INTRODUCTION

In investment management, the most important decision is to allocate the funds among asset classes. Two most major asset classes are equity and fixed income. Other alternative asset classes are real estate, private equity, hedge funds and commodities. In practice we use the terms fixed income securities and bonds

 A bond is a security instrument which acknowledges that the issuer has borrowed money and must repay it to the bondholder at a specified rate of interest over a predetermined period of time. These securities are referred to as debt obligations, contrasted with stocks, which represent ownership in a corporation (equity stake). A bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the interest. Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets.

Features of Bonds
In fixed income an entity promises to pay a specified sum of money at specified future dates. Nominal, Principal Or Face Amount: The amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Issue Price : The price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. Maturity of a bond is the number of years remaining prior to the final principal payment. Maturity Date : The date on which the

 Coupon rate is the interest rate that the issuer agrees to pay each year. Indentures and Covenants : An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement. The par value is the amount that is repaid to the bondholder at the maturity date. It is also called the principal value, face value, and maturity value. High yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are more risky than investment grade bonds, investors expect to earn a higher yield.

 Callability : Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to as callable bonds. Putability : Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates

TYPES OF BONDS
Type Central Government Securities State Government Securities Government Guaranteed Bonds PSU Corporate Typical Features Medium long term bonds issued by RBI on behalf of GOI. Coupon payment term semi annually by RBI on Medium long are bonds issued behalf of state govt. Coupon payment term semi annually by govt Medium long are bonds issued agencies and guaranteed by central or state govt. Medium long term bonds issued by PSU. Coupon payment are semi annually 51% govt equity stake Short - Medium term bonds issued by private companies. Coupon payment are semi annually

Classification on the Basis of Variability of Coupon

Fixed Rate Bonds: Have a coupon rate that remains constant throughout the life of the bond ie: a Rs 1000 bond with 8% fixed interest rate and you will receive Rs 80 every year until maturity and at maturity you will receive the Rs 1000 back Floating Rate bonds: Interest rates depends on some

e.g. Coupon rates based on LIBOR can be LIBOR+ Quoted margin, Interest rates are then reset periodically Coupon rates are based on the rate calculated on the reset date. Special features-caps, floors and collars Caps: Specifies the maximum coupon rate of the floater. Also known as Range Notes Floors: Specify the minimum rate of Coupon Collars: Combinations of caps and floors Dual Indexed floaters: Based on

More frequently used in the housing loan markets where coupon rates are reset at longer time intervals (after one year or more), these are well known as Variable Rate Bonds and Adjustable Rate Bonds

PAYABLE AT MATURITY: Receive no payments until maturity and at that time of payment principal plus the total interest earned compounded semi-annually at the initial interest rate

Zero Coupon Bonds:

Pay no regular interest Issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity Bondholder receives the full principal amount on the redemption date E.g. Series E savings bonds issued by the U.S. government Difference between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders Issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the maturity period lesser would be the issue price and vice-versa

C la ssifica tio n o n th e B a sis o f V a ria b ility a n d M a tu rity

Callable Bonds:
Issuer of a callable bond has the right (but not the obligation) to change the tenor of a bond (call option) Issuer may redeem a bond fully or partly before the actual maturity date These options are present in the bond from the time of original bond issue and are known as embedded options Embedded option helps issuer to reduce the costs when interest rates are falling, and when the interest rates are rising it is helpful for the holders

Puttable Bonds:
Holder of a puttable bond has the right (but not an obligation) to seek redemption (sell) from the issuer at any time before the maturity date In riding interest rate scenario, the bond holder may sell a bond with low coupon rate and switch over to a bond that offers higher coupon rate The issuer will have to resell these bonds at lower prices to investors.

Convertible Bond:

Lets a bondholder exchange a bond to a number of shares of the issuer's common stock or cash of equal value at an agreed upon price Hybrid security with debt and Equity like features Carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company's equity value

Convertible bonds in different markets of the world: USA: Highly liquid market compared to other domestic markets. Domestic investors have tended to be most active within US convertibles Japan: More regulated than other markets, consists of a large number of small issuers Europe: Important source of finance for firms in Europe. European convertible bonds tend to be of high credit quality Asia (ex Japan): Asia region provides a wide range of choice for an investor. The maturity of Asian convertible bond

Some of the other bonds are: Exchangeable Bond:

Allows for exchange to shares of a corporation other than the issuer Not mutually exclusive, and more than one of them may apply to a particular bond

Asset-Backed Securities:

Bonds whose interest and principal payments are backed by underlying cash flows from other assets E.g. Mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs)

Subordinated Bonds
Have a lower priority than other bonds of the issuer in case of liquidation Risk is higher Subordinated bonds usually have a lower credit rating than senior bonds E.g. Bonds issued by banks, and asset-backed securities. Asset-backed securities - issued in tranches, Senior tranches get paid back first

Types of Bonds
Domestic Bonds issued in the domestic market denominated in the domestic currency Foreign Bonds denominated in domestic currency and in the local market by a foreign borrower

Types of foreign Bond

Yankee bonds: Issued in US by a foreign
borrower and are denominated in US dolllar.

foreign borrower and are denominated in Japanese Yen.

