There are a number of variables to look at when investing in bonds: the bond's maturity, redemption features, credit quality, interest rate, price, yield and tax status. Together, these factors help determine the value of your bond investment and the degree to which it matches your financial objectives.

Maturity

A bond's maturity refers to the specific future date on which the investor's principal will be repaid. Bond maturities generally range from one day up to 30 years. In some cases, bonds have been issued for terms of up to 100 years, popularly referred to as Century Bonds. Usually bond having a maturity of less than 1 year are classified as short term bonds, bonds with a maturity of 1-3 years are classified as medium term and bonds with a maturity of over 3 years are classified as long term bonds.

Redemption Features

While the maturity period is a good guide as to how long the bond will be outstanding, certain bonds have structures that can substantially change the expected life of the investment.

Call Provisions : Some bonds have redemption, or "call," provisions that gives the issuer an option to repay the investors' principal at a specified date before maturity. Bonds are commonly "called" when prevailing interest rates have dropped significantly since the time the bonds were issued. It allows the issuer to replace the existing debt with a cheaper one. The recent IDBI decision to call back its FlexiBonds 1996 series is a case in point. Before you buy a bond, always ask if there is a call provision and, if there is, be sure to obtain the "yield to call" as well as the "yield to maturity." Bonds with a call provision usually have a higher return to compensate for the risk that the bonds might be called early.

Puts : Conversely, some bonds have "puts," which allow the investor an option of requiring the issuer to repurchase the bonds [at a specified time] prior to maturity. Investors typically exercise this option when they need cash for some purpose or when interest rates have risen since the bonds were issued. They can then reinvest the proceeds at a higher interest rate.

Average Life : Mortgage-backed securities are typically priced and traded on the basis of their "average life" rather than their stated maturity. When mortgage rates decline, homeowners often prepay mortgages. This may reduce the average life of the investment. If mortgage rates rise, the reverse may be true - homeowners will be slow to prepay and investors may find their principal committed longer than expected.

Your choice of maturity will depend on when you want or need the principal repaid and the kind of investment return you are seeking within your risk tolerance. Some individuals might choose short-term bonds for their comparative stability and safety, although their investment returns will typically be lower than would be the case with long-term securities. Alternatively, investors seeking greater overall returns might be more interested in long-term securities despite the fact that their value is more vulnerable to interest rate fluctuations and other market risks.

Credit Quality

Bond choices range from the highest credit quality Treasury securities, which are backed by the full faith and credit of the central government, to bonds that are below investment grade and considered speculative, popularly referred to as junk bonds. Since a bond may not be redeemed, or reach maturity for years-even decades-credit quality is another important consideration when you're considering a fixed-income investment.

When a bond is issued, the issuer is responsible for providing details as to its financial soundness and credit worthiness. This information is contained in a document known as an offer document, prospectus or official statement, which will be provided to you by your investment representative. But how can you know whether the company or government entity whose bond you're buying will be able to make its regularly scheduled interest payments in five, 10, 20 or 30 years from the day you invest? Rating agencies assign ratings to many bonds when they are issued and monitor developments during the bond's lifetime. Securities firms and banks also maintain research staffs that monitor the ability and willingness of the various companies, governments and other issuers to make their interest and principal payments when due. Your investment representative can supply you with current research on the issuer and on the characteristics of the specific bond you are considering.

Credit Ratings

How can you find out if the credit factors affecting your bond investment have changed? For this purpose it is compulsory for all medium and long term bonds to be rated by an approved credit rating agency. What the credit rating actually does is to certify that the company has the ability, both financial and qualitative, to discharge its interest and principal obligations as and when they become due. Credit ratings are a dynamic concept and are hence subject to periodic review as and when any industry or company level changes warrant. In India the main rating agencies are CRISIL, ICRA, CARE and Duff & Phelps.

Bond Insurance

Credit quality can also be enhanced by bond insurance. Specialized insurance firms serving the fixed-income market guarantee the timely payment of principal and interest on bonds they have insured. In the United States, major bond insurers include MBIA, AMBAC, FGIC and FSA. (See glossary for list.) Most bond insurers have at least one triple-A rating from a nationally recognized rating agency attesting to their financial soundness; and insured bonds, in turn, receive the same rating based on the insurer's capital and claims-paying resources. While the focus of their underwriting activities has historically been in municipal bonds, bond insurers also provide guarantees in the mortgage and asset-backed securities markets and are moving into other types of securities as well.

