Bond Market

The bond market (also known as the debt, credit, or fixed income market) is a financial
market where participants buy and sell debt securities, usually in the form of bonds. As of
2009, the size of the worldwide bond market (total debt outstanding) is an estimated $82.2
trillion, of which the size of the outstanding U.S. bond market debt was $31.2 trillion
according to BIS (Bank of International Settlements).

Nearly all of the $822 billion average daily trading volume in the U.S. bond market takes
place between broker-dealers and large institutions in a decentralized, over-the-counter
(OTC) market. However, a small number of bonds, primarily corporate, are listed on
exchanges.

References to the "bond market" usually refer to the government bond market, because of its
size, liquidity, lack of credit risk and, therefore, sensitivity to interest rates. Because of the
inverse relationship between bond valuation and interest rates, the bond market is often used
to indicate changes in interest rates or the shape of the yield curve.

Market structure

Bond markets in most countries remain decentralized and lack common exchanges like stock,
future and commodity markets. This has occurred, in part, because no two bond issues are
exactly alike, and the variety of bond securities outstanding greatly exceeds that of stocks.
However, the New York Stock Exchange (NYSE) is the largest centralized bond market,
representing mostly corporate bonds.

Besides other causes, the decentralized market structure of the corporate and municipal bond
markets, as distinguished from the stock market structure, results in higher transaction costs
and less liquidity. A study performed by Profs Harris and Piwowar in 2004, Secondary
Trading Costs in the Municipal Bond Market, reached the following conclusions: (1)
"Municipal bond trades are also substantially more expensive than similar sized equity trades.
We attribute these results to the lack of price transparency in the bond markets. Additional
cross-sectional analyses show that bond trading costs decrease with credit quality and
increase with instrument complexity, time to maturity, and time since issuance." (2) "Our
results show that municipal bond trades are significantly more expensive than equivalent
sized equity trades. "

Types of bond markets

The Securities Industry and Financial Markets Association (SIFMA) classifies the broader
bond market into five specific bond markets.

• Corporate
• Government & agency
• Municipal
• Mortgage backed, asset backed, and collateralized debt obligation
• Funding

Bond market participants

Bond market participants are similar to participants in most financial markets and are
essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both.

Participants include:

• Institutional investors
• Governments
• Traders
• Individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many smaller
issues, the majority of outstanding bonds are held by institutions like pension funds, banks
and mutual funds.

Bond market size

Amounts outstanding on the global bond market increased 10% in 2009 to a record $91
trillion. Domestic bonds accounted for 70% of the total and international bonds for the
remainder. The US was the largest market with 39% of the total followed by Japan (18%).
Mortgage-backed bonds accounted for around a quarter of outstanding bonds in the US in
2009 or some $9.2 trillion. The sub-prime portion of this market is variously estimated at
between $500bn and $1.4 trillion. Treasury bonds and corporate bonds each accounted for a
fifth of US domestic bonds.

Bond market volatility

For market participants who own a bond, collect the coupon and hold it to maturity, market
volatility is irrelevant; principal and interest are received according to a pre-determined
schedule.

But participants who buy and sell bonds before maturity are exposed to many risks, most
importantly changes in interest rates. When interest rates increase, the value of existing bonds
fall, since new issues pay a higher yield. Likewise, when interest rates decrease, the value of
existing bonds rise, since new issues pay a lower yield. This is the fundamental concept of
bond market volatility: changes in bond prices are inverse to changes in interest rates.
Fluctuating interest rates are part of a country's monetary policy and bond market volatility is
a response to expected monetary policy and economic changes.

Economists' views of economic indicators versus actual released data contribute to market
volatility. A tight consensus is generally reflected in bond prices and there is little price
movement in the market after the release of "in-line" data. If the economic release differs
from the consensus view the market usually undergoes rapid price movement as participants
interpret the data. Uncertainty (as measured by a wide consensus) generally brings more
volatility before and after an economic release. Economic releases vary in importance and
impact depending on where the economy is in the business cycle.

Bond market influence

Bond markets determine the price in terms of yield that a borrower must pay in able to
receive funding.
Bond investments

Investment companies allow individual investors the ability to participate in the bond markets
through bond funds, closed-end funds and unit-investment trusts. Exchange-traded funds
(ETFs) are another alternative to trading or investing directly in a bond issue. These securities
allow individual investors the ability to overcome large initial and incremental trading sizes.

Bond indices

A number of bond indices exist for the purposes of managing portfolios and measuring
performance, similar to the S&P 500. The most common American benchmarks are the
Barclays Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are
parts of families of broader indices that can be used to measure global bond portfolios, or
may be further subdivided by maturity and/or sector for managing specialized portfolios.

