Let us take an example of a three year SBI (State Bank of India) bond. The bond is rated AAA, which is the highest safety rating given by rating agencies. The terms of the bond are
Issue date: 1st March 2016
Maturity period: 3 years
Maturity date: 1st March 2019
Face value of the bond: Rs 100
Coupon rate: 8%
Coupon payable: Annually on 1st March every year
Amount payable on maturity: Rs 100
If you invest in this bond and hold it till maturity you will receive 8% on your investment every year for three years and at the end of three years you get back your original investment. The face value of the bond is Rs 100 and if you invest Rs 100,000/- you get 1000 bonds (Rs 100,000/Rs 100).
The bond is listed on the NSE (National Stock Exchange) and is tradable. You can sell your holding in the SBI bond partly or wholly. We will elaborate on buying and selling of bonds in later tutorials.
You do not want to hold the SBI bond for three years and after one year of investment you want to sell the bond. Let us assume you sell the bond on the 1st of March 2017 after receiving the first coupon payment of 8%. In your case you will receive Rs 8000 as you have invested Rs 100,000 in the SBI bond.
What will you receive after one year? Let us take three scenarios 1) Interest rates are the same at 8%. 2) Interest rates have moved up by 100bps (1%) to 9% and 3) Interest rates have moved down by 100bps (1%) to 7%. 1bps (basis point)= 0.01%
1.Interest rates are the same at 8%
Bond price = Rs 100. You get back your investment of Rs 100,000 (1000 bonds * Rs 100)
Total returns including interest received = Rs 108,000 or 8%.
- Interest rates are higher by 100bps.
Bond price = Rs 97.47 You get back Rs 97,470 (1000 bonds * Rs 97.47)
Total returns including interest received = Rs 105,470 (97,470 +8000) or 5.47%
- Interest rates are lower by 100bps
Bond prices= Rs 102.62 You get back Rs 1,02,624 (1000bonds * Rs 102.62)
Total returns including interest received= Rs 110624 (1,02,624 +8000) (10.62%)
We can see that if interest rates fall your returns are higher than the coupon returns while if interest rates rise your returns are lower than the coupon returns. You should be buying three year SBI bonds if you believe interest rates will fall and you should be investing in SBI fixed deposits instead of SBI bonds if you believe interest rates will rise.
Bond prices are inversely related to interest rates. The simple equation below gives you the relationship.
SBI three-year maturity bond with coupon of 8%.
Bond price = 8/(1+8%)^1 + 8/(1+8%)^2 + 108 /(1+8%)^3
where 8 is the coupon on face value of 100, 8% is the discount factor (or prevailing interest rates for a three-year maturity bond) and 108 is the coupon + face value received on maturity.
If you plug this equation in an excel sheet and change the discount factor from 8% to 9% or 7% you will see that the bond prices fall when interest rates rise and bond prices rise when interest rates fall.