undefined | unit 2 fixed income securities

FOI

Unit 2

Fixed income Securities

Q1) Define bond. Discuss different features of bond. 8

A1) Bond is a debt instrument issued by Government and companies to raise capital from the market for the business. It is issued for long duration and the investors get interest over the loan. Some of the significant features of bond are-

1. Issuer

The entities that borrow money by issuing bonds are called as issuers. There are mainly 4 major issuers of bonds which include the government, government agencies, municipal bodies, and corporates.

2. Face value

Every bond that is issued has a face value, which is usually the principal amount that is borrowed and returned on maturity. In layman’s term, it is the value of the bond on its maturity.

3. Coupon

The rate of interest paid on the bond is called as a coupon.

4. Rating

Every bond is usually rated by credit rating agencies; higher the credit rating lower will be the coupon required to pay by the issuer and vice versa.

5. Coupon payment frequency

The coupon payments on the bond usually have a payment frequency. The coupons are usually paid annually or semi-annually; however, they may be paid quarterly or monthly as well.

6. Yield

The effective return that the investor makes on the bond is called a return. Assuming a bond was issued for a face value of Rs 1000 and a coupon rate of 10% on initiation. The Price at a later date may rise or fall and hence the investor who invests at a rate other than Rs 1000 will still receive a coupon payment of Rs 100 (1000 * 10%) but the effective earning shall be different since investment amount is not Rs 1000.

Q2) Discuss the classifications of bond. 12

Q3) How bonds are classified?

A) to Q2 & Q3. There are many types of bonds issued that differ from each other in respect of their features. Some of the major types of bonds are-

1. Plain vanilla bonds

A plain vanilla bond is a bond without any unusual features. It is one of the simplest forms of bond with a fixed coupon and a defined maturity and is usually issued and redeemed at the face value. It is also known as a straight bond or a bullet bond.

2. Zero coupon bonds

A zero-coupon bond is a type of bond where there are no coupon payments made. Zero-coupon bonds are issued at a price lower than the face value (say Rs 950) and then pay the face value on maturity (Rs 1000). The difference will be the yield for the investor. These are also called as discount bonds or deep discount bonds if they are for longer tenor.

3. Deferred coupon bonds

This type of bond is a blend of a coupon-bearing bond and a zero-coupon bond. These bonds do not pay any coupon in the initial years and thereafter pay a higher coupon to compensate for no coupon in the initial years. Such bonds are issued by corporates whose business model has a gestation period before the actual revenues start. Examples of a company which may issue such type of bonds include construction of companies.

4. Step-up bonds

These are bonds where the coupon usually steps up after a certain period. They may also be designed to step up not once but in a series too. Such bonds are usually issued by companies where revenues/ profits are expected to grow in a phased manner. These are also called as a dual coupon or multiple coupon bonds.

5. Step down bonds

These are just the opposite of Step-Up Bonds. These are bonds where the coupon usually steps down after a certain period. They may also be designed to step down not once but in a series too. Such bonds are usually issued by companies where revenues/ profits are expected to decline in a phased manner; this may be due to wear and tear of the assets or machinery as in the case of leasing.

6. Floating rate bonds

Floating rate bonds are so called because they have a coupon which is not fixed but rather linked to a benchmark. For example, a company may issue a floating-rate bond as Treasury bond rate + 50 bps (100 bps = 1%). In such cases on every interest payment date, the payment will be made 0.50% more than the treasury bill rate prevailing on the fixing date.

7. Inverse floaters

These types of bonds are similar to the floating rate bond in that the coupon is not fixed and is linked to a benchmark. However, the differentiating thing is that the rate is inversely related to the benchmark. In simple words, if the benchmark rate goes up; the coupon rate comes down and vice versa.

8. Participatory bonds

A participatory bond is a bond whereby the issuer promises a fixed rate but the coupon cash flow may increase if the profit/ income levels of the company rise to a pre-specified level and may reduce when income falls below a pre-specified level; thereby the investor participates in the return enjoyed based on company revenues/ income.

9. Income bonds

Income bonds are similar to participatory bonds however these types of bonds do not have a reduction in interest payments if income/ revenue reduces.

10. Payment in kind bonds

These types of bonds pay interest/coupon, not in terms of cash pay-outs but in the form of additional bonds.

11. Extendable bonds

Extendable bonds are bonds that allow the holder to enjoy the right to extend the maturity if required. The holder has an additional benefit in this case because if the rate of interest in the market reduces, the holder may choose to extend the tenor and enjoy the higher rate of interest in terms of coupon payment. For this benefit, the holder may enjoy the coupon rates that are usually lower than a plain vanilla bond.

12. Extendable reset bonds

These are types of bonds which allow the issuer and the bondholders to reset the coupon rate based on the then prevailing market scenario. This is not linked to any benchmark but on the basis of renegotiation between the issuer and the bondholders. This is usually the case where the bond tenor is very long.

13. Convertible bonds

Convertible bonds are a special variety of bonds which have an inbuilt feature of being converted to equity shares at a specified time at a pre-set conversion price.

