Fixed Income Securities: Types, Valuation & Associated Risks

What is Debt?
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y Means a borrowing, hence to be repaid by:  Periodic Interest payments  Principal Repayment

Brief look at classification of debt according to maturity:  Less than 1 yr- Money Market instruments  More than 1 yr- Govt. securities, bonds, debentures etc.

Types Of Money Market Instruments

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y Treasury Bills- They represent short term

obligations of GOI. Do not carry an explicit interest rate, as they are issued at a discount and redeemed at par value. y Certificate of Deposits As the name suggests, it is a certificate of deposit, i.e. negotiable receipt of funds deposited in a bank for fixed period, sold at discount and redeemed at par. y Commercial Papers These are short term unsecured promissory notes issued by firms, which are considered financially strong.

Debt instruments more than 1 year old

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y Govt. issued securities These are medium to long

term bonds issued by RBI on behalf of the GOI (central & State govt.). y Corporate Debt These are bonds issued frequently by public sector cos, financial institutions, private cos. Etc. y Hence Bonds- Financial Contracts between the issuer and the holder

Types of Bonds
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y Straight Vanilla Bonds y Zero Coupon or Deep Discount bonds y Floating rate bonds y Bonds with embedded options- Convertibles,

Warrants y Callable Bonds y Puttable bonds

Bonds : Formal Definition & Terminologies used

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y Bonds are negotiable promissory notes that can be

used by individuals, business firms, govt. or govt. agencies y Some bond related terms:  Face Value / Par Value  Coupon Rate  Maturity  Redemption Value  Market Value (Price)

Basic Bond Valuation Model

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y With the above background, it is quite clear that the

holder of a bond receives a fixed annual interest payment for a certain number of years and a fixed principal repayment( equal to par value) at the time of maturity. Therefore, the intrinsic value (or the present value) of a bond can now be written as: Value(price of bond) = I/(1+kd)^t +F/(1+kd)^n, (where t varies from 1 to n) Or

Basic Bond Valuation Model contd.

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y Value = I(PVIFA kd, n) + F(PVIF kd ,n )

Where, I = annual interest payable on bond F= Principal amount(Par Value) repayable at the maturity time. N= maturity period of the bond Kd = cost of capital( the prevailing interest factor)

Brain Gym
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Q1) A bond whose par value is Rs.1,000 bears a coupon rate of 12% and has maturity period of 3 years. The required rate of return on the bond is 10%. What is the value of the bond?

Solution to brain Gym

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Value = Rs. 120(PVIFA 10%,3yrs.) + Rs. 1000 (PVIF 10%, 3 yrs) = Rs.120 *(2.487) + 1,000(0.751) = Rs. 298.44 + Rs. 751 = Rs.1,049.44

Bond Values with Semi annual Interest

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y Some of the bonds carry interest payment semi

annually. As half- yearly interest amounts can be reinvested the value of such bonds would be more than the bonds with annual interest payments. Hence our bond valuation model gets modified as: Value = (I/2)/(1+kd/2)^t + F/(1+kd/2)^2n, (where t varies from 1 to 2n)

Brain Gym
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Q2) A bond of Rs. 1,000 value carries a coupon rate of 10% and a maturity period of 6 years. Interest is payable semi annually. If the required rate of return is 12%, calculate the value of the bond.

Solution to Brain Gym

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Value = Rs. 50(PVIFA 6%, 12 yrs) + 1,000(PVIF 6%,12 yrs) =Rs. 50(8.384) + 1,000 (0.497) = Rs. 419.2 + Rs. 497 = Rs. 916.20

Bond Yield Measures

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y One Period Rate of Return

Eg: X purchased Rs. 1,000 par value bond for Rs.900. The coupon payment on his bond is Rs.80 i.e, 8%. One yr later he sells the bond for Rs. 800. The rate of return of Mr. X for this one year period is: = [(800-900) +80]/900 =[-100+80]/900 = - 2.22%

Bond Yield Measures contd.

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y Current Yield It measures the rate of return earned

on a bond if it is purchased at its current market price and if the coupon interest is received. Current yield = Coupon Interest/ Current Market Price In the previous example, if the current market price of the bond is also Rs. 800, then the current yield = 80 / 800 = 10% Coupon rate and current yield are two different measures. Coupon rate and current yield will be equal if the bonds market price equals its face value.

Bond Yield Measure: Yield to Maturity(YTM)

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Q) How are two bonds compared? 1)On the basis of prices? or 2) On the basis of yield? Q) What is yield? Q) Is yield same as coupon?

Bond Yield Measure: Yield to Maturity(YTM)

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y Yield to Maturity It is the rate of return earned by an

investor who purchases a bond and holds it till maturity. The YTM is the discount rate which equals the present value of promised cash flows to the current market price(purchase price).
y Eg: Consider a Rs. 1,000 par value bond whose current

market price is Rs. 850. The bond carries a coupon rate of 8% and has a maturity period of 9 years. What would be the rate of return that an investor earns if he purchases the bond and holds till maturity??

