Overview of Fixed Income

Markets

Features of Debt Securities

Bond and Bond Indenture
Bond Covenants
Negative Covenants: restrictions on
asset sale, additional borrowing,
negative pledge of collateral
Affirmative Covenants: maintain
certain ratios and profitability

Types of Bonds
According to Coupon rate
structure:

Straight Bond
Zero Coupon bonds
Step Up notes
Deferred Coupon Bonds
Floating rate securities:

Floating rate bonds, inverse floater, inflation indexed

bonds
Floor and cap in floater

Types of Bonds
According to redemption and
retirement:
Non-Amortizing securities: Bullet Bonds
Amortizing securities; Prepayment
Options: risk while investing in MBS
Call provisions
Non refundable bonds; Redemption vs.
Refunding.

Options Embedded in Bonds

Options with investor:
Conversion Option
Put provision
Floors

Options with issuer

Call provision
Prepayment Option
Accelerated Sinking Fund
Caps

Risks Associated with Investing

in Bonds

Interest rate risk

Yield Curve Risk
Call Risk
Prepayment Risk
Reinvestment Risk

Risks Associated with

Investing in Bonds
Credit risk (Credit spread risk &
downgrade risk)
Liquidity Risk
Risk in Floating rate Bonds
Reset risk: if reset period increases
Cap risk: if coupon cannot go beyond a value
Formula/spread risk: if spread above reference
reflects the credit risk, then required return will
be equal to coupon and Bond = par else differ.

Risks Associated with Investing

in Bonds
Reinvestment risk
Which of the following statements
concerning reinvestment risk is most
accurate?
A)Reinvestment risk is highest for zerocoupon bonds.
B)Reinvestment risk is increased if there
are prepayment provisions on the bond.
C)Lower coupon bonds have more
reinvestment risk.

Risks Associated with Investing

in Bonds
Exchange Rate risk
For a US investor Which of the following
statements concerning the exchange rate
risk of investing in foreign bonds is most
accurate? If the foreign currency:
A)appreciates, the bond's coupon increases.
B)depreciates, bond investors lose, all else
equal.
C)depreciates, the bond's coupon payments
will turn into more U.S. dollars.

Risks Associated with Investing

in Bonds
Inflation risk
Sovereign Risk
Volatility Risk(for bonds with options)

Auction of Bond Securities

Uniform Price Auction (book building)
Discriminatory Price Auction

Bond Market Index

Benchmark for measuring
performance especially if a portfolio
is being managed on performance
fee basis.
Benchmark for bond index funds
Determining risk and return of a
bond portfolio.

Building and Maintaining a

Bond Index
Universe of Bonds is broader and more
diverse than stocks; different issuers,
maturity, type.
Universe of bonds changes constantly;
several
bond
issues
by
various
corporations, changing characteristics,
special features etc.
Volatility of bonds
Problems in bond pricing due to liquidity.

Bond Valuation
A bond has coupon interest of 10% and
FV= Rs. 1000. If time to maturity is 10
years, what is the price of the bond
given a yield of 8%?
What if the interest payment is semi
annual?
Calculate the value of a 10 yr zero
coupon bond with FV= 1000 and yield
of 8% compounded semi-annually.

Bond Valuation
Discount, Premium and par value
bonds
Value with time
A 10% bond has YTM =8% If bonds
YTM remains constant then in 1 year
the bond price will be higher, lower
or unchanged? Why?

Bond Yield
What is yield?
Current Yield
What is the current yield of a 20 year
bond with par value of Rs 1000
coupon rate of 6% paid semiannually
trading @ Rs. 802.07

Bond Yield
Yield to Maturity
Total return = Coupon Interest +
Recovery of Principal along with capital
gain or loss + Reinvestment Income
A bond has 3 yr maturity, FV= Rs.
1000, Issue price = 898.80 and
coupon =10% paid annually. Calculate
YTM.

Yield to maturity
Consider a 20 year $1000 par value bond
with 6% coupon rate (semi annual
payments) with a full price of $802.07.
Calculate the YTM.
Promised Yield vs. Realized yield.
A 2 year bond with par value of 1000,
coupon of 10% and YTM of 10%. If
reinvestment rate remains same as YTM for
2 yrs what will the investors ending wealth
and realized yield?

YTM vs. Realized Yield

What if reinvestment rate changes to 8%
in first year? What is the realized yield
now?
An investor has a bond of maturity 30
years, paying annual coupon of 7.5%
purchased @ Rs. 980. (YTM = 7.77%) He
sells it off after 20 years when YTM is 8%
and sales price is 966.45, while the
reinvestment rate of coupons had been
6% for 20 yrs, what is the investors
realized yield?

Bond prices and Yields

Reinvestment risk
Practice yourself:
Consider a bond with 8% coupon
selling @953.10 with 3 yrs to maturity
making annual coupon payments. If
the interest rates in next 3 yrs are yr 1
= 8%, yr2 = 10% yr3 = 12% calculate
the YTM and realized compounded
yield.