Bond Market in India

The Bond Market in India with the liberalization has been transformed completely. The
opening up of the financial market at present has influenced several foreign investors
holding upto 30% of the financial in form of fixed income to invest in the bond market in
India. The bond market in India has diversified to a large extent and that is a huge
contributor to the stable growth of the economy. The bond market has immense potential in
raising funds to support the infrastructural development undertaken by the government and
expansion plans of the companies.

Sometimes the unavailability of funds become one of the major problems for the large
organization. The bond market in India plays an important role in fund raising for
developmental ventures. Bonds are issued and sold to the public for funds.

Bonds are interest bearing debt certificates. Bonds under the bond market in India may be
issued by the large private organizations and government company. The bond market in
India has huge opportunities for the market is still quite shallow. The equity market is more
popular than the bond market in India. At present the bond market has emerged into an
important financial sector.
The major reforms in the bond market in India

• The system of auction introduced to sell the government securities

• The introduction of delivery versus payment (DvP) system by the Reserve Bank of
India to nullify the risk of settlement in securities and assure the smooth
functioning of the securities delivery and payment
• The computerization of the SGL
• The launch of innovative products such as capital indexed bonds and zero coupon
bonds to attract more and more investors from the wider spectrum of the populace
• Sophistication of the markets for bonds such as inflation indexed bonds
• The development of the more and more primary dealers as creators of the
Government of India bonds market
• The establishment of the a powerful regulatory system called the trade for trade
system by the Reserve Bank of India which stated that all deals are to be settled
with bonds and funds
 • A new segment called the Wholesale Debt Market (WDM) was established at the
NSE to report the trading volume of the Government of India bonds market

• Issue of ad hoc treasury bills by the Government of India as a funding

instrument was abolished with the introduction of the Ways And Means
agreement

Bond Yield

In order to select a bond from numerous options available in the market, an investor would
need to calculate the ROI (return on investment). This ROI, which indicates how lucrative a
bond is, is also known as bond yield, or yield to maturity. Thus, bond yield is the cumulative
return on a bond, which takes into account all the interest payments as well as the difference
between the purchase price and the face value of the bond.

Apart from yield to maturity, an investor may need to know two other types of yields. These
are:

 Coupon yield: The annual interest rate that is fixed at the time of the issuance of a bond.
 Current yield: The ratio of the annual interest payment to the bond's current price.

Calculating Yield to Maturity

Investors usually consider yield to maturity (YTM) to gauge the profitability of a bond. The
steps to calculate the YTM of a bond with a face value of $1,000 and a 7% coupon rate are:

• Find the amount of annual interest offered by the bond. In the above example, the
bond will yield an annual interest of $70.
• If the purchase price of the bond is lower than the par value, the profit on the price
would be the difference between the par value and the purchase price. Thus, if you have
bought the bond at $940 and hold it till maturity, you would realize a minimum profit of
$60.
• To calculate the bond yield, consider that the coupon rate is compounded annually
and you are reinvesting the interest into the bond.
• Consider the maturity period of the bond and the purchase price to calculate the
compound interest on the bond for this period. If the bond is maturing in five years, the
compound interest on the bond would be $378.40.
• Thus, the total return on your investment in the bond is $378.40 + $60 = $438.40.
• Derive the percentage returns on your investment. For this, multiply the total return
on investment with 100 and divide by the purchase price of the bond. Thus, the bond is
generating 46.63% ROI ($438.40 * 100 / 940 = 46.63%).
• Calculate the yield to maturity for this bond by dividing the percentage returns on
your investment by the maturity period. Thus, 46.63 / 5 = 9.33% is the yield to maturity.

Investors can also calculate the current yield with the following formula:

Current Yield = [(Coupon Rate ÷ Bond Price) x Par Value] + [(Par Value - Bond Price) ÷
YTM]
Price In The Market
The factor that influences a bond more than any other is the level of prevailing interest rates
in the economy. When interest rates rise, the prices of bonds in the market fall, thereby
raising the yield of the older bonds and bringing them into line with newer bonds being
issued with higher coupons. When interest rates fall, the prices of bonds in the market rise,
thereby lowering the yield of the older bonds and bringing them into line with newer bonds
being issued with lower coupons.

Advanced Bond Concepts: Yield and Bond Price

The general definition of yield is the return an investor will receive by holding a bond to
maturity. So if you want to know what your bond investment will earn, you should know how
to calculate yield. Required yield, on the other hand, is the yield or return a bond must offer
in order for it to be worthwhile for the investor. The required yield of a bond is usually the
yield offered by other plain vanilla bonds that are currently offered in the market and have
similar credit quality and maturity.