Interest Rate

Bonds pay interest that can be fixed, floating or payable at maturity. Most debt securities carry an interest rate that stays fixed until maturity and is a percentage of the principal amount. Typically, investors receive interest payments semiannually. For example, a $1,000 bond with an 8% interest rate will pay investors $80 a year, in payments of $40 every six months. When the bond matures, investors receive the full face amount of the bond-$1,000. Investors are also paid annually and quarterly in some cases.

But some sellers and buyers of debt securities prefer having an interest rate that is adjustable, and more closely tracks prevailing market rates. The interest rate on a floating-rate bond is reset periodically in line with changes in a base interest-rate index, known as the benchmark rate, such as the LIBOR. Some bonds have no periodic interest payments. Instead, the investor receives one payment-at maturity-that is equal to the purchase price (principal) plus the total interest earned, compounded semiannually at the original interest rate. Known as zero-coupon bonds, they are sold at a substantial discount from their face amount. For example, a bond with a face amount of $20,000 maturing in 20 years might be purchased for about $5,050. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $5,050 represents the interest, based on an interest rate of 7%, which compounds automatically until the bond matures.

Price

The price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to their face value. Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates. When ever the interest rates fall in the economy, the prices of bonds rise and vice - versa. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.

Yield

Yield is the return you actually earn on the bond-based on the price you paid and the interest payment you receive. There are basically two types of bond yields you should be aware of: current yield and yield to maturity or yield to call.

Yield to maturity (YTM)

Yield to maturity and yield to call, which are considered more meaningful, tell you the total return you will receive by holding the bond until it matures or is called. It also enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity (including interest on interest at the original purchasing yield), plus any gain (if you purchased the bond below its par, or face, value) or loss (if you purchased it above its par value).

YTM is the most commonly sited statistics about the debt instruments. It is the discount rate, which equals all the cash flows (coupon payments and the debt repayment) arising from the instrument with the purchase price. The concept of YTM is based on following implicit assumptions:

• The instrument is held till maturity
• The intermediate cash flows are reinvested at the rate of YTM  
• There is no put and call facility available to investors or the issuers

YTM is the value of 'r' in the following equation:

Purchase price = Interest for each period * PV factor (r, time) + Principal repayment * PV factor (r, t)

One can compare the YTM with one's required rate to take investment decisions. If the YTM is more than the required rate of return of an investor, he should invest in the instrument otherwise not.

Yield to call is calculated the same way as yield to maturity, but assumes that a bond purchased at a premium will be called and that the investor will receive face value back at the call date. You should ask your investment representative for the yield to maturity or yield to call on any bond you are considering purchasing. Buying a bond based only on current yield may not be sufficient, since it may not represent the bond's real value to your portfolio.

Current yield (CY)

Current yield is the yield on the debt instrument based on the current market price. It is actually the return you earn on the instrument, if you purchase the instrument at the current market price. It is calculated as follows:

CY = Coupon payment / Current market price

Again the thumb rule is that if the CY is more than the required rate of return, invest in the instrument otherwise not.

Intrinsic value

Whenever one thinks of investing in debt, he has to take a decision whether to invest at the current market price. The current market price may be at par or at a discount or at a premium to the face value. So one can get confused whether to invest at that price or not. To overcome this problem, one can calculate the intrinsic worth of a debt instrument and compare it with the going market price to decide. It can be calculated by discounting the cash flows from the instrument by the required rate of return of the investor. Mathematically, it is the value of IW in the following equation:

IW = Coupon for each period * PV (r, t) + Redemption value * PV (r, t)

Where r is required rate of return and t is time to maturity

Once you have IW of a debt instrument, you can compare it with the going market price. If it is more than or equal to the going market price, you should invest in it otherwise not.

As of today, most of the trading in the debt instruments is carried out on the NSE because it is the only active debt market in India. So in the following section, we will present the system of trading in debt instruments on the NSE.