14. Foreign currency convertible bonds

Foreign currency convertible bond is a special type of bond issued in the currency other than the home currency. In other words, companies issue foreign currency convertible bonds to raise money in foreign currency.

Q4) Discuss briefly the estimation of bond yield. 6

Q5) How bond yields are estimated?

A) to Q4 and Q5 The estimation of bond yield are discussed under the following heads-

1. Coupon Rate and Current Yield

A familiarity with bond yield measures is important for understanding the financial characteristics of bonds. As we briefly discussed in Chapter 3, two basic yield measures for a bond are its coupon rate and current yield. A bond's coupon rate is defined as its annual coupon amount divided by its par value or, in other words, its annual coupon expressed as a percentage of face value:

Coupon rate = Annual coupon / Par value

For example, suppose a Rs. 1,000 par value bond pays semi-annual coupons of Rs. 40. The annual coupon is then Rs. 80, and stated as a percentage of par values the bond's coupon rate is Rs. 80 / Rs. 1,000 = 8%. A coupon rate is often referred to as the coupon yield or the nominal yield.

A bond's current yield is its annual coupon payment divided by its current market price:

Current yield = Annual coupon / Bond price

For example, suppose a Rs. 1,000 par value bond paying an $80 annual coupon has a price of Rs. 1,032.25.

The current yield is Rs. 80 / Rs. 1,032.25 = 7.75%. Similarly, a price of Rs. 969.75 implies a current yield of Rs. 80 / Rs. 969.75 = 8.25%.

2. Straight Bond Prices and Yield to Maturity

The single most important yield measure for a bond is its yield to maturity, commonly abbreviated as YTM. By definition, a bond’s yield to maturity is the discount rate that equates the bond’s price with the computed present value of its future cash flows. A bond's yield to maturity is sometimes called its promised yield, but, more commonly, the yield to maturity of a bond is simply referred to as its yield. In general, if the term yield is being used with no qualification, it means yield to maturity. The standard formula used to calculate a bond’s price given its yield is-

Bond price = C/YTM [1- 1/(YTM/2)2M] + FV/(1+YTM/2)2M

Where, C = annual coupon, the sum of two semi-annual coupons

FV = face value

M = maturity in years

YTM = yield to maturity

Relationships among Yield Measures

We have discussed three different bond rates or yields in this chapter - the coupon rate, the current rate, and the yield to maturity. We’ve seen the relationship between coupon rates and yields for discount and premium bonds. We can extend this to include current yields by simply noting that the current yield is always between the coupon rate and the yield to maturity (unless the bond is selling at par, in which case all three are equal).

Putting together our observations about yield measures, we have the following:

Premium bonds: Coupon rate > Current yield > Yield to maturity

Discount bonds: Coupon rate < Current yield < Yield to maturity

Par value bonds: Coupon rate = Current yield = Yield to maturity

Thus when a premium bond and a discount bond both have the same yield to maturity, the premium bond has a higher current yield than the discount bond.

Q6) Discuss the concept of bond valuation. 8

Q7) How valuation of bond is made by using suitable methods?

A) to Q6 & Q7. The value of a bond is the present value of the expected cash flows on the bond, discounted at an interest rate that is appropriate to the riskiness of that bond. Since the cash flows on a straight bond are fixed at issue, the value of a bond is inversely related to the interest rate that investors demand for that bond. The interest rate charged on a bond is determined by both the general level of interest rates, which applies to all bonds and financial investments, and the default premium specific to the entity issuing the bond.

Bond Prices and Interest Rates:

The value of a straight bond is determined by the level of and changes in interest rates. As interest rates rise, the price of a bond will decrease and vice versa. This inverse relationship between bond prices and interest rates arises directly from the present value relationship that governs bond prices.

The Present Value Relationship

The value of a bond is derived from the present value of the expected cash flows on that bond, discounted at an interest rate that reflects the default risk associated with the cash flows. There are two features that set bonds apart from equity investments

The cash flows on a bond,

Bonds usually have fixed lifetimes, unlike stocks, since most bonds specify a maturity date.

The present value of a bond, expected to mature in N time periods, with coupons every period can be calculated-

PV of Bond = Coupont /(1+t)t + Face Value/(1+r)N

Where,

Coupont = Coupon expected in period t

Face Value = Face value of the bond

r = Discount rate for the cash flows

The discount rate used to calculate the present value of the bond will vary from bond to bond depending upon default risk, with higher rates used for riskier bonds and lower rates for safer ones.

If the bond is traded, and a market price is therefore available for it, the internal rate of return can be computed for the bond, i.e., the discount rate at which the present value of the coupons and the face value is equal to the market price. This internal rate of return is called the yield to maturity on the bond.

A Measure of Interest Rate Risk in Bonds

The effect of interest rate changes on bond prices will vary from bond to bond and will depend upon a number of characteristics of the bond.

The maturity of the bond: The present value of cash flows changes much more for cash flows further in the future, as interest rates change, than for cash flows which are nearer in time.

