The Hindu Business Line : Strike an investment bond!

Investment in bonds may not appear to be as inviting as investing in equity. If you thought so, you are wrong. Okay, bonds may not give you the kind of returns that equity can offer but bonds don’t sink like a tank the way equity can. It makes sense to have bonds as part of your portfolio.

But before you actually get down to understanding the how, when and why of bond investing, here is a low-down of some of the basic terminology associated with bonds.

Par value: Also known as face value or coupon value, this is the value written on the face of the bond certificate. A bond need neither be issued nor redeemed (repaid) at par value.

If issued below par value it is said to be at a discount and if issued above par value it is said to be at a premium. Similarly, if the redemption takes place above par value it is said to be redeemed at a premium and if it takes place below par value it is said to be redeemed at a discount.

However, the issue and redemption price are expressed with reference to par value. For instance, if the par value is Rs 100, issued at a discount of 3 per cent would mean issued at Rs 97 and redeemed at a premium of 6 per cent would mean redeemed at Rs 106.

Redemption Price: The term redemption means repayment. Bonds can be redeemed at par, premium or discount. From an investor’s perspective, redemption at premium means more return.

Often, companies redeem at a premium by keeping coupon rates a shade low so as to entice the investor to stay with the company longer.

For example, instead of paying 8 per cent coupon on a five-year bond of Rs 1,000, a company may pay 7 per cent coupon on the bond and then give a Rs 6 premium on redemption.

This would cost the company almost the same but would act as a good reward for investors who stay on

Coupon rate: Coupon rate is the interest rate written on the face of the bond certificate. This is the rate applied by the issuer on the par value of the bond to arrive at interest payable to the bond holder.

For instance, if the par value is Rs 1,000 and the coupon is 9 per cent, it means that the annual interest that you will receive is Rs 1,000 x 9 per cent = Rs 90, irrespective of whether the bond was issued above par or below par.

We can twist this around. If a bond pays Rs 90 on a coupon of Rs 1,000, it means that the coupon rate is 9 per cent.

Zero coupon bonds (ZCB): These bonds do not pay any interest; hence the term zero coupon. In other words the coupon rate is Nil. Then how do investors earn return? Well, these bonds are redeemed at a premium.

For the investor the difference between purchase price and redemption price is the return. People prefer ZCB because since they do not receive periodic interest, the reinvestment risk (i.e. the risk that intermediate payments cannot be invested at good rates) is eliminated.

Deep discount bond (DDB): But for semantics, this is very much the same as ZCB. Here the bond is issued at a significant discount to face value and is redeemed at face value. For the investor the difference between purchase price and redemption price is the return.

Typically Indians love discounts and hence the popularity of DDB

Annuity bond: Also known as self-liquidating bond, this bond pays you an identical sum every year till maturity. This identical sum (called annuity) includes an element of principal and an element of interest.

For example, if you invest Rs 1,00,000 in such a bond for a five-year period, you will get Rs 26,400 each year if the interest rate is 10 per cent. For those who are mathematically minded, the present value of the annuity of Rs 26,400 discounted at 10 per cent is Rs 1,00,000.

Callable bond: This is a bond where the issuer has the right to redeem the bond before the maturity date. Issuers like to build in a call feature because should interest rates drop down dramatically they could call back the bond. Suppose X Ltd raised Rs 100 crore at 12 per cent three years ago. Suppose then the market rates today are 9 per cent.

If X Ltd had built a call option it can now raise new bonds at 9 per cent and settle the old bond of 12 per cent, thus saving cost significantly.

Irredeemable bond: These bonds do not contemplate repayment of principal at all. An investor buys such a bond in order to be assured of life long interest. Such bonds are not available in India.

Some use the phrase irredeemable bond to refer to a non-callable bond. In that case it means that the bond will be and can be repaid only on maturity.

(The writer is a Chennai-based chartered accountant.)

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