DEBT MARKET AND ITS TERMINOLOGIES
The Debt market is a financial market where debt securities are issued and traded. It is also known as the bond market.
The issuers sell the bonds in the primary market to finance the operation of their organization.
The debt market also is known as the fixed-income securities market because of the following fixed features
· Maturity of the bond is fixed
· Fixed cash flow (coupon amount)
It should be noted that fixed-income security does not mean fixed-return security.
This merely means the timing of cash flows is fixed and known in advance. It doesn’t guarantee any fixed return for the following reasons.
· Credit Risk – The company may not be able to pay back the interest and principle
· Market Risk – If investors want the money back before maturity, they cannot demand prepayment from the issuing company but should sell in the secondary market. The sale price may be varied from the initial price.
· Reinvestment Risk – Until maturity, there should be no interim payments, the coupon amount will be reinvested until the horizon at the unknown future interest rate.
TYPES OF BONDS:
Based on the cash flows, the bonds are classified into three types
· Coupon bond
· Zero-coupon bond
In the bond market, many complex terminologies are involved. Let us explain one by one coupon instrument pays a periodic fixed amount called the coupon.
The principal amount that is paid on maturity or while redemption is called the redemption amount.
Remember one thing, the coupon is your interest paid by the issuer, and the redemption amount is your initial payment.
Annuity disburses the part of coupon and principal periodically in such a manner that the cash flows are equal in size and same time period. Most housing and consumer loans are structured as annuities. It has a high reinvestment risk.
A zero-coupon bond also called a discount bond. It doesn’t pay any coupon amount before the maturity date. The interest is accumulated and paid along with maturity as a single bullet payment. Ex 91 days Govt treasury bills.
HOW BOND MARKET WORKS:
Bonds are debt investments where an individual lends money to the government or corporation. They come up with an agreement that the borrower will pay the money back when the bond reaches its maturity date along with the coupon payment.
For example, if you invest in government bond with a face value of 1000 and a 10% interest rate, the maturity of the bond will three years. Let us calculate the yield of the bond
Bond Yield = (coupon / market price of the bond) * 100
= (100 /1000)*100
Don’t confuse with the term, the yield is simply your return of investment that is Rs. 100 every year as a coupon payment. If the demand for the bond increase in the secondary market, most people willing to buy at a premium price.
Finally, the market price of the bond will increase to 1100. Let us calculate the yield of the bond
Bond Yield = (100 / 1100) *100
Let us consider another way if any speculative selling of that particular bond leads to a price decrease in the bond, for example, the bond price comes to 800 than the yield of the bond will 12.5%.
DEBT MARKET – KEY TAKEAWAYS:
· The coupon is fixed but the yield on a bond will vary
· The yield will vary inversely with the current market price of the bond traded in the secondary market.
· When bond prices are rising, the yield will fall
· When bond prices are falling, the yield will rise
This is how our 10-year Govt bond yield also calculated in the same manner. Most of us have confusion on, how the interest rate of the economy will impact the bond market.
Let us have a quick discussion on it. All must know the current pandemic situation and the condition of the economy. If the economy is bad condition, the Govt is planned to issue a bond with a lower interest rate. So, the price of existing bonds will increase in line with the demand.
If new bonds are issued with higher interest rates than current market bonds, the price of the existing bond will decline and demand those bonds price falls drastically.
We know still most people don’t understand the concept clearly. Let us take a simple example, If any trader or investor predict the interest rate will fall in coming future due to economic recession or any other factor.
They simply invest in bonds because of the investor demand that will increase the price of the bond.
At any time economy revise, the interest rate will increase. Investors will sell the bonds in the secondary market and shift their investment into equity or other investments.
To check the bond yield. Please check at Trading Economics
· No one predicts the interest rate of the economy, but any economic collapse or pandemic situation will create a huge demand in the bond market.
· Bonds are safer than equity and a better return than debt mutual funds
· There is always a high risk in equity, even after long term holding there is no guarantee of high returns.
· Bonds on other hand will increase your wealth at constant rate.