1.1.11 Trading in Bonds / Fixed Income securities

This topic describes trading in bonds on the stock exchanges.

Bonds are traded on the stock exchanges. However, they are traded more in an Over The Counter (OTC) market scenario, wherein, most of the deals in the bonds lead to the Delivery vs Settlement scenario. The deals are done in such a manner that normally get settled within a few days. The quantity of bonds is generally quoted in the market in two forms:

• Units
• Nominal value

In the units scenario, bonds are bought in units and are quoted at a nominal price. Since fixed income securities usually mature at the face value, the prices of such securities are always quoted at discount. Years to maturity and interest rate of the fixed income security are the two primary factors, which determine the price of the security. Here again, the price at which it is quoted can be either a Clean price or it can be Flat price. Clean price is the basic price of the security and flat price contains the basic price plus the accrued interest on the security from the last interest payment date. In the first case, the buyer will pay the seller the accrued interest from the last interest payment date separately. Even though the outflow for the buyer is the same in both cases, the important thing is from the accounting point of view.

Accrued = [Face value of bond] x [rate of interest] x

Interest {[Number of days bond is owned /360]}

Days used for interest computation (the variables mentioned within {} in the above formula) can be done using any of the nine methods as mentioned below:

• Actual / Actual
• Actual / 360
• Actual / 365
• Actual / 364
• 30 (US) / Actual
• 30(US) / 360
• 30(US) / 365
• 30 (US) / 364
• 30 (EURO) / Actual
• 30 (EURO) / 360
• 30 (EURO) / 365
• 30 (EURO) / 364

In the nominal value scenario, bonds are bought at face value. These bonds are normally traded at a discount on the face value. The investors then hold on these bonds to maturity at which time the face value of the security is recovered from the issuer.

In the bond market, three types of yield are typically encountered:

• Nominal Yield
• Current Yield
• Yield to maturity

Nominal Yield - This is the percentage of interest paid on the face value of the instrument. For instance, a $1000 bond with an interest obligation of 7% has a nominal yield of 7% (.07 x $1000). It pays $70 interest per year on each $1000 bond.

Current Yield - Bonds pay interest based on the face value. The interest or coupon rate remains the same regardless of fluctuations in the market price of the bond. The investor is concerned with the return or the amount of interest received on the amount of money paid. The current yield tells the investor what the return is, given the price of the bond.

For example, the bond in the previous example is selling for 120, that is, the bond costs the investor $1200 to acquire. It still pays only $70 in interest (7% on the face value of $1000). Although, as the bond’s owner, the investor receives $70, the return is based on a cost of $1200. The current yield is therefore only 5.83%. ($70 / $1200)

Yield to Maturity: This type of yield takes into account the net dollar amount that an investor can expect if the bond is held to its maturity date.

For instance, a $1000 bond paying 7% interest will mature in 30 years. When the investor purchases it for $1200, the bond has twenty years of life left. At the end of the 20 years (at maturity), the corporation is obligated to retire the debt for $1000 (face value). If the investor paid $1200 today for the bond, he will receive only $1000 at maturity. Divide the $200 loss (or amortize it) over the 20 remaining years: $200 divided by 20 years equals $10 per year. The investor is losing $10 per year, which accumulates on this transaction. Yet the bond is going to pay him $70 per year in interest. So over 20 years, the investor actually earned an average of $60 per year every year he owns the bond. In dollars, this is the yield to maturity.

Yield to maturity = Interest received +/- amortized figure

(Face value + cost) / 2

$70 - $10 = 0.0545

($1000 + $1200) / 2

The yield to maturity is 5.45%

Certain bonds like Zero coupon bonds trade with the price being quoted as ‘Yield to Maturity’ (YTM). These securities carry a face value, but they are usually traded at a discount. The 2-10 YTM for such securities would be quoted in the market. Yield to maturity in such scenario can be understood using the following formula:

YTM = (Face value – Purchase Price)* Days in a year Current price * Days to maturity