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Fixed income securities

UNIT 1

1. Valuation of Fixed Income Securities


2. Introduction to Bond Markets
3. Yield and Conventions
4. Spot and Forward Rates
5. Terminology and characteristics of Bonds/Types of fixed income
securities:
Central Government securities
State Government securities
Government-guaranteed bonds
PSU bonds
Corporate debentures
Money market instruments and preferred stock
Valuation/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

Bond

DIFFERENCES BETWEEN
BOND AND EQUITY

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 Government
State Government
Public sector Undertakings
Private 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
Same Day Settlement
(Government Securities)
Other Day Settlement
(Government Securities)
Same Day and Other Day
Settlement (NonGovernment Securities)

Monday to Friday

10.00 hrs to 15.00 hrs


10.00 hrs to 17.15 hrs
10.00 hrs to 18.15 hrs

PHASES OF TRADE

Trading on WDM segment is divided into three phases as under:


Pre-Open Market Phase
The pre-open period commences from 9.00 hrs This period
allows the trading member/Participant to:
set up counter party exposure limits
set up Market Watch (the security descriptor)
make inquiries
Market Open Phase
The system allows for inquiries of the following activities when
the market is open for trading:
Order Entry
Order Modification
Order Cancellation
Trade 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)-1 / r(1+r)
P= Present Value in rupees
A= Annual coupon amount
n= Number of years to Maturity
r= Periodic required return
M= Maturity Value

+ M/ (1+r)

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 on
o Time
o Level of risk
o 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 similarquality 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

8%

10

2
3

Year

Price

YTM

925.93

8%

841.75

8.995

11

758.33

9.660

11

683.18

9.993

1000/1.08= 925.93
1000/(1.08*1.10) = 841.75
1000/(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
rate
o Steeply +ve sloping yield curve is an indicator of an
economic recovery and found at the end of a recession

Inverted 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.

0
Bond A
Bond
B

1
8%

2
Rs.1000

10%

Present value of both bonds can be easily calculated

Rs.1000

FORWARD RATES

Let us say I had invested Rs.826.45, it would grow as below


826.45 X (1.10)
The above when expressed as below gives us the forward rate
826.45 X (1.10) = 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)
1+r1

CHARACTERISTICS OF YIELD CURVES

Three characteristics of yield curves


The change in yields of different term
bonds tend to move in the same direction
The yields of short term bonds are more
volatile than the long term bonds
The 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

Return

EXPECTATION HYPOTHESIS

3
Term

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