Fixed income securities

UNIT 1

1. Valuation of Fixed Income Securities 2. Introduction to Bond Markets 3. Yield and Conventions4. Spot and Forward Rates5. Terminology and characteristics of Bonds/Types of fixed income securities:

Central Government securitiesState Government securitiesGovernment-guaranteed bondsPSU bondsCorporate debenturesMoney market instruments and preferred stockValuation/Pricing of bonds, Bond Yields

6. Term structure of interest rates

INTRODUCTION

Companies and governments need money for developmental activities

They can borrow from banks or raise money from the public by issuing bonds

A bond is nothing but a loan for which the public is the lender A bond can be considered as an IOU given by the borrower

(issuer) to the lender (investor) The issuer of the bonds pays interest to the lender at a pre-

determined rate and schedule Bonds are called as fixed-income securities as the investor is

aware of the exact amount he will get back if he holds the security till maturity

DEFINITION AND FEATURES A bond represents a contract under which a borrower promises to pay

interest and principal on specific dates to the holder of the bond.

The most important things to note in a fixed income instrument are Issuer – Example BOB,ICICI, L&T, SBI, Hindalco, NHB, NABARD, Railway

finance corpn. Coupon or interest – Ex. 8%, 9%, 10%, Zero Coupon Tenure – Say 5 yrs., 10 yrs, 15 years Maturity date – the date on which the borrower repays the amount Interest payment schedule – Monthly, Quarterly, Semi Annually,

Annually, Compounded, Simple, Floating Ratings – AA, AA+ Pre closure options – Call after 5 years, Put after 5 years, 1 % interest

penalty. Issue price or value – At par, At discount

DIFFERENCES BETWEEN BOND AND EQUITY

Bond Bonds are debt instruments An investor becomes a creditor to the organisation A bond holder has a higher claim on the assets He does not have a share in the profits – he gets only principal and

interest

Stocks and shares Shares are equity An investor becomes an owner in an organisation – he has voting

rights A shareholder is paid only after all the debt payments are made He has a right to share in the profits of the company – he is paid

dividend depending on the amount of profits

WHY INVEST IN BONDS? Bonds are not as volatile as the stock markets They provide a fixed income and thus are safe retirement plans They are good investments for short term horizons when money

is required for a definite purpose If a person is in his 20s and 30s, a majority of investment can be

in equities, whereas if a person is in his middle age, a majority of investments must be in fixed income securities

WHO ISSUES BONDS?

Central GovernmentState GovernmentPublic sector UndertakingsPrivate Sector Companies

BOND MARKET - HOW IT EVOLVED INTO A MARKET

Investors had a general perception that bonds with longer maturity give higher returns.

Some investors who had bought these bonds wanted to exit, but the issuer was not ready to buy it back

There were some who sensed that they can sell their bonds and make capital gains

There were some regulatory requirements due to which people wanted to sell

There were some changes in the risk profile of the issuer and holders wanted to offload

As the category of “Available for sale” increased and more investors flocking to buy bonds round the year, it created what is called the bond market

BOND MARKET

The National Stock exchange has a Wholesale debt Market segment. It is a market for high value transactions

The retail trade in corporate debt securities is done primarily on the capital market segment of the NSE and the debt segment of the Bombay Stock exchange

TRADE TIMINGS

Trading in the WDM segment is open on all days except Saturdays, Sundays and other holidays, as specified by the Exchange.

Settlement Monday to FridaySame Day Settlement (Government Securities) 10.00 hrs to 15.00 hrs

Other Day Settlement (Government Securities) 10.00 hrs to 17.15 hrs

Same Day and Other Day Settlement (Non-Government Securities) 10.00 hrs to 18.15 hrs

PHASES OF TRADE

Trading on WDM segment is divided into three phases as under: Pre-Open Market PhaseThe pre-open period commences from 9.00 hrs This period allows the trading member/Participant to:set up counter party exposure limitsset up Market Watch (the security descriptor)make inquiries Market Open PhaseThe system allows for inquiries of the following activities when the market is open for trading:Order EntryOrder ModificationOrder CancellationTrade Cancellation

PHASES OF TRADE

Post Market Phase (also called SURCON)During the period of SURCON (SURveillance and CONtrol) a trading member gets only inquiry access with a facility to request for trade cancellation. On completion of SURCON the trading system processes data and gets the system ready for the next day.

RISK ASSOCIATED WITH BONDS

RISK ASSOCIATED WITH BONDS

BOND VALUATION

Requirements An estimate of expected cash flows An estimate of the required rate of return

The formula :

P=A*(1+r)ⁿ-1 / r(1+r) ⁿ + M/ (1+r) ⁿ

P= Present Value in rupeesA= Annual coupon amountn= Number of years to Maturityr= Periodic required returnM= Maturity Value

A BOND SPECIMEN COPY

TERM STRUCTURE OF INTEREST RATES

Term structure of interest rates is the variation of yields of bonds with similar risk profiles with the terms of bonds

Interest rates depend ono Timeo Level of risko Market trends

Identical bonds (same risk profile, liquidity, tax structures) with different terms to maturity have different interest rates

YIELD CURVES

The term structure of interest rates is shown by the yield curve

It is a graph that plots the yields of similar-quality bonds against their maturities, ranging from shortest to longest.