Bond prices and Yields

Bond price vs Yields
A bond has face value Rs. 1000
coupon of 6% paid semi annually.
What is its price if the YTM of the
bond is
i) 3% ii) 6% iii) 12%
Ans: i)1085.45 ii) 1000 iii) 852.48

Yield to call
An 8% coupon paying 30 yr bond
sells for Rs.1150 and is callable in 10
years at a call price of Rs.1100.
Calculate the yield to call.

Yield to Worst
It is the worst yield outcome of all the
given possible call provisions of the
bond
For Eg: A 20 yr, 10% semiannual pay
bond has a full price of 112 and can be
called at 102 in five years and at par in
seven years. Calculate the YTM, YTC ,
Yield to first Par call.
What is yield to worst?

Clean Price vs. Dirty Price

Dirty Price = Clean Price + Accrued
Interest
Calculation of Accrued Interest:
Coupon(No. of days since last
coupon/no. of days between two
coupons payment dates)
Day Count Conventions: 30/360,
Actual/360, Actual/365, Actual/Actual

Measuring Interest rate risk

Change in price due to change in
yield
Measured by DURATION
Measures interest rate senstivity

Duration
Concept 1
Weighted
time
to
maturity
(Maculays Duration)
Calculate the duration of a bond with
face value 1000 coupon rate 8% and
time to maturity 3 years given a yield
of 10%
Yield vs duration
Coupon vs. duration
Time to maturity vs. duration

Duration
Adding a Call option vs. duration
Adding a Put option vs. duration
So
Higher (Lower) coupon means Lower
(higher) duration.
Longer (shorter) maturity means
higher (Lower) duration.
Higher (lower) market yield means
Lower (higher) duration

Duration
Concept 2
Slope of Price Yield Curve; first derivative
of price yield curve w.r.t yield (maculay
and modified duration
Duration = change in price/change in
yield
As slope of price yield curve of bond is
negative RHS is negative
Change in price = - D * change in yield
Measures interest rate risk

Duration
Concept 3
Shows the percentage change in
price for one percent change in yield.
Measures interest rate senstivity
Say duration is 6.85, what does it
P
*
mean?
D y
P

Duration Questions
A bond has a duration of 5. If yield
increases from 7% to 8% calculate
the approximate percentage change
in bond price.
A bond has a duration of 7.2. If yield
decreases from 8.3% to 7.9%
calculate
the
approximate
percentage change in bond price.

PVBP
It is the change in value (rupee
terms) of a bond/portfolio when yield
changes by 1 basis point or 0.01%
It can be calculated directly by
finding price at new yield or via
duration
PVBP = duration x 0.0001 x bond
value

Convexity
An increase in price of a bond with 1%
decrease in yield is more than a
decrease in price of the bond with 1%
increase in yield.
Yield = 10%, time = 3 yrs, FV = 1000
coupon = 9% paid annually. What is the
price if YTM = 9% and if YTM = 11%
What do you observe in terms of
percentage change in price?

Convexity
Reason: Convexity
More convex a bond; better it is
Measures change in Duration; second
derivative of price w.r.t yield divided
by bond price
CF

P
1

(t t)

y (1 y)
(1 y)
2
2

t 1

1 2 P
Convexity
P 2 y

Convexity
Convexity makes Maculays and
Modified duration less reliable
measure of risk.
Effective Duration is suitable for bonds
Due to presence of convexity as it
takes average price change
In case of embedded options in a bond

Convexity
Callable
bonds
have
negative
convexity. So price fall is more than
price rise, hence average price
change
captured
by
effective
duration is useful.

Effective Duration
The formula for calculating the
effective duration of a bond is:
Effective duration = (bond price
when yields fall -bond price when
yields rise) / 2 X (initial price) X
(change in yield in decimal form)

Effective Duration
Practice Question
Suppose a callable bond has a call
price of $1005 is selling today for
$980. If yield curve shifts by 0.5%,
the bond price falls to $930 and if it
shifts down by 0.5% the price will
rise to $1010. What is the effective
duration of the bond?

Duration and Convexity

effect
Convexity makes duration alone
insufficient measure of price risk
8% bond has a YTM of 9% and is priced
@ 908. Duration = 9.42. If YTM rises to
10% actual price = 828.41 if it falls to 8%
actual price is equal to 1000. Calculate
the Duration based price estimate.
Duration based estimate is lower than
actual both on decrease and increase in
yield.

Duration and Convexity

effect
Duration does not alone measure the
entire price change effect
percentage change in price =
duration effect + convexity effect
[-duration x ( y) +[convexity X
( y)2] x 100
If y is in decimal convert each effect
back to percentage.

Duration and Convexity

effect
Same question as earlier
A bond has 8% coupon and 9% yield.
Its current price is Rs. 908. Duration =
9.42 and convexity = 68.33. Calculate
the percentage change in price for 1%
increase and 1% decrease in yield.
What did you observe on
accommodating both effects.