Basics of Fixed Income – Module 1
March 2012
Why Allocate in Fixed Income?
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Capital Stability
– One of the key characteristics of fixed Income investments is the repayments of capital at maturity. The capital repayment is subject to
the ability of the issuer of the bond to meet this obligations.
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Regular Income
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Fixed Income securities provide a regular income stream through coupon payments, where the dates and amount of the coupon
payable are defined at the time of issue of bond.
Diversification
– Diversification spreads investment across asset classes, maturities, industries and risk with the aim to reduce the impact of any one
investment in the portfolio.
– Fixed income allows diversification away from the two most cyclical asst classes –equities & real estate.
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Liquidity
– Most of the open ended fixed income products offers high liquidity. Low risk and highly liquid fixed income investments such as
governments bonds can be sold at a short notice if required. Liquidity is a fundamental factor in building portfolio.
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Low correlation to between fixed income & equities
– Fixed income has relatively predictable rate of return than equities. The volatility in fixed income is much lower than equity. Hence
adding fixed income in one’s portfolio brings higher stability to the portfolio.
Fixed Income Instruments
Fixed Income securities represent the debt of financial institutions, companies, banks and the governments .
One of the key benefits of fixed Income instruments is low risk i.e. the relative safety of principal and a relatively predictable rate of return( yield)
Examples of various fixed income instruments are as follows:
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Company Fixed Deposits
Non convertible debentures of companies
Bank Fixed Deposits
Fixed Income Mutual Funds
Public Provident Fund
Post office Monthly Income Scheme
National Saving Certificate
Fixed Maturity Plans
Government Bonds
Governments Treasury Bills
Bank certificate of deposits
Understanding a Bond
Let’s watch this video
(video from Investopedia)
What is a Bond?
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A bond is a promissory note issued by a borrower to the lender.
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Debt instruments/bonds are contracts in which one party lends money to another on pre-determined terms with regards to
– Rate of Interest to be paid by the borrower to lender
– The periodicity of such Interest payment
– Repayment of principal amount borrowed and the date of repayment
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The principal features of a bond are :
– Maturity: Maturity of a bond refers the date on which the borrower has agreed to replay the principal amount in full
– Coupon: Refers to the periodic interest payment that are made by the borrower. Coupon are stated upfront either directly specifying
the number (e.g. 8%) or indirectly tying with a benchmark rate ( e.g. MIBOR+0.5%) . Coupons are normally annual payment.
– Principal: The amount that has been borrower.
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Bonds are issues at different face value or par value. The most commonly are of Rs 1000.
For example 8.90%GOI2030 bond refers to a Government of India bond maturing in the year 2030, and paying a coupon of 8.90%
Compounding, Present Value & Future Value
The process of investing money as well as reinvesting the interest earned thereon is call compounding.
Suppose you invest Rs 1000 for 3 yrs in a fixed deposit that pays 10% interest per year. If you let your interest income reinvested, your investment
will grow as follows:
1st Year: Principal at the beginning + Interest of the year i.e. Rs 1,000+ Rs 100;
2nd year: Principal ( Rs 1100) + Interest of 10% (Rs 110) i.e. Rs 1210
3rd Year: Principal ( RS 1210) +Interest of 10% ( Rs 121) i.e. Rs 1,331
The future value of an investment after n year when the interest rate is r% is FVn=PV(1+r)n
Where FV is Future Value and PV is present value.
Present Value of an series of cash flow ‘C’ can be explained by
PV= C1/(1+r)1+C2/(1+r)2+C3/(1+r)3 …….Cn/(1+r)n where “C” are the future cash flow; “r” is the rate of interest and “n” is the number of period over
which the cash flow occurs.
Valuation of bonds
The future cash flows expected from a bond are primarily made up of
– Coupon payments
– Redemption of principal
Lets take an example of 10%GOI 2017 bonds (assume bond pay coupons annually) and understand how does the cash flow looks like
Assume the prevailing rate of interest or the required rate of interest is 9%.
C1=Rs 10
T=0
T=1
1st Jan 2013
1st Jan 2012
C2=Rs 10
T=2
1st Jan 2014
C3=Rs 10
C4=Rs 10
C5=Rs 10 +
Prl Repay Rs 100
T=3
T=4
T=5
1st Jan 2015
1st Jan 2016
1st Jan 2017
Face Value (Rs)
100
Coupon (c)
10%
Current Market Rate of Interest (r)
9%
Period
Cash Flow ( C )
Formula
PV
1
10
10/1.09
9.17
2
10
10/1.09^2
8.42
3
10
10/1.09^3
7.72
4
10
10/1.09^4
7.08
5
110
110/1.09^5
71.49
PV of Bond = Cash Flow / (1+r)^ n
103.89
PV=Rs 103.89
While one may have issued a bond at the prevailing market interest rate today, the rates keeps on changing. So we have to keep valuing the bond.
Disclaimer: The above example Is just for illustrative purpose
Yield
The return to an investor in a bond is made up of three component
– Coupon
– Interest from re-investment of coupon
– Capital gain/loss from selling in the secondary market
In simple term yield is income return on an investment and is usually expressed annually as a percentage.