Samurai bonds: Issued in Japan by a

Bulldog bond: Issued in UK by a foreign

borrower and are denominated in UK Pound Sterling.

Eurobonds:

Eurobonds are bonds which are denominated in foreign currency and are issued by a foreign firm and sold to the home country residents. A Eurobond does not necessarily have to originate or end up in Europe although most debt instruments of this type are issued by non-European entities to European investors.

Global bonds:

These bonds are sold to many other markets as well as Euromarkets. Global bonds can be issued in same currency as the country of issuance, which is not the case with euro bonds

Perpetual Bonds

are also often called perpetuities or 'Perps'. They have no maturity date. ultra-long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 ).

Bearer Bond
is an official certificate issued without a named holder. Often they are registered by a number to prevent counterfeiting traded like cash. very risky because they can be lost or stolen

Registered Bond

is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent

Municipal Bond
is a bond issued by a state, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

Book-Entry Bond Serial Bond

is a bond that does not have a paper certificate.

is a bond that matures in installments over a period of time. In effect, a $100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval.

Revenue Bond

is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Revenue bonds are typically "non-recourse,"

G e n e ra l O b lig a tio n ( G O )
Unlimited-tax GO bonds are secured by the full faith, credit, and taxing powers of the issuing government Legally obligate the local government to levy taxes on all assessable property within its jurisdiction to a level necessary to meet the bond payment obligation GO bonds are an appropriate financing vehicle for capital projects that benefit the community as a whole. May be limited by constitutional and statutory restrictions.

Credit Ratings
Each of the agencies assigns its ratings based on an in-depth analysis of the issuer's financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond.

Credit Ratings
Credit Risk
Prime Excellent UpperMedium LowerMedium Speculative VerySpeculative Default

Moody's
Aaa Aa A Baa Ba B,Caa Ca,C

Standard and Fitch Poor's

AAA AA A BBB BB B,CCC,CC D AAA AA A BBB BB B,CCC,CC,C DDD,DD,D

Bond Market Creditor fixed % return on your money which o to tra d e ( b u y I ve sto rs g is paid annually n a n dck mla d e bt h a s ce ti s,l S to se l ) rke t se cu ri tra ne p rocei e n tl bvolatiles ( sto ck n y l a s o less a n g e Lessmrisky r excho n d s e xch a n g e s) w h e re sto cks a re b o u g h t a n d so l d

Bond Market v/s Stock Market

Stock Market Ownership profits & losses I ve sto rs g o to tra d e ( b u y n a n d d mla rkeu i o e s cuo tti as ) ty B o n se l e q t d se n ri he ve l ke nrisky more g p l ce fo r i a ce tra ltra d i volatile n a More co m d s;o ra sto ckso&d s a re so l b o n m n th e r b n d d ea iva ti s (-o p ti n s, fu tu re s m ri l over the o counter n y ve e tc ). (OTC)

Bonds on NYSE(9:30a.m. 4:00p.m)

U.S. Government Bonds Issued by US Treasury bills, notes and bonds Safest bond investments-faith & credit of US govt Income earned is exempt from state & local taxes Municipal Bonds Riskier than Treasury Federal govt can't tax interest on state or local bonds (&vice versa) Triple tax free city, state & federal

Bonds on NYSE
Corporate Bonds Riskiest fixed-income securities Most lucrative fixed-income investment risk ST, IT and LT Credit quality monitored by debt-rating agencies Federal Agency Bonds Support projects relevant to public policy, such as farming, small business, or loans to first-time home buyers Do not carry the full faith-and-credit guarantee of government-issued bonds

Bonds on NYSE
Revenue Bonds A municipal debt on which the payment of interest and principal depends on revenues from the particular asset that the bond issue is used to finance. Eg - toll roads and bridges, housing developments, and airport expansions Great amount of variance in risk depending on the particular assets financed Soveriegn Bonds Issued by national govt in foreign currencies Sovereign debt total amount owed to holders of sovereign bonds