Market Fluctuations: The Link Between Price and Yield

From the time a bond is originally issued until the day it matures, its price in the marketplace will fluctuate according to changes in market interest rates or credit quality. The constant fluctuation in price is true of individual bonds-and true of the entire bond market-with every change in the level of interest rates typically having an immediate, and predictable effect on the prices of bonds.

When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues. When prevailing interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues.

Because of these fluctuations, you should be aware that the value of a bond will likely be higher or lower than its original face value according to the level of interest rates, if you sell it before it matures.

Link Between Interest Rate and Maturity

Changes in interest rates don't affect all bonds equally. The longer it takes for a bond to mature, the greater the risk that prices will fluctuate along the way and that the fluctuations will be greater-and the more the investors will expect to be compensated for taking the extra risk. There is a direct link between maturity and yield. It can best be seen by drawing a line between the yields available on like securities of different maturities, from shortest to longest. Such a line is called a yield curve.

A yield curve is a relatioship between term to maturity and yield to maturity. It can be drawn for any bond market but it is most commonly drawn for the U.S. Treasury market, which offers securities of every maturity, and where all issues bear the same top credit quality. By watching the yield curve, as reported in the daily financial press, you can gain a sense of where the market perceives interest rates to be headed-one of the important factors that could affect your bonds' prices.

A normal yield curve would show a fairly steep rise in yields between short and intermediate issues and a less pronounced rise between intermediate and long-term issues. That is as it should be, since the longer the investor's money is at risk, the more the investor should expect to earn.

If the yield curve is said to be "steep," it means the yields on short-term securities are relatively low when compared to long-term issues. This means you can obtain significantly increased bond income (yield) by buying a longer maturity than you can with a short one, and you may wish to modify your choice of bond accordingly. On the other hand, if the yield curve is "flat," it means that the difference between short and long-term rates is relatively small. This means that the reward for extending maturities is relatively small, and some investors will choose to stay in the short end of the maturity range. When yields on short-term issues are higher than those on longer-term issues, the yield curve is called "inverted." It suggests that investors' expectations are that interest rates are going to decline. An inverted yield curve is sometimes considered to be a harbinger of recession.

Tax Status

Some bonds offer special tax advantages. Usually most government bonds are free from tax. The treatment of tax on deep discount bonds is yet to evolve in India. But certain infrastructure bonds do attract income tax rebate under Section 88 of the Income Tax Act.

Do you want income that is taxable or income that is tax-exempt? The answer depends on your income tax bracket-and the difference between what can be earned from taxable versus tax-exempt securities-not only presently but also throughout the period until your bonds mature. Your investment representative can provide you with a chart showing how much taxable income you would need at each income tax bracket to match the return from a tax-exempt security. The decision about whether to invest in a taxable bond or a tax-exempt bond can also depend on whether you will be holding the securities in an account that is already tax-preferred or tax-deferred, such as a pension account.

The Interest Rate-Inflation Connection

The exact relationship between the interest rates and inflation was explained by Prof. Irving Fischer. According to Fischer, interest rates prevailing in an economy at any point of time are a sum of the real interest rates and the inflation. In the long run, interest rates rise one for one with inflation. The reason is that the cash flows arising from a debt involves a time lag during which the purchasing power of rupee might go down. The investors want to be compensated for this loss of purchasing power. Therefore, they want a premium for the inflation, which is reflected in the nominal interest rates prevailing in the economy.

As an investor, you need to know how bond market prices are directly linked to economic cycles and concerns about inflation. You may have wondered why press reports say the bond market fell after the government released positive economic news about job growth or housing status in the economy. As a general rule, the bond market, and the overall economy, benefit from steady, sustainable growth rates. Moderate economic growth also benefits the financial strength of the municipal and corporate issuers whose bonds you may hold, making them a stronger credit.

But steep rises in economic growth can lead to inflation, which raises the costs of goods and services for everyone, leads to higher interest rates and erodes a bond's value. Ultimately, persistent, rapid economic growth will lead to rising interest rates, either through actions taken by the Reserve Bank of India to slow the expansion, or through market forces acting in anticipation of interest rate moves. Since rising interest rates push bond prices down, the bond market tends to react negatively to reports about strong economic growth.

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