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Bonds – RBI Grade B Study Notes for Finance & Management

Bonds - RBI Grade B Study Notes

Reserve Bank of India being the central bank of the country is a great organisation to work for. Every year Lakhs of aspirants apply for the RBI Grade B posts as it offers great career opportunities as well as impressive perks & allowances to its officers. The Grade B recruitment notification is expected to be announced in the month of June 2019 most probably. It is highly advisable to start with your preparations from now on itself so that when you are suddenly notified of the recruitment notification, you have already covered a prominent portion of the syllabus. The Grade B Exam is conducted in three stages namely Phase I, Phase 2 and the Interview round.

Toppers of the exam have always suggested to carry on the preparations and study for both Phase 1 and Phase 2 simultaneously because the syllabus of the Phase 2 of RBI Grade B is vast and requires thorough knowledge and persistence in studies. The subjects asked in the Phase 2 Exam are Economics & Social Issues, Finance & Management and Descriptive English. So to give you a helping hand in your studies for the Grade B Exam, we at Oliveboard would be providing you study notes on important topics from the syllabus of Phase 2. In this blog we will cover the topic of Bonds – RBI Grade B Study Notes.

 

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Bonds – RBI Grade B Study Notes – Finance & Management

Bonds and their valuation is one such topic that is being consistently asked in RBI Grade B Exams. Many aspirants find this a uphill task but with proper theory and practising enough numericals on bonds can fetch good marks.

What are Bonds?

Whenever Companies, Organizations or Governments need money they can go for a loan. This loan either they can borrow from the banks at their prevailing interest rates but may have to follow certain rules and provide certain collateral for getting those loans. Alternatively, they can also get loans in the form of Bonds. Companies or Governments sells the bonds to the Public in the market to get the required money. Banks also participate in case of Government Bonds.

A bond, a fixed-income security, is a debt instrument created for the purpose of raising capital. They are essentially loan agreements between the bond issuer and an investor, in which the bond issuer is obligated to pay a specified amount of money at specified future dates.

Reason for Buying Bonds: One should be interested why anyone buys Bonds. Public may be interested in the interest which they earn on redeeming the Bonds while Banks have to meet their statutory requirements to meet their liquidity targets like SLR.

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1. Some Definitions Related to Bonds

  • The interest rate is referred to as the coupon.The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.
  • The date on which the issuer must repay the amount borrowed also known as face value is called the maturity date.
  • The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. It is also the money which bondholder lends to the Company.
  • The company or the government who is borrowing money is called Issuer.

2. Bond Issuers

There are three main categories of bonds.

  • Corporate bonds – are issued by companies.
  • Municipal bonds – are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors.
  • Government bonds – such as those issued by the central Government. Bonds issued by the Government with a year or less to maturity are called “Bills”; bonds issued with 1-10 years to maturity are called “notes”; and bonds issued with more than 10 years to maturity are called “bonds”. The entire category of bonds issued by a government treasury are often collectively referred to as “treasuries.”

Let’s Understand this with a practical example.

Ravi buys a bond with a face value of 1,00,000 a coupon of 9%, and a maturity of 10 years. This means Ravi will receive a total of 9000 of interest per year for the next 10 years. Here 9% is the coupon rate and maturity period is 10 years. Ravi will receive 100000 after 10 years.

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3. Bonds are Tradable:

Bonds can be traded between persons or entities. Bonds are either sold at a premium to the face value or at a discount.

4. Bonds at Premium:

The bond is issued at face value of 100000 at coupon rate of 10% with maturity 10 years in future. Anyone who wanted to get a guaranteed return and fixed deposits in the bank were only offering 8%. Now suppose after 1 year the interest rate on fixed deposit decreases to 7%. Since the bond is valid for 10 years, he/she will get 10% interest even though fixed deposit would just give 7% return. Therefore, more people will become interested in buying bonds of 10 % interest rate and would be ready to pay you higher than the face value of Rs. 1000. In such a case the Bond gets sold at a premium meaning more than 100000.