Current Yield: Annual Coupon receipts/Market price of the bond.
E.g. if a 13% bond sells in the market for Rs 105, current yield will be computed as = ( Annual Coupon Rs 13/ Market Value of Bond Rs 105)*100
i.e. (13/105)*100=12.38%
Current yield is no longer used as a standard yield measure, because it fails to capture the future cash flows, re-investment income and capital
gains/losses on investment returns.
Yield to Maturity (YTM)
Yield-to-maturity is the most important yield because it measures the investor’s total over all return. It includes the coupon received, as well as any
appreciation or depreciation in value at maturity.
YTM is the internal rate of return an investor would realize if he bought a bond at a particular price, received all the coupon payments, reinvested
the coupon at the same YTM rate and received the principal at maturity.
Yield to maturity
Case 1 YTM= Coupon
Case 2 YTM> Coupon
Case 3 YTM< Coupon
Face Value (Rs)
100
Face Value (Rs)
100
Face Value (Rs)
100
Yield (YTM)
10%
Yield (YTM)
12%
Yield (YTM)
8%
Coupon
10%
Coupon
10%
Coupon
10%
Tenor( n)
5
Tenor (n)
5
Tenor (n)
5
PV= Cn/ (1+YTM)n
Period Cash Flow Formula
PV= Cn/ (1+YTM)n
Present Value
PV= Cn/ (1+YTM)n
Period Cash Flow Formula Present Value
Period Cash Flow Formula Present Value
1
10
10/1.10
9.09
1
10
10/1.12
8.93
1
10
10/1.08
9.26
2
10
10/1.10^2
8.26
2
10
10/1.12^2
7.97
2
10
10/1.08^2
8.57
3
10
10/1.10^3
7.51
3
10
10/1.12^3
7.12
3
10
10/1.08^3
7.94
4
10
10/1.10^4
6.83
4
10
10/1.12^4
6.36
4
10
10/1.08^4
7.35
5
110
110/1.10^5
68.30
5
110
10/1.12^5
62.42
5
110
10/1.08^5
74.86
PV of bond
100.00
Investor hold a bond with a coupon equal
to market rate. The Bond trades at par.
PV of bond
92.79
Investor hold a bond with a coupon less that
market rate. The Bond trades at discount.
PV of bond
107.99
Investor hold a bond with a coupon more
market rate. The Bond trades at premium.
Disclaimer: The above example Is just for illustrative purpose
Debt Market Segment
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Money Market – Maturity of money market instrument are typically =< 1 yrs
– E.g. Certificate of Deposits, Commercial Paper, Treasury bills
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Debt Market- Maturity are more than 1 year.
– Government Securities
– Public Sector Units (PSU) Bonds
– Corporate Securities /Bonds
Participant & Products in Debt Market
Issuer
Instrument
Maturity
Investors
Central Government
Dated Securities
1-30years
RBI, Banks, Insurance Companies, Provident Funds,
Mutual Funds, PDs, Individuals
Central Government
T-Bills
91/182/364 days
RBI, Banks, Insurance Companies, Provident Funds,
Mutual Funds, PDs, Individuals
State Government
Dated Securities
10 years
Banks, Insurance, Companies, Provident Funds, RBI,
Mutual Funds, Individuals, PDs
PSUs
Bonds, Structured Obligations 1-30 years
Banks, Insurance Companies, Corporate, Provident
Funds, Mutual Funds, Individuals
Corporates
Debentures
91 days-10 years
Banks, Mutual Funds, Corporates, Individuals
Corporates, PDs
Commercial paper
7 days to 1 year
Banks, Corporate, Financial institutions, Mutual Funds,
Individuals, FIIs
Scheduled Commercial Banks
Certificates of Deposit (CDs)
Financial Institutions
7 days to 1 year
3 months to 3 years
Banks, Corporations, Individuals, Companies, Trusts,
Funds, Associations, FIIs, NRIs
Scheduled Commercial Banks
Bank Bonds
1-10 years
Corporations, Individual Companies, Trusts, Funds,
Associations, FIIs, NRIs
Municipal Corporation
Bonds
1-7 years
Banks, Corporations, Individuals, Companies, Trusts,
Funds, Associations, FIIs, NRIs
Source: Fixed Income Money Market and Derivatives Association of India.
Risk Associated With Fixed Income Instruments
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Credit Risk
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Interest rate Risk
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Reinvestment Risk
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Call Risk
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Liquidity Risk
Credit Risk
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Credit risk is the risk of not receiving the payment of coupon or principal as per the agreed terms and condition. This is also referred as risk
of default of payment..
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Credit risk arise due to lack of ability or willingness of the borrower to meet its obligations.
How do I access Credit Risk?
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Credit quality of the instrument can be assess by the credit rating given by independent credit rating agencies.
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Bonds issued by government of India enjoys highest credit rating.
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Considering the current scenario of credit worthiness of the issuer, rating agencies may downgrade/ upgrade the rating of debt instruments
Rating of Debt instrument
Symbol
Description
AAA
Highest Safety
AA
High Safety
A
Adequate Safety
BBB
Moderate Safety
• CRISIL’s short term instruments categories range from P1 to
P5 and the fixed deposit rating symbols commence with “F”.
