate the return of a lumpsum investment in mutual funds. For calculating the returns of a SIP investment, IRR is used.
The Coupon is the rate of interest paid by fixed-interest security such as Bond/ Debenture. It is the annual payment by the bond issuing company to the bond investor towards the face value of a bond.
You buy a bond with the face value of Rs. 10,00,000, coupon rate of 10 %, and maturity four years. Let us assume that the date of payment is on 10th March every year. The Bond will also mature in the 4th year on 10th March. You will receive the annual interest payment for four years on every 10th March. The annual payment or the coupon value will be 10% of the face value of the Bond i.e., Rs. 1,00,000 (10% of 10,00,000). And at the date of maturity i.e., 10th March of the 4th year, you will get back your principal amount i.e., Rs 10,00,000 plus the last coupon payment of Rs 1,00,000
A convertible bond (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of Equity Shares in the issuing company or cash of equal value at a predetermined time in future.
A credit rating is an evaluation of the credit risk of a prospective debtor, predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.
The current yield is the present interest rate that the bond is offering to its owner. This is the rate of interest that a potential buyer can expect if they acquire this bond and hold on to it for a year.
Current Yield = Annual interest payment/ Current bond price.
A security issued by a company in which the company acknowledges that a stated sum is owed and will be repaid at a certain date. A corporate bond, like a government-issued bond, usually pays a stipulated amount of interest throughout its life to the holder.
Face value is the designated value per unit of a bond when the bond is issued by the bond issuer. Normally, in the Indian Bond market, the face value of a bond can range from as low as Rs 1000 to as high as Rs 1 Cr.
FIXED INTEREST RATE
A fixed interest rate is an unchanging rate paid on bonds. It remains the same for a predefined period of time (it can apply for the part of the term or entire term).
A government bond or sovereign bond is a bond issued by a national government, generally with a promise to pay periodic interest payments and to repay the face value on the maturity date.
A municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures, including the construction of highways, bridges or schools.
The Capital market where companies or governments directly issue securities (debt-based or equity-based) to raise funds for the first time is called Primary Market. In the primary market, the issuer sells securities at predetermined prices. The buyers in the market can be financial institutions, corporates, mutual funds, and individuals.
The payment frequency or payment schedule of bonds is the dates on which the interest in paid to bond holders by bond issuing companies. The payment frequency can vary from monthly, quarterly, semi-annually to annually. Some payment dates can be customised by the bond holder.
A bond rating is the grade given to a bond depending on its credit worthiness. The ratings can vary from AAA to AA to A and further down. AAA is considered the highest rating and bonds with this rating are generally considered the safest.
Any bond that has credit ratings of BBB and above are labelled as investment grade bonds or safe bonds in India. This rating is given to the company (bond issuer) by rating agencies based on various financials factors of the bond issuer. Some of the commonly considered factors are the issuer’s previous financial strength or ability to repay the principal and interest on time.
The secondary market is the capital market where securities are traded among investors. Trading can happen between Financial institutions, individual investors, or both. The issuer does not participate in trading. The price of the securities in the Secondary Market is dependent on current demand and supply.
The advantage of the Secondary market is, it facilitates trade between investors and makes securities available to investors who could not participate in the Primary Market. The secondary market plays a vital part of ensuring liquidity. This away helps the issuing entity to raise capital in the future as investors are assured of liquidity/ exit option when needed.
TIER II BONDS
As per BASEL III norms, Banks raise money via Tier II bonds to meet regulatory norms around capital adequacy. Tier II bonds are subordinated debt and hence not first to be paid during the liquidation process. Tier II bonds are senior to Tier I Bonds.
Note: When a bank has to write off losses, it will first write off Tier I bonds and then, if required, move on to Tier II bonds. It also can be written off if PONV (point of non-viability) is triggered.
Let’s see what IRR is and then XIRR is just an extension of it.
IRR stands for internal rate of return and gives us the annual growth rate given a bunch of regular cashflows and dates of the cashflows.
XIRR, on the other hand, stands for extended internal rate of return and give us the annual growth rate given a bunch of cashflows that may be irregular and dates of cashflows.
Let’s see where you see XIRR as the return metric used – an SIP in mutual funds.
Let’s assume you invest Rs. 20,000 every month for 12 months on the 1st of every month. Now the value of your portfolio is about Rs. 2,65,000 on the last day of the 12th month.
How will you calculate your returns? CAGR won’t work because there are multiple investments made at different points in time. Here’s how XIRR will help you…
Here’s how I calculated the XIRR using the data points from a real mutual fund- Axis Bluechip Fund -
|Date||SIP||Value||Incremental % Change|
We’ve used the XIRR formula in excel – the inputs required are the dates (column 1) and cashflows (column 2). The XIRR of the above set of cashflows comes out to be 19.75%.
This will change every time the current NAV changes – it is likely to be different on 1st Jan 2020.
The yield is the effective interest rate on bonds. The yield will vary inversely with the market price of the bond.
Yield= (Coupon/ Market Price of Bond) X 100
Let’s assume that
Market Price of Bond = Rs 10,00,000
Coupon= Rs 1,00,000
Let’s calculate the yield:
Yield= (100000/1000000) X 100 = 10%
– If the market price of the bond reduces by Rs. 20,000 then yield increases.
Yield = (100000/980000) X 100= 10.20 %
-If the market price of the bond goes up by Rs.50,000 then yield reduces.
Yield= (100000/1050000) X 100= 9.52%
Note: When bond price increases the yield decreases and when the bond price decreases the yield increases.
YIELD TO CALL
Some bonds have a call option where the bond issuer can redeem the bond before the maturity date. The issuer needs a call option to reduce interest rate risk and avoid damage when interest rates decline. Having a call option will allow the issuer to redeem bonds and reissue them at a lower interest rate. However, there are some pre-set terms and conditions that have to be met. The calculation of yield to call depends on the coupon rate, the call date and the price at which the bond was purchased by the holder.
YIELD TO MATURITY (YTM)
The yield to maturity is the total return expected from a bond if it is held to maturity. In other words, it is the internal rate of return (IRR) of a bond if the investor holds the bond until maturity, and if all payments are made as per schedule.