The coupon rate of the bond: Holding maturity and default risk constant, increasing the coupon rate of a straight bond will decrease its sensitivity to interest rate changes.

Q8) What are the different types of risk associated with bond? 6

A8) Different types of risk associated with bonds are-

Interest rate risk: It measures bond price sensitivity to changes in interest rates. All things equal, long-term bonds have more interest rate risk than short-term bonds. All things equal, low coupon bonds also have more interest rate risk than high coupon bonds.

Reinvestment risk: It is the risk of having to reinvest proceeds at a lower rate than what the funds were previously earning. One of main the ways this risk presents itself is when interest rates fall over time and callable bonds are exercised by the issuers.

Inflation risk: When an investor buys a bond, they essentially commit to receiving a rate of return either fixed variable for the duration of the bond or at least as long as it is held.

Default risk: When the investor purchases a bond, they are actually purchasing a certificate of debt. If the bond issuing company unable to give the expected return to the investors, than it is known as default risk.

Rating downwards of bonds: A company’s ability to operate and repay its debt issues is frequently evaluated by major rating institutions. If the institutions are not performing well than its rating downgraded.

Liquidity risk of bonds: When there is always a ready market for government bonds, corporate bonds are sometimes entirely different animals. There is a risk an investor might not be able to sell their corporate bonds quickly less number of buyers and sellers.’

Q9. What is credit rating? Discuss the credit rating agencies operating in India. 10

Q10. Write a note on CRISIL, CARE and ICRA. 8

A) to Q9 & Q10 Credit rating is a qualitative & quantitative assessment of the probability of default on payment of interest and principal on a debt instrument. Credit Rating only provides an additional input to the investor and the investor is required to make his own independent and objective analysis before arriving at an investment decision. Rating is denoted by a simple alpha-numeric symbol, for e.g. AAA, AA+, A-, etc. Ratings are based on a comprehensive evaluation of the strengths and weaknesses of the company fundamentals including financials along with an in-depth study of the industry as well as macro-economic, regulatory and political environment. Credit rating agencies like CRISIL, CARE, Standard and Poor etc. provide rating to the companies. Credit rating agencies are regulated by Securities and Exchanges Board of India (SEBI).

Some of the credit rating agencies operating in India are-

CRISIL (Credit Rating & Investment Services of India Ltd.)

It is the largest credit rating agency in India headquartered at Mumbai and comprises more than 60% of the market share. It was established in 1987 and the full form is Credit Rating Information Services of India. CRISIL has become a global analytical company that gives ratings to companies, researches the markets and provides risk and policy advisory services to its clients. The world’s biggest credit rating agency i.e. Standard & Poor’s has majority stake in CRISIL. CRISIL works with the government as well as with the governments of other developing nations to enhance the rating infrastructure.

Features of credit rating-

It provides reliable information as it provides rating depending on the performance of the companies.

Rating is provided in symbols like A, AA, BB, B+ etc.

Rating is provided by expert institutions.

The rating implies the risk and return policy of the company/financial product/instrument.

Advantages of credit rating

Reduce cost of borrowing: A highly rated company able to reduce the cost of borrowing by lowering the interest rate. It is because there no requirement to provide high interest rate for attracting the investors.

Wide audience: A highly rated company can get wide audience than a low rated company. It is because the probable investors are able to know that there is less risk in such investment.

Growth: It promotes growth in the rated company because they know that their performance and effort is promoted in the market through ratings.

Credit arrangement: The highly rated company can easily arrange credits from the financial institutions because the lenders ensure about their credibility through the ratings.

Benefits to brokers: The brokers and other intermediaries benefited from such ratings because they need to give less effort in studying and analysing the performance of the company.

CARE (Credit Analysis and Research limited)

India’s second largest credit rating agency established in 1993 and headquartered at Mumbai. Credit Analysis and Research limited (CARE)I s 100% wholly owned subsidiary of Fitch Group. CARE is tasked with the provision of ratings to debt instruments, loan ratings, corporate governance ratings, credit analysis ratings and claim spaying ability of insurance companies. It also rates construction companies and maritime training institutes. CARE provides ratings to State Governments, Municipal corporation bodies, banks and other financial institutions. CARE also rates SMEs based on their financial health.

ICRA (Investment Information and Credit Rating Agency of India)

It is an independent and professional investment information and credit rating agency established in 1991 and headquartered at Gurugram, Haryana. Investment Information and Credit Rating Agency of India, ICRA was a joint venture between Moody’s and various Indian commercial banks and financial services companies. ICRA provides ratings to Indian Corporates, Hospitals, Construction and Real Estate companies as well as provides grading and ranking to various mutual funds in India. It also assigns corporate governance ratings to companies.

FITCH INDIA (INDIA RATINGS AND RESEARCH)

It is headquartered in Mumbai, Ind-Ra is a 100% owned subsidiary of the Fitch Group. Ind-Ra currently maintains coverage of corporate issuers, financial institutions including banks and insurance companies, finance and leasing companies, managed funds, urban local bodies, and structured finance and project finance companies.

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