The Hindu Business Line : A long wait for maturity

Zoe continued, "The government, like individuals, needs loans to finish big projects. So they issue bonds and notes. You pay the loan and the government pays interest and the principal back to you.

"When you give loans to the government, you have the advantage of getting periodic interest payments plus the principal at the end of the loan period."

Jack asked, "Interesting. Give me an example."

Zoe, pleased to have an audience, said, "Say, you want to invest $100,000 on a 10-year treasury bond and the government gives you 6 per cent interest. Then, every year, you will get a constant income of $6,000. At the end of 10 years, you will get back your original $100,000. The interest payment is once in six months, so you will receive a payment of $3,000 each time."

Jack said, "Neat. Since the income that is generated from the investment is fixed every year, I assume this type of investment is known as fixed income. Also, you described a treasury bond that matures in ten years. What do you do when you need the money after two years?"

"Glad you are listening," Zoe remarked. "Well, you got to trade with someone who would buy this bond, someone who wants to get a steady income for the next eight years.

"You may have paid $100,000 as the principal investment and accepted to receive 6 per cent as coupon. However, after two years, the interest rates might have been increased in the general market. So when you sell this instrument, the interest rate of 6 per cent is lower than the general market interest rate. Thus, you wouldn't be able to sell it for the original amount of $100,000. Instead, you may have to sell it at a lower principal amount. Now, a buyer who is ready to buy may pay only $90,000 but he would still receive 6 per cent interest on $100,000 original amount and after eight more years, he would still get back $100,000. This original amount of $100,000 is known as principal or face value of the bond."

Zoe and Jack both heard the warden outside tell someone, "They will be out in four months."

(The dark room is not a jail cell)

Jack said, "Suppose after two years, I want to sell the instrument for personal reasons and the general interest rate has dropped because of lower inflation?"

"Jack, my dear roommate," said Zoe, "the instrument that you bought for $100,000 would still receive 6 per cent coupon every year. However, since the general market is paying lesser interest than what your instrument is receiving, your instrument is more valuable for the market. So, when you are selling, you will receive higher value than your principal. Hence, the price of the bond for an already issued instrument varies even though the face value doesn't change.

"Since the instrument is one of the most liquid instruments and is commonly traded every day across the world, the principal is most likely to vary when you buy or sell from the secondary market. Say, you buy a $100,000 instrument for $90,000 but still receive 6 per cent interest. In this case, you receive the same interest payment but you paid lesser amount than the original buyer from the primary market. This calculation is known as yield."

Jack said, "Ah! Here comes food. I can't believe we are forced to eat what the warden eats."

Zoe said, "Let me ask you a tough one. When interest rates go up, does the yield go up or down?"

Jack had a murderous look, trying to swallow a liquid meal.

Zoe laughed, "Okay, when you buy a $100,000 bond at 6 per cent interest from the primary market, your yield is also same as the coupon rate. However, after two years, when you want to sell this bond, and if the interest rate goes up, the price of the bond comes down. Thus, you will be selling for, say, $90,000. Thus, the buyer would pay only $90,000 but receive 6 per cent interest on $100,000. So, the yield goes up, when the interest rates go up."

(The dark room is not a college dorm)

Jack asked, "When is it a good time to buy or sell a bond?"

Zoe playfully kicked Jack's leg and said, "At least you ask intelligent questions. When the interest rates go down, the bond at 6 per cent rate is more valuable than the market conditions. Thus, you would be selling it at a higher price, say, $110,000. Thus, the buyer would be paying $110,000 to you and receive 6 per cent interest on $100,000. When the interest rates go down, the yield goes down and it is good to sell a bond in the secondary market. However, when the interest rate goes up, it is good to buy a bond from the secondary market."

Jack complimented Zoe, "You are quite knowledgeable. Wait a minute. This might sound silly, but does anyone look at the government's credit history?"

Zoe nodded, "Of course, pal. In fact, the US government has been rated with the highest credit rating. There are thousands of individuals and institutions willing to provide loan."

Jack summed up, "In simple terms, bonds are the loans that are issued to the government. There is an agreement between the loaner and receiver. In this case, the loaner is the individual and the receiver is the federal government. Since this money is given to the treasury department, it is known as treasury bonds. Okay, but who decides the loan amount?"

Zoe said, "The treasury department decides how much money it needs to raise and how long does it need before it could repay the amount. Based on different circumstances, the treasury may need the money for a very short to long terms. It issues instruments maturing at different periods.

The instrument that matures in less than a year is known as treasury bills. These are short-term instruments. The instrument that matures between two and 10 years is known as treasury notes and they are very commonly issued by the government. The instrument that matures after 10 years is known as treasury bonds. Someone yelled. "Your turn, Mrs Greene."

(The dark room shook and silenced Jack and Zoe.)

Alice Greene got up along with the talkative twins in her womb and proceeded to the door, that was appropriately marked — PUSH.

The authors are publishers of www.wisepen.com

Racy@TheHindu.co.in

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