While there are several concepts related to evaluating bonds and debentures, the key concepts include Coupon, Face Value, Yield, Yield Curve and Credit Profile of borrower.
1. Coupon
This is the interest rate that the bond issuer pays on the debt instrument. Example, a 5% coupon INR 100 bond issued by HDFC Bank will pay INR 5 per year per bond
2. Face Value
The is the principal value per bond. Example, a 5% coupon INR 100 bond issued by HDFC Bank, each bond has a Face Value of INR 100.
3. Yield
This is the actual return made by the bond holder. This number is different from the Coupon and is dependent on the existing interest rate environment. As an example, HDFC Bank might have issued a 5% coupon INR 100 bond. However, if debentures with a similar risk profile are offering around 4% then the HDFC Bank bond will sell for around INR 101 in the market, so that the buyer of the bonds get an effective return of around 4%.
The Yield is a function of (1) The Yield Curve; and (2) Credit profile of the issuer
(a) The Yield Curve
The Yield Curve shows the risk-free interest rate for different tenors based on current bond prices. To give a very basic example, if the Yield of a 6 month Government bond is 5% per annum, 1 year bond is 6% per annum, 2 year bond is 6.5% per annum and 5 year bond is 7% per annum, then the yield curve will look like the following. The macro economic situation is factored into this curve.
The yield curve is one of the most important concepts of all of investing. The yield curve gives markets an assessment of risk-free interest rates for different time periods. Then when evaluating a riskier product, a premium is attached to interest rates for that particular period.
(b) Credit profile of the issuer
The credit profile of the issuer indicates how comfortable it will be for the issuer to meet the obligations of the issued debt. Credit Rating Agencies provide these ratings after analyzing the cash flows of the company. An issuer is mandatorily required to engage a Credit Rating Agency so that a Credit Rating is assigned to debt securities issued by the issuer and these credit rating are regularly updated based on the financial performance of the issuer. Credit Rating Agencies such as ICRA, CARE, etc. in India or Moody’s, Fitch, S&P (in the US) provide these ratings.
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