Bonds

Debt instruments are contracts in which one party lends money to another on predetermined basis with regard to:

Rate of interest Periodicity of the interest payment Repayment of principal amount borrowed

(installments or bullet)

PRINCIPAL: Principal is the par value or the face value or the maturity value the bond.

COUPON: a) Refers to the periodic interest payments that are made by the

borrower (issuer of the bond) to the lender (subscriber of the bond).b) Is represented as a percentage of the par value of the bond. TERM TO MATURITY:a) Is called the term or tenor of the bondb) Number of years remaining for the bond to mature. c) Changes everyday from the date of issue of a bond until its maturity. MATURITY: Refers to the date on which the bond matures or the

date on which the borrower has agreed to repay (redeem) the principal amount to the lender.

STRAIGHT BOND/PLAIN VANILLA BOND: Pays a fixed periodic coupon over its life and returns the principal on the maturity date

ZERO COUPON BOND:a) No coupons are paid.b) Issued at a discount to the par value.c) Interest is the difference between the FV and the discounted price at which

the bond is bought.d) In case of a very long tenure, the bond is issued at a very steep discount to

the FV – Deep Discount Bond FLOATING RATE BOND:a) Coupon rate is not fixed, but reset with reference to a benchmark rate.b) Some FRBs have caps and floors.c) Cap represents the maximum interest that the borrower will pay should the

benchmark rate move above such a level.d) Floor represents the minimum interest that the lender should receive should

the benchmark rate fall below the threshold.

CALLABLE BOND:a) Allows the issuer to alter the tenor of the bond, by redeeming it prior to the

original maturity rate.b) Call option enables the issuer to redeem a bond if interest rates decline and

re-issue it at a lower rate.c) Investor looses the opportunity to stay invested in a high coupon bondd) Investor is subject to CALL RISK and REINVESTMENT RATE RISKe) Call option can be a European option, where the issuer specifies the date on

which the option should be exercised.f) Call option can be a American option, giving the issuer the right to call the

bond on or anytime before a pre-specified date.

PUTTABLE BOND:a) Allows the investor to seek redemption from the issuer prior to the maturity

rate.b) Put option enables the investor to redeem a low coupon paying bond and

invest in a high coupon paying bond (if interest rates rise).c) The issuer will have to re-issue the put bond at higher coupons, thus

subjecting the issuer to RE-PRICING RISK.

The value of a bond is equal to the PV of the cash flows expected from it.

Determining the value of a bond requires:a) Estimate of expected cash flowsb) Estimate of expected return

Assumptions of bond valuationa) Coupon rate is fixed for the term of the bondb) Coupon payments are made every yearc) Next coupon payment is receivable exactly a year from nowd) Bond will be redeemed at par on maturity

If a bond of FV = 100 is selling for Rs.90 Bond is trading at a DISCOUNT If a bond of FV = 100 is selling for Rs.110 Bond is trading at a PREMIUM

CURRENT YIELD:a) Reflects only the coupon rateb) Does not consider the capital gain that the investor will

realise if the bond is purchased at a DISCOUNT and held till maturity

c) Does not consider the capital loss that the investor will realise if the bond is purchased at a PREMIUM and held till maturity

d) Ignores the TVMe) Incomplete and simplistic measure of yieldf) Formula: Annual Interest Price

YIELD TO MATURITY:a) Popularly known as YTMb) It is the discount rate that makes the PV of the cash flows (receivable

from owning the bond) equal to the price of the bondc) Considers the current coupon and the capital gain/loss that the

investor will realise by holding the bond till maturityd) It also takes into account the timing of the cash flowse) Can be interpreted as• Internal rate of return (IRR) on an investment in the bond• Compound rate of return over the life of the bond, assuming that

all the coupons can be reinvested at a rate of return equal to the YTM

• Return the investor will receive if the bond is held till maturity

YIELD TO CALL:a) Popularly known as YTCb) Applies to CALLABLE BONDS

YIELD TO PUT:a) Popularly known as YTPb) Applies to PUTTABLE BONDS

Relationship between bond price and YTM is CONVEX

BOND PRICES and YIELDS have an inverse relationship

Increase in yield causes a proportionately smaller price change than a decrease in yield of the same magnitude

Prices of LT bonds are more sensitive to interest rate changes than prices of ST bonds

Prices of low-coupon bonds are more sensitive to interest rate changes than prices of high coupon bonds

•Reflects the term structure of interest rates•POSITIVE (ASCENDING) YIELD CURVE – Yield at the longer end is higher than the yield at the shorter end•NEUTRAL (FLAT) YIELD CURVE – More or less the same the same returns across maturities•NEGATIVE (DESCENDING) YIELD CURVE – Long term yield is lower than short term yield – represents an impending downturn in the economy

Commonly known as ZCYC

Depicts the relationship between interest rate and maturity for zero coupon instruments

Differs from the YIELD CURVE because it does not plot the YTM - Represented against TERM TO MATURITY are the YIELDS on zero coupon instruments across maturities

Generally positively sloped

Widely used measure for BOND VALUATION

Used:• For estimating the premium to be charged for DEFAULT RISK• As a benchmark yield for risk free securities

INTEREST RATE RISKa) Interest rates tend to vary over time fluctuating with bond prices.b) Rise in interest rate will depress the prices of outstanding bondsc) Fall in interest rates will push the prices will push the market prices upd) DURATION is a precise measure of interest rate sensitivitye) It is a function of the MATURITY PERIOD and the COUPON RATEf) Measured as the % change in the price (value) of the bond in response to a

% change in interest rate.

LONGER THE MATURITY PERIOD Greater sensitivity of price to changes in interest rate

LARGER THE COUPON RATE Lesser sensitivity of price to changes in interest rate

DEFAULT RISK: Risk accruing from the fact that a borrower may not pay principal and/or interest on time

CALL RISK: Bonds are typically called for repayment when interest rates have fallen. Investors will not find a comparable investment vehicle

LIQUIDITY RISK: Barring GOI securities which are traded actively, most of the debt instruments do not seem to have a very liquid market. Investors may have to accept a discount while selling and pay a premium while buying.

INFLATION RISK: Inflation risk is greater for long term bonds.

REINVESTMENT RISK: a) When a bond pays periodic interest there is a risk that the interest payment

mat have to be reinvested at a lower rateb) REINVESTMENT RISK IS GREATER FOR BONDS WITH LONGER MATURITY AND

FOR BONDS WITH LARGER COUPON PAYMENTS

Measure of the weighted average life of a bond which considers the size and timing of each cash flow

Measures sensitivity of a bond’s price to change in yield - INTEREST RATE SENSITIVITY

Duration and Coupon are inversely related• For a given maturity, a bond’s duration is higher when its coupon rate is lower

• For a given coupon rate, a bond’s duration increases with maturity

Duration of a ZCB is same as its maturity

Useful tool for immunising against INTEREST RATE RISK and REINVESTMENT RATE RISK and MATURITY RISK

Default Risk or Credit Risk are normally gauged by the rating assigned to the bond by an independent credit rating agency

Rating Agencies in India – CARE, CRISIL, ICRA, Fitch Ratings, Phelps & Duff

Rating Methodology:1. Industry and Business Analysis2. Financial Analysis

Debt ratings are supposed to:1. Provide superior information2. Offer low cost information3. Serve as a basis for a proper risk-return tradeoff4. Impose healthy discipline on corporate borrowers5. Greater credence to financial and other representations

Thank You