Calculating Current Yield

A simple yield calculation that is often used to calculate the yield on both bonds and the
dividend yield for stocks is the current yield. The current yield calculates the percentage
return that the annual coupon payment provides the investor. In other words, this yield
calculates what percentage the actual dollar coupon payment is of the price the investor pays
for the bond. The multiplication by 100 in the formulas below converts the decimal into a
percentage, allowing us to see the percentage return:

So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of
5%, this is how you'd calculate its current yield:

Notice how this calculation does not include any capital gains or losses the investor would
make if the bond were bought at a discount or premium. Because the comparison of the bond
price to its par value is a factor that affects the actual current yield, the above formula would
give a slightly inaccurate answer - unless of course the investor pays par value for the bond.
To correct this, investors can modify the current yield formula by adding the result of the
current yield to the gain or loss the price gives the investor: [(Par Value – Bond Price)/Years
to Maturity]. The modified current yield formula then takes into account the discount or
premium at which the investor bought the bond. This is the full calculation:
Let's re-calculate the yield of the bond in our first example, which matures in 30 months and
has a coupon payment of $5:

The adjusted current yield of 6.84% is higher than the current yield of 5.21% because the
bond's discounted price ($95.92 instead of $100) gives the investor more of a gain on the
investment.

One thing to note, however, is whether you buy the bond between coupon payments. If you
do, remember to use the dirty price in place of the market price in the above equation. The
dirty price is what you will actually pay for the bond, but usually the figure quoted in U.S.
markets is the clean price.

Now we must also account for other factors such as the coupon payment for a zero-coupon
bond, which has only one coupon payment. For such a bond, the yield calculation would be
as follows:

n = years left until maturity

If we were considering a zero-coupon bond that has a future value of $1,000 that matures in
two years and can be currently purchased for $925, we would calculate its current yield with
the following formula:

Calculating Yield to Maturity

The current yield calculation we learned above shows us the return the annual coupon
payment gives the investor, but this percentage does not take into account the time value of
money or, more specifically, the present value of the coupon payments the investor will
receive in the future. For this reason, when investors and analysts refer to yield, they are most
often referring to the yield to maturity (YTM), which is the interest rate by which the present
values of all the future cash flows are equal to the bond's price.
An easy way to think of YTM is to consider it the resulting interest rate the investor receives
if he or she invests all of his or her cash flows (coupons payments) at a constant interest rate
until the bond matures. YTM is the return the investor will receive from his or her entire
investment. It is the return that an investor gains by receiving the present values of the
coupon payments, the par value and capital gains in relation to the price that is paid.

The charted relationship between bond price and required yield appears as a negative curve:

This is due to the fact that a bond's price will be higher when it pays a coupon that is higher
than prevailing interest rates. As market interest rates increase, bond prices decrease.

The second concept we need to review is the basic price-yield properties of bonds:

Premium bond: Coupon rate is greater than market interest rates.

Discount bond: Coupon rate is less than market interest rates.

Thirdly, remember to think of YTM as the yield a bondholder receives if he or she reinvested
all coupons received at a constant interest rate, which is the interest rate that we are solving
for. If we were to add the present values of all future cash flows, we would end up with the
market value or purchase price of the bond.

The calculation can be presented as:

OR
Example 1: You hold a bond whose par value is $100 but has a current yield of 5.21%
because the bond is priced at $95.92. The bond matures in 30 months and pays a semi-annual
coupon of 5%.

1. Determine the Cash Flows: Every six months you would receive a coupon payment of
$2.50 (0.025*100). In total, you would receive five payments of $2.50, plus the future value
of $100.

2. Plug the Known Amounts into the YTM Formula:

Remember that we are trying to find the semi-annual interest rate, as the bond pays the
coupon semi-annually.

3. Calculate IRR: The present value of our bond (the price) is equal to $95.92 when we have
an interest rate of 6.8% using Excel IRR formula.

Calculating Yield for Callable and Puttable Bonds

Bonds with callable or puttable redemption features have additional yield calculations.
A callable bond's valuations must account for the issuer's ability to call the bond on the call
date and the puttable bond's valuation must include the buyer's ability to sell the bond at the
pre-specified put date. The yield for callable bonds is referred to as yield-to-call, and the
yield for puttable bonds is referred to as yield-to-put.

Yield to call (YTC) is the interest rate that investors would receive if they held the bond until
the call date. The period until the first call is referred to as the call protection period. Yield to
call is the rate that would make the bond's present value equal to the full price of the bond.
Essentially, its calculation requires two simple modifications to the yield-to-maturity
formula:
Note that European callable bonds can have multiple call dates and that a yield to call can be
calculated for each.

Yield to put (YTP) is the interest rate that investors would receive if they held the bond until
its put date. To calculate yield to put, the same modified equation for yield to call is used
except the bond put price replaces the bond call value and the time until put date replaces the
time until call date.

For both callable and puttable bonds, astute investors will compute both yield and all yield-
to-call/yield-to-put figures for a particular bond, and then use these figures to estimate the
expected yield. The lowest yield calculated is known as yield to worst, which is commonly
used by conservative investors when calculating their expected yield. Unfortunately, these
yield figures do not account for bonds that are not redeemed or are sold prior to the call or put
date.