Risk Associated with Investing in Bonds

Interest Rate Risk

The price of the bond will change in the opposite direction from the change in interest rate.
W h e n th e i te re st ra te ri s th e n se va l e o f th e b o n d w i o l e r a n d u th d th u s l w e r i te re st ra te fa l s o n l b e ca u se th e i te re st th e y p a y i n s l w e r th a n w h a t i ve sto rs ca n o n get on a new bond W h e n th e i te re st ra te ri s th e n se va l e o f th e b o n d w i h i h e r u th g i te re st ra te i cre a se s b e ca u se n n th e i te re st th e y p a y i h i h e r n s g th a n w h a t i ve sto rs ca n g e t o n n a new bond

Interest Rate Risk

This risk also depends on the type of option bought with the bond : ie. if the bond is callable or puttable

Price of callable bond = Price of straight bond Price of call option

In a Callable Bond theissuerof the bond has the right, but not the obligation to buy back the bond at some point before the bond reaches the date of maturity. If interest rates in the market have gone down by the time of the call date, the issuer will be able torefinanceits debt at a cheaper level and so will be incentivized to call the bonds it originally issued With a callable bond, investors have the benefit of a highercouponthan they would have had with a straight, non-callable bond. On the other

Reinvestment Risk
The risk that a particular investment might be canceled or stopped somehow, that one may have to find a new place to invest that money with the risk being there might not be a similarly attractive investment available. This primarily occurs ifare paid back earlier then Risk Credit expected.

If the issuer of a bond will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed ie Default. Yield = market yield + risk associated with credit risk

Inflation Risk
Purchasing power risk arises because of the lowering in the value of cash flow from the security due to inflation.

Exchange Rate Risk

Risk associated with the currency value for non-rupee denominated bonds. e.g.: US Treasury bond. Thus if the dollar appreciates, The bond will continue to pay the same returns in dollars But the amount of returns in terms of rupees will decrease

Liquidity Risk

A bond cannot be sold due to lack of liquidity in the market

It can be measured by the size of the spread between bids and asks price quoted. Wider spread is risky. For investors keeping till maturity, this is unimportant.

V o l ti i R i a l ty sk

Value of bond will increase when expected interest rate volatility increases.

Accrued Interest
If a bond is sold between coupon payment dates then the amount of interest received by the buyer which was earned by the seller is called accrued interest. Full price (dirty price) bond price + accrued interest. Clean price bond price.

EMBEDDED OPTIONS
Granted to Issuers decrease the price Call option Prepayment Cap on a floater Granted to Bondholders increase the price Conversion privilege Put option Floor on a floater

BONDS VALUATION
Steps - Estimating the cash flows problems in case of floater, convertible, callable bonds. - Determining the rate of interest - Calculating the present value As bond moves towards maturity, its price will move to its par value pull to par value.

BONDS YIELD MEASURES

Sources of return
The interest payments Any capital gain Income from reinvestment

Current yield = (Annual coupon interest/Price) No consideration is given to capital gain or reinvestment income.

BONDS YIELD MEASURES

Yield to maturity it is the interest rate that will make the PV of a bonds cash flow equal to its market price plus accrued interest. It assumes that coupon payments can be reinvested at rate equal to yield to maturity. Yield to call it assumes that issuer will call the bond at a specified date and a price given in call schedule and then calculates yield similar to

BONDS YIELD MEASURES

Yield to put Yield to worst Cash flow yield for amortizing bonds (with principal prepayment). Typically the cash flow of such asset backed securities is monthly.

SPOT RATE
The 10 year 8% coupon Treasury issue can be viewed as a package of 20 zero coupon bonds whose maturity value is equal to cash flows payment date. This gives opportunity for arbitrage profit. The zero coupon treasury rate that the U.S. Treasury would have to pay to eliminate this arbitrage opportunity is called spot rate. Forward rate is the markets

DURATION AND CONVEXITY

The price of an option free bond changes in the opposite direction to the change in the bonds yield. Measurement of interest rate risk
Duration Convexity Duration is the approximate change in price for a 100 basis change in rates. Duration always underestimates the price.

DURATION AND CONVEXITY

DURATION AND CONVEXITY

DURATION AND CONVEXITY

For a given large change in the yield, the percentage price increase is greater than the percentage price decrease. Since duration is like a tangent (linear), it always underestimates the prices. Duration works fine for smaller changes. Convexity adjustment is calculated and added to the

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