Solution
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y Rs 850 = Rs.80( PVIFA kd%, 9yrs) + Rs. 1000 (PVIF

kd%, 9yrs) Use Interpolation to find the YTM

Solution , approximate Formulae

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y We find that the YTM comes to 10.71%

Approximate Formulae: YTM [I +(F-P)/n] / [0.4F +0.6P] Where, I= annual interest payment F= par value or redemption value of the bond P= current market price of the bond N= years to maturity

Brain Gym
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Q3) Zeta Industries Ltd. Bond a par value of Rs. 500 is currently traded at Rs. 435. The coupon rate is 12% and it has a maturity period of 7 yrs. What is the YTM? (use approximate formulae)

Solution to Brain Gym

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y YTM [ 60 + (500 -435)/7]/[(0.4*500)+(0.6*435)]

15%

Bond Value Theorems

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y Relationship between the required rate of return and

the coupon rate. y Number of the years to maturity y Yield to maturity

Relationship between required rate and coupon rate

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y Eg: Consider a bond of Kenstar Intermediaries Ltd.

With the following features: y Par Value : Rs.100 y Coupon Rate: 12% y Years to maturity: 5 years Find the value of the bond if the required rate of return is 12%? - Do a quick calculation using approximate formulae

Relationship between required rate and coupon rate 24

y We find that the value of the bond equals Rs.100,

hence it can be said that When the required rate of return is equal to the coupon rate, the value of the bond is equal to its par value y Now consider the same example if the required rate of return is 14%. ( Do a quick calculation using approximate formulae. Keep the answer as a secret) y Now consider the same example if the required rate of return is 10%. y So what do you conclude??????????

Relationship between required rate and coupon rate 25

y Hence we see that:  If Kd = Coupon rate, Value of bond= Par value  If Kd> Coupon rate, Value of bond< Par value  If Kd< Coupon rate, Value of bond> Par Value

Effect of Number of years to maturity on Bond 26Value

y Eg: Consider a bond of Enucon Ltd. with the

following features: y Par Value: Rs.1000 y Coupon rate: 11% y Years to Maturity: 7 If the required rate of return is 13%, then the value of the bond is.(Do a quick calculation)

Effect of Number of years to maturity on Bond Value

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y We see that the value of the bond is approx = Rs. y y y

911.53 One year from now , when the maturity period will be 6 years, the value of the bond will be: Rs. 919.78 For a required rate of return of 13%, the value of the bond will increase with the passage of time, i.e until maturity Look at the following table:

Effect of Number of years to maturity on Bond Value

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Years to Maturity 5 4 3 2 1 0

Bond Value 929.87 940.14 952.71 966.48 982.35 1,000.00

Effect of Number of years to maturity on Bond Value

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y Hence what do you conclude???? y For a required rate of return of 13%( which is greater

than the coupon rate of 11%), the value of the bond will increase with the passage of time, i.e. until its maturity. y Hence, When the required rate of return (kd) is greater than the coupon rate, the discount on the bond declines as the maturity approaches y What would you say if the required rate of return(kd) is less than the coupon rate???????

Home exercise
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y Prove that if the required rate of return is less than

the coupon rate, the premium on the bond declines as maturity approaches y Use the previous example with the required rate of return 9% in this case.

Effect of YTM on bond prices

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y As the YTM determines a bonds market price and

vice-versa, we can say that the bonds price will fluctuate in response to the change in market interest rates. y Eg: The YTM of a Rs. 1,000 par value bond bearing a coupon rate of 10% and maturing in 10 years is 12%. Thus, the market value of the bond is Rs.887( as calculated previously, do a quick calculation). If the YTM increases to 14%, the market value of the bond will drop to Rs.791.60 9 do a quick calculation)

Effect of YTM on bond prices

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y Hence what do we conclude???? y A bonds price moves inversely proportional to its

Yield To Maturity y The present value principle states that the present value of a cash flow varies in inverse proportion to the interest rate used as a discount rate. As such if the YTM of the bond rises, the bonds market price drops and if the YTM falls, the bonds market price rises. y How would this relation look graphically????

Risks associated in Debt Investments

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y Interest Rate Risk Price Risk and Reinvestment y y y y

Risk Inflation Risk/ Purchasing Power Risk Default / Credit Risk Call Risk Liquidity Risk

Yield Curve
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Yield Curve shows the relation between YTM (in %) and the term to Maturity ( in yrs). It plots the interest rate, at a set point of time of bonds having equal credit quality, but different maturity dates. The shape of the yield curve is closely scrutinized, because it helps to give an idea of future interest rate change and economic activity.

Yield Curve
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Generally it is upward sloping , indicating that long term rates are greater than the short term rates.
YTM

Maturity

Yield Curve
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y Can we have an inverted yield curve? y Or a Flat Yield Curve?

YTM

Maturity

Thank You

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