Understanding Fixed Income Concepts
Basic structure of a bond
The institution that
‘issues’ a bond, or
‘borrows’ from the
public
YEAR 1
ISSUER
YEAR 2
@ x%
@ x%
YEAR 3
The year in which the
bond ‘matures’ – the
lender receives the last
coupon and the
principal
YEAR 4
@ x%
YEAR 5
@ x%
@ x%
COUPON Tenor COUPON
COUPON
– number of years
the bond has toCOUPON
pay all returns COUPON
+
Regular pre-specified
payments, based on the
interest rate
Rate at which the
coupon is generated
PAR
The amount on which interest is paid, and what the
bond holder receives when the bond matures.
Also called the ‘face value’ of the bond.
Par value, premium and discount
PREMIUM
108
If the bond trades at a premium,
the investor pays more than the
face value of the bond
Par
100
Value
If the bond trades at a discount,
the investor pays less than the
face value of the bond
DISCOUNT
95
What is a bond rating?
Bonds are rated on the basis of their risk of default
Default: the risk that the lender may not get his money back
The ratings do not convey other risks: change in liquidity, or interest rates
Bond ratings are carried out by agencies
What goes into a bond rating?
Capacity
Character
The Four C’s of Corporate Credit
Capital
Conditions
What are bond ratings?
High Risk
Low Risk
CRISIL
Source: Crisil
Long Term
Ratings
Short Term
Ratings
AAA
AA
A
BB
B
C
D
P-1
P-2
P-3
P-4
P-5
What are bond ratings?
High Risk
Low Risk
ICRA
Source: ICRA
Long Term
Ratings
Medium Term
Ratings
Short Term
Ratings
LAAA
LAA
LA
LBBB
LBB
LB
LC
LD
MAAA
MAA
MA
MBBB
MBB
MB
MC
MD
A1
A2
A3
A4
A5
Understanding yield to maturity
What the investor gets if bond is held to maturity
Yield to Maturity
Assumes all cash flows reinvested at the YTM
Bond price is the sum of all cash flows discounted at YTM
Math Check
Individual cash flows
CPN
Bond Price
CPN
+
1
=
1+r
Present value
of the bond
Discount rate: Yield to
Maturity
1+r
Terminal cash flow: coupon +
par value of bond
…+
+
2
CPN + PAR
n
1+r
Number of times discount
occurs: based on time period
The term structure – normal yield curve
Economy stable.
No inflationary shocks expected.
Longer maturities generate higher risk expectation.
Greater risk demands greater yield.
Yield
1.
2.
3.
4.
10 Yr
5 Yr
3 Yr
1 Yr
Maturity
The term structure – steep yield curve
1.
2.
3.
Economy about to boom.
Inflation expected to rise.
Long term investors demand higher returns to
avoid getting locked into lower rates.
10 Yr
Yield
5 Yr
3 Yr
1 Yr
Maturity
The term structure – flat yield curve
1.
Yield
2.
Flat yield curves mark a transition between
economic cycles.
Flatness occurs through a combination of rising
short term rates and falling long terms rates.
1 Yr
5 Yr
3 Yr
Maturity
10 Yr
The term structure – inverted yield curve
1.
Yield
2.
An inverted curve means that the market expects
interest rates to fall in future.
This could signal an economic slowdown, as interest
rates are lowered to stimulate growth.
1 Yr
3 Yr
5 Yr
Maturity
10 Yr
The concept of yield spread
In a positive economic
environment, the spread
between corporates and g-secs
contract, reflecting lower longterm default possibility in a
lower interest rate
environment.
The high yield, or speculative grade, bond
market is not yet prevalent in India.
High - yield
Yield
AAA Corporate
Gilts
Yield spreads are a function of
credit. Investment grade
corporates have lower credit
than G-secs, so other things
being equal, G-secs will have
lower yields than corporates at
every maturity.
Maturity
Risks associated with fixed income
investment
Credit Risk
Default Risk
Issuer could fail to meet debt obligations in a
timely manner.
Credit Spread Risk
Risk premium required for particular corporate
bond (or bond class, sector, industry, or
economy) increases, leading to price reduction
in existing bonds
Downgrade Risk
Rating agency could lower rating on a bond after
conducting analysis, increasing the credit
spread, causing yields to go up and prices to go
down
Interest Rate Risk
Prices and yields have inverse relationships
Yields are influenced by interest rates
PRICE AT DISCOUNT
YIELD ABOVE COUPON
YIELD = COUPON
PRICE = PAR
PAR VALUE
YIELD BELOW COUPON
PRICE AT PREMIUM
When rates change, yields move to track the new rate
Prices move in the opposite direction to reflect the new yield
If yield = coupon rate, the bond will sell at par
Duration
Duration measures interest rate sensitivity
In other words, how much does the price of a bond change with a
change in interest rates?
Duration
+VE RELATIONSHIP
-VE RELATIONSHIP
Term to maturity
Yield to maturity
Coupon
Math Check: Approximate price change using duration
The delta sign denotes
‘change’. This means
change in yield.
-
Duration
x
The negative sign is
because of the inverse
relationship between
price change and yield
change
Δy
x 100
=
Approx. percentage
price change
Math Check: Approximate price change using duration
-
3.33
x
0.015
x
100
=
-
5%
Practical application: Portfolio duration
Interest rate scenario
Portfolio manager action
Lower Duration
Higher Duration
Portfolio managers often change the duration of their securities to
manage changing interest rates
Reinvestment Risk
8%
7.5%
7%
6.5%
10%
10%
10%
10%
6.5%
EXISTING BOND
6.5%
6.5%
NEW BOND
ROLLOVER
6.5%
Liquidity Risk
The greater the bid – ask spread, the less certain the fair value of the price
Liquidity risk is not important for hold-to-maturity investors
It is an issue for those seeking to profit from bond price movements
Liquidity risk is a function of the following factors
Expectation of
interest rate changes
Number of market
makers
Comfort level with
security
Securitisation – What is it all about ?
Loan Pmt
Originator
Obligors
Issues loan
Sale of assets
Proceeds of rated securities
Fees
SPV
Credit
Enhancement
Issuance of rated securities
Credit
Enhancement
Payment for rated securities
Underwriter
Issuance of rated securities
Payment for rated securities
Investors
Key Macro-economic indicators for fixed
income
Liquidity indicators
Liquidity Indicators
25
100000
80000
Net LAF amount (LHS)
Call (RHS)
60000
20
40000
20000
Rs. crore
15
0
-20000
10
-40000
-60000
5
-80000
-100000
-120000
01/01/2008
12/02/2008
28/03/2008
Source: Bloomberg, Fidelity. 20th November 2008
15/05/2008
30/06/2008
12/08/2008
26/09/2008
0
18/11/2008
Source: Bloomberg, Fidelity. 20th November 2008
04/10/2008
16/08/2008
28/06/2008
10/05/2008
22/03/2008
CRR
02/02/2008
10-yr G-Sec
15/12/2007
27/10/2007
08/09/2007
WPI
21/07/2007
02/06/2007
14/04/2007
24/02/2007
06/01/07
Key rates
Key rates
14
12
Repo
10
8
6
4
2
0
Other key macro indicators

Fiscal deficit

Government borrowings

Credit growth

Deposit growth

GDP

Rupee
QUESTIONS ??
Thank You.