The price or the market value of the bond may be different depending on the attractiveness and demand for the bond.Money Matters Nupur Pavan Bang
Srikanth was already waiting in the cafeteria when Prof. Nicky walked in for her morning cup of coffee.
Prof. Nicky: Good Morning Srikanth. What pulls you out of your bed at this time?
Srikanth: (Offended), well I am generally awake by this time. But today I am here to show you an sms and ask you about what it means.
Srikanth: Here it is: “Shriram Transport Finance Corporation launches the first public issue of Non-Convertible Debentures (NCDs) this financial year from July 26th. The issue closes on August 10, 2012. The bonds offer an annual coupon rate of 10.25 per cent and 10.50 per cent for a period of 36 months and 60 months respectively”.
Prof I know that a bond is an instrument which allows one to invest in a company (corporate bond) or with the government (government bond), for a fixed period of time and with a fixed return. In the case of this sms, a corporate bond is being offered for a fixed period of either 3 years or 5 years and will give a return of 10.25 and 10.5 percent respectively. But I have a few more questions.
Nicky: Let me make a correction in your previous statement, related to your question. 10.25% and 10.5% are not returns. They are coupon rates. Coupon rate is the interest that the bond issuer pays on the face value of a bond.
Nicky: Face Value of the bond is the amount which is returned to the investors by the issuer when the Bond matures. The price or the market value of the bond may be different depending on the attractiveness and demand for the bond.
Let me explain. If the prevailing price of a similar bond, with same coupon rates, in the market is say `97. Nobody will be willing to pay more than `97 for another bond. Hence the company will have to sell their bond at a discount of 3 per cent on the face value. On the other hand, if the other similar bonds in the market are being sold at `105, the company will not be willing to sell their bond at the face value of `100. So, they will sell their bond at a premium of 5% on the face value.
Now, if the bond is bought at the face value, and held till maturity, it will give us a return which is equal to the coupon rate. But, if it is bought at a price less than or more than the face value, we will incur a capital loss or gain on maturity. This results in our return from bonds being different from the coupon rate. In finance parlance, the return on a bond is known as yield.
Srikanth: But why will a bond price be `97 or `105?
Nicky: That’s because, a bond need not be held till maturity. It can be traded in the market. It’s transferrable. So a bond which is more in demand due to its higher coupon rate, its price increases. Whereas a bond which has a lower coupon rate, its price decreases.
Srikanth: Ah… Demand and Supply at work here too! Economics everywhere!
Nicky: Absolutely. No wonder it is known as the mother of all subjects!
The author is Senior Researcher at Centre for Investment, Indian School of Business, Hyderabad.