By Sunil K Parameswaran
The price of interest paid by a bond issuer is known as ‘coupon’. In the days prior to electronic payments, bonds would come with a booklet of coupons. Each was like a post-dated cheque. Since most bonds spend interest semi-annually, the bondholder was anticipated to detach the relevant coupon each six months and present it for payment.
These days most bond issuers credit the holders’ accounts straight on each coupon payment date. In 1996, I purchased some RBI bonds and essentially got a booklet of coupons. Today even in India, the credit requires location electronically. Even now nevertheless, bearer bonds come with a booklet of coupons. Unlike registered bonds, exactly where a record is maintained of the ownership at all points in time, bearer bonds belong to whoever has them at a point in time. It is like a currency note. If you drop a Rs 500 note on the floor, you can not prove that it belongs to you. The exact same holds accurate for bearer bonds. As they made use of to say in college, ‘finders keepers and losers weepers’.
Rate of return
The price of return that a bond holder gets from it is known as the Yield to Maturity (YTM). The price tag of a bond and its yield are inversely associated for bonds with a offered principal quantity, time to maturity, and coupon price. The logic is as follows. The issuer is going to spend pre-determined money flows to the holders. So how can a holder extract a larger return from a offered set of money flows?
Obviously, by lowering the price tag that he or she pays for the bond. Thus, price tag and yield are inversely associated. Think of coupon as the price of return provided by the issuer. YTM, on the other hand, is the price of return demanded by the market place.
If the coupon is equal to the YTM the bond will sell for its par worth, and such bonds are known as par bonds. If the yield is additional than the coupon the bond will be much less for a price tag that is much less than its par worth, and such bonds are known as discount bonds.
Premium bonds
On the other hand, if the yield is much less than the coupon the bond will sell for a price tag that is larger than the face worth or par worth. Such bonds are known as premium bonds. At maturity, all bonds will have to trade at par. Consequently, if the yield does not alter, the price tag will progressively method the par worth as we go from one particular coupon date to the subsequent. Thus, par bonds will trade at par on each coupon date. Premium bonds will steadily decline in price tag as we method the maturity date, although discount bonds will steadily boost in price tag as we method the maturity date.
This is known as the ‘Pull to Par Effect’. The rationale is as follows. As we go from one particular coupon date to the subsequent, one particular coupon payment drops out of the pricing equation. This pulls down the price tag. However, when we go to a subsequent coupon date, the face worth gets discounted for one particular period much less. This pulls up the price tag. For par bonds, the effects neutralise every single other, and the price tag remains unchanged. For premium bonds, the initially impact dominates, and the price tag steadily decreases. For discount bonds the second impact dominates, and the price tag steadily increases.
The writer is CEO, Tarheel Consultancy Services