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Introduction
Treasury Bonds are medium to long term negotiable instruments issued by the Central Bank of Sri Lanka on behalf of the Government with maturities ranging from 2 to 20 years. Treasury Bonds features are different to that of Treasury Bills.
Treasury Bonds carry a fixed rate coupon (expressed as a percentage of the face value at the time of issuing), which is paid semi-annually (It is not uncommon to have floating rate Bonds; however, the Treasury Bonds issued in Sri Lanka have fixed coupons). The price of a Bond is the sum of the present values of all cash flows of the Bond, which include all future coupons plus the face value of the Bond. The interest rate the investor will receive depends on the current market rates, which is called ‘Yield to Maturity (YTM)’. The market yield could be higher or lower than the coupon rate.
It is important that the investors understand the following basic rules governing price to yield relationship of a Bond.
| 1. | If the yield is higher than the coupon, then the clean price (see below) of the bond will be lower than 100/-. |
| 2. | If the yield is lower than the coupon, then the clean price (see below) of the bond will be higher than 100/-. |
| 3. | Bond prices change inversely to yield, i.e., price falls as the market yield goes up and vice-versa. |
| 4. | Longer the duration (see below under Macaulay Duration) of a Bond, the more sensitive the price to a given change in yield, i.e., change in price is larger in relation to the change in yield. |
| 5. | Lower the coupon rate on a Bond, the more sensitive the price to a given change in yield, i.e., change in price is larger in relation to the change in yield. |
Important Terms used in Treasury Bonds:
| Face Value | This is the maturity value that is stated on the face of a Treasury Bond. This is sometimes referred to as the ‘redemption value' also. Although Treasury Bonds are now issued in scripless form, i.e. in electronic form, the term 'Face Value' has survived and denotes the maturity value. |
| Present Value | This is the investment amount of the Treasury Bond arrived at by discounting all future cash flows of the bond including the coupons and the maturity value by the market interest rate. |
| Yield | The return on investment expressed as a percentage per annum i.e. 8.5% per annum. |
| Coupon Rate | A percentage of the face value determined at the time of issuing and paid semi-annually on the Bonds until its maturity. |
| Dirty Price | A Bond pricing quote referring to a price that includes the present value of all future cash flows, including interest accruing on the next coupon payment. |
| Accrued Coupon | If the Bond is not traded on a coupon payment date, then current bond is accrued on a daily basis until the payment date of that coupon. The purpose of this is to separate trading gains from income accruals for tax purposes and may not be relevant in the case of individuals. |
| Clean Price | Clean Price = Dirty Price – Accrued Coupon. This too is important to a trader to separate the accrued income from trading profits for tax purposes as well as ease of portfolio valuation. |
| Macaulay Duration | A measurement to calculate how long in years it takes for the Price of a Bond is to be repaid by its internal cash flows. |
| Modified Duration | Macaulay duration that is modified to account change in interest rates. It calculates how much the duration change for each percentage change in yield. |
| Business Day Convention | If the coupon payment date falls on a week-end or public holiday, coupon payment is made on the next business day. |