The yield curve is generally indicative of future interest rates, which are indicative of an economy's expansion or contraction

Therefore, yield curves and changes in yield curves can convey a great deal of information.

YIELD CURVES

Year Interest rate

0 8%

1 10

2 11

3 11

Year Price YTM

1 925.93 8%

2 841.75 8.995

3 758.33 9.660

4 683.18 9.993

1000/1.08= 925.931000/(1.08*1.10) = 841.751000/(1.08*1.10*1.11) = 758.33

841.75=1000/(1+y2)2

YIELD CURVES

TYPES OF YIELD CURVES

TYPES OF YIELD CURVES

Normal Yield curve – upward sloping – depicts normal economic conditions – growth at a normal rateo Steeply +ve sloping yield curve is an indicator of an economic

recovery and found at the end of a recessionInverted yield curve – downward sloping – rare and

abnormal market conditions – Long term rates are lower than short term rates

Flat yield curve – Finally, a flat yield curve exists when there is little or no difference between short and long term yields – market is sending mixed signals – Short term rates may rise, Long term may fall

SPOT AND FORWARD RATES

Let us consider 2 zero coupon bonds with a maturity value of Rs.1000 Bond A is a 1 year bond with a rate of 8% Bond B is a 2 year bond with a rate of 10%I will be able to buy these bonds today at the above rates. So we refer to this as the spot rate.

Present value of both bonds can be easily calculated

0 1 2

Bond A Rs.1000

Bond B

8%

10% Rs.1000

FORWARD RATES

Let us say I had invested Rs.826.45, it would grow as below 826.45 X (1.10)² The above when expressed as below gives us the forward rate 826.45 X (1.10)² = 826.45 X 1.08 X 1.1204

When an individual invests in a two-year zero coupon bond yielding 10 percent, his wealth at the end of two years is the same as if he received an 8 percent return over the first year and a 12.04 percent return over the second year. This hypothetical rate over the second year, 12.04 percent, is called the forward rate.

More generally, given the 1 year (r1) and the 2 year (r2) spot rates, we can calculate the forward rate as below f = (1+r2)² 1+r1

CHARACTERISTICS OF YIELD CURVES

Three characteristics of yield curvesThe change in yields of different term bonds tend to

move in the same directionThe yields of short term bonds are more volatile

than the long term bondsThe yields of long term bonds tend to be higher

than the short term bonds

THREE THEORIES TO EXPLAIN YIELD CURVES

1. The “expectations theory”2. The “liquidity preference hypothesis”3. The “segmented market hypothesis”

EXPECTATION HYPOTHESIS

The Expectation hypothesis states that different term bonds can be viewed as a series of 1-period bonds with yields of each bond equal to the expected short term interest rate for that period.

The forward interest rates are unbiased estimates of future interest rates

The expectation hypothesis is about maximization of utility of money in the form of higher expected return over the long term horizon

Accordingly present long term interest rate is just an average of the current short term rates and one period forward rates

EXPECTATION HYPOTHESIS

1 2 3 4 5

Term

Retu

rn

LIQUIDITY PREFERENCE THEORY

This theory propounded by J R Hicks, states that investors have a preference for liquidity

Long term investments are comparatively less liquid and investors demand a higher compensation while investing in long term investments

This results in the increased interest rate for longer maturity in contrast to the shorter maturity.

As a parallel, long term investments are more risky and hence investors demand more return to compensate such higher degree of risk

LIQUIDITY PREFERENCE THEORY

However, forward rates differ from expected short rates because of a risk premium known as liquidity premium

A liquidity premium can cause the yield curve to slope upward even if no increase in short rates is anticipated

TERM STRUCTURE OF INTEREST RATES

Fact 1: Interest rates for different maturities tend to move together over time.

Fact 2: Yields on short-term bond more volatile than yields on long-term bonds.

TERM STRUCTURE OF INTEREST RATES

Fact 3: Long-term yield tends to be higher than short term yields (i.e. yield curves usually are upward sloping).

SEGMENTATION THEORY

This theory is based on the rational behavior of investors. Here rational behavior implies that investors are risk averse or risk minimizers.

Different market participants with differing requirements invest in different parts of the term structure.o for. Eg. Banks and financial institutions invest in short term bonds

whereas pension funds will invest in long term bonds. The best way to minimize risk is by having a proper match

between the investment requirement and the term of the bond Investors have a preferred maturity pattern and will choose

other maturities only if compensated with premium. Investors prefer short term investments and will be attracted

only if they are offered sufficient premiums.

Thank you