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5. Bonds at a Discount:

Let’s take the above example. But after 1 year the interest rate on fixed deposit increases to 11%. Since the bond is valid for 10 years, he/she will get 10% interest even though fixed deposit would give 11% return. Therefore, people will not be interested in buying bonds of 10 % interest rate and would not be ready to pay you higher but lesser than the face value of Rs. 1000. In such a case the Bond gets sold at a discount meaning less than 100000.

6. Other important term in Bonds is Yield:

Yield:  Yield is the return one gets on the Bond.

Yield (coupon rate) = Coupon amount/Price

IN the beginning when we buy the bond yield is equal to the interest rate but When the price
changes, the yield also changes.

As bond prices increase, bond yields fall. For example, assume an investor purchases a bond that matures in five years with a 10% annual coupon rate and a face value of 1,000. Each year, the bond pays 10%, or 100, in interest. Its coupon rate is the interest divided by its par value.

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7. Yield to Maturity:

Yield is the return we get as interest on the Bonds. If these interest payments are again invested in buying the bond then an extra interest money is earned on the extra investments we make. In such a case the total yield or the total return is called yield to maturity.

 Yield can be understood as Simple interest while Yield to maturity is a compound interest.

Price and Yield and Interest Rate Relation:

  • Decrease in Interest Rate Results in Increase in Bond Price and vice versa
  • When price goes up, yield goes down and vice versa
  • When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the bonds and When interest rates fall, the prices of bonds in the market rise, thereby decreasing the yield of the older bonds.

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8. Zero-Coupon Bonds:

  • Not all bonds have coupon payments. Such bonds are referred to as zero coupon bonds.
  • These bonds are issued at a deep discount and repaid the par value at maturity.
  • The difference between the purchase price and the par value represents the investor’s return.
  • The payment received by the investor is equal to the principal invested plus the interest earned.

The price of a zero-coupon bond can be calculated as:

Price = M / (1 + r)^n

where M = Maturity value or face value of the bond

r = required rate of interest

n = number of years until maturity

If an investor wishes to make a 6% return on a bond with 25,000 par value due to mature in three years, he will be willing to pay: 25,000 / (1 + 0.06)^3 = 20,991.

If the debtor accepts this offer, the bond will be sold to the investor at 20,991 / 25,000 = 84% of the face value. Upon maturity, the investor gains 25,000 – 20,991 = 4,009, which translates to 6% interest per year.

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9. Perpetual Bonds

These are bonds with no maturity date. They don’t expire. The investor doesn’t get the principal he invested as such, but he gets it in form of higher interest rates.

There are very few people who opt for it as no one can guarantee such an infinite time period for any entity.

The formula for the present value of a perpetual bond is simply:

Present value = D / r

Where:

D = Periodic coupon payment of the bond

r = Discount rate applied to the bond

For example, if a perpetual bond pays 1000 per year in perpetuity and the discount rate is assumed to be 4%, the present value would be:

Present value = 1000 / 0.04 = 25000

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10. Corporate Bonds

  • A company can issue bonds just as shares.
  • Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years.
  • Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government.
  • Corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.

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11. Government Bonds:

These are safest instruments and their value sometimes in secondary market varies according to the stability of the governments.

Bills – Debt securities maturing in less than one year.
Notes – Debt securities maturing in one to 10 years.
Bonds – Debt securities maturing in more than 10 years.

Coupon Bond Valuation:

VCoupons  =∑ C/(1+r)t

Vfacevalue = ∑F/(1+r)T

Where C = future cash flows, that is, coupon payments

r = discount rate, that is, yield to maturity

F = face value of bond

t = number of periods

T = time to maturity

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This was all from us in this blog of “Bonds – RBI Grade B Study Notes”. We hope that the you find the information given above in the blog of Bonds – RBI Grade B Study Notes useful. For more study notes for RBI Grade B, stay tuned to Oliveboard.

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