Debt instruments are contracts in which one party lends money to another on predetermined basis with regard to: Rate of interest Periodicity of the interest payment Repayment of principal amount borrowed (installments or bullet)
PRINCIPAL: Principal is the par value or the face value or the maturity value the bond. COUPON:a) Refers to the periodic interest payments that are made by the borrower (issuer of the bond) to the lender (subscriber of the bond).b) Is represented as a percentage of the par value of the bond. TERM TO MATURITY:a) Is called the term or tenor of the bondb) Number of years remaining for the bond to mature.c) Changes everyday from the date of issue of a bond until its maturity. MATURITY: Refers to the date on which the bond matures or the date on which the borrower has agreed to repay (redeem) the principal amount to the lender.
STRAIGHT BOND/PLAIN VANILLA BOND: Pays a fixed periodic coupon over its life and returns the principal on the maturity date ZERO COUPON BOND:a) No coupons are paid.b) Issued at a discount to the par value.c) Interest is the difference between the FV and the discounted price at which the bond is bought.d) In case of a very long tenure, the bond is issued at a very steep discount to the FV – Deep Discount Bond FLOATING RATE BOND:a) Coupon rate is not fixed, but reset with reference to a benchmark rate.b) Some FRBs have caps and floors.c) Cap represents the maximum interest that the borrower will pay should the benchmark rate move above such a level.d) Floor represents the minimum interest that the lender should receive should the benchmark rate fall below the threshold.
CALLABLE BOND:a) Allows the issuer to alter the tenor of the bond, by redeeming it prior to the original maturity rate.b) Call option enables the issuer to redeem a bond if interest rates decline and re-issue it at a lower rate.c) Investor looses the opportunity to stay invested in a high coupon bondd) Investor is subject to CALL RISK and REINVESTMENT RATE RISKe) Call option can be a European option, where the issuer specifies the date on which the option should be exercised.f) Call option can be a American option, giving the issuer the right to call the bond on or anytime before a pre-specified date. PUTTABLE BOND:a) Allows the investor to seek redemption from the issuer prior to the maturity rate.b) Put option enables the investor to redeem a low coupon paying bond and invest in a high coupon paying bond (if interest rates rise).c) The issuer will have to re-issue the put bond at higher coupons, thus subjecting the issuer to RE-PRICING RISK.
The value of a bond is equal to the PV of the cash flows expected from it. Determining the value of a bond requires: a) Estimate of expected cash flows b) Estimate of expected return Assumptions of bond valuation a) Coupon rate is fixed for the term of the bond b) Coupon payments are made every year c) Next coupon payment is receivable exactly a year from now d