BB
Inadequate Safety
• An illustration of CRISIL’s long term rating scale and its
description on each category is given on the right hand side
table.
B
High Risk
C
Substantial Risk
D
Default
• There are various credit rating agencies in India like CRISIL,
ICRA, CARE etc which provides a rating on various categories
of debt instrument.
• CRISIL’s credit rating fall under three categories: Long term,
short term and fixed deposit ratings.
Source: CRISIL
Interest Rate Risk
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When interest rates are on the decline, investors try to capture or lock in the highest rates they can for as long as they can. To do this, they will
pick up existing bonds that pay a higher rate of interest than the prevailing market rate. This increase in demand translates into an increase in
bond price. On the flip side, if the prevailing interest rate were on the rise, investors would naturally throw away bonds that pay lower rates of
interest. This would force bond prices down.
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Interest rates and bond prices carry an inverse relationship; as interest rates fall, the price of bonds trading in the marketplace generally rises.
Conversely, when interest rates rise, the price of bonds tends fall.
Example - Interest Rates and Bond Price
Bond Price
Interest Rate
Mr Sharma owns a bond that trades at par value and carries a
coupon of 8%. Suppose that the prevailing market interest rate
surges to 9%. What will happen?
Mr Sharma will want to sell the 8% bonds in favor of a bond that
returns 9%, which in turn forces the 8% bonds' price below par.
Interest Rate Risk
When does interest rate affect the investor?
– Investors, who are likely to sell their bonds before maturity in the secondary market
– Investor who have invested in portfolios, where the securities are valued at the market price (price is sensitive to interest rate movements).
E.g. Mutual Funds
– Trade prices or market price at the exchange are generally higher or lower than purchase price
– This difference can be either positive or negative for investors
– Positive difference is capital gains & Negative difference is capital losses
– The entire process of discovering market price is called Marking to Market (MTM)
Investor holding onto their debt instrument till maturity and do not plan to sell it earlier are unaffected by interest rate risk.
Reinvestment Risk & Call Risk
Reinvestment Risk
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Reinvestment risk arises when the coupons are received and the interest rate in the market has come down.
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In such a scenario, the coupons get invested at lower rates than what the bond earns.
Call Risk
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In certain types of bonds an issue has a right to prepay the entire sum borrowed at a pre-agreed price. This types of bonds are called Callable
bonds. Thos bonds carry a risk in a declining interest rate scenario. However this option may not be there in all bonds.
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In a falling interest rate scenario, there is a possibility that the bond may be called back by the issuer.
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In such a scenario, the investor stops earning the high interest rates locked in earlier.
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The proceeds get invested at the prevailing lower rates
Liquidity Risk
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Even Bonds are traded in the exchange but there is a risk that investor might not be able to sell his/her bond and may not get the money if
needed before maturity. This creates liquidity risk.
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Managers of open ended mutual funds have to keep it mind as they need to provide liquidity as and when there is a redemption call. Some of
the institutional investors have stringent requirement regarding liquidity.
Managing the risks
Portfolio Managers manage
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Credit risk
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Interest rate using techniques of duration management
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Liquidity risk by appropriate Asset liability matching
Price-yield Relationship
Price-Yield Realtionship of Bonds
200
180
160
Price(Rs)
140
120
100
80
60
40
20
0
0.025
0.05
0.1
0.15
YTM(%)
• Yield and price of a bond are inversely related
• Price change for yield change in not symmetrical
• Higher the term to maturity, greater the price sensitivity
0.2
0.25
Tutorials
1. The yield of a bond has increased by ½%. This means that the yield has increased by :
a.
10 basis pt
b. 25 basis pt
c. 50 basis pt
d. 100 basis pt
2. The current yield on a Rs 1000 par value 8% bond selling at 850 and maturing in 10 years is :
a.
7.25%
b. 8.00%
c. 9.41%
d. 10.63%
3. Rating agencies are primarily concerned with the risk of :
a.
Declining purchase power
b. Market price fluctuations c. Default
d. Illiquidity
4. If an investor is primarily seeking appreciation in the market price of a bond, the investor should buy the bond when:
a.
Interest rate are high and are expected to drop
b.
Interest rate are low and expected to rise
c.
The interest rate are stable and are expected to remain stable
d.
Bond price are low and interest rates are expected to rise.
Answers
1.
1 basis point is equal to 0.01%, making 1.00% equals to 100 basis points. Therefore, ½ % equals 50 basis points.
2.
Current yield is found by dividing the yearly interest payment of Rs 80 by the market price of Rs 850. This equals to 9.41%. The fact that the
bond will mature in 10 years is not necessary to find the current yield (It is needed to find the yield to maturity)
3.
Rating organizations are primarily concerned with the risk of default. A high rating indicates a low risk of default.
4.
The market price of a bond will increase (appreciate) as interest rate decrease. Thus, the best time to buy bonds in order to see the
investment appreciate is when interest rates are high and expected to drop.
Disclaimer
Mutual Fund investments are subject to market risks, read all scheme related
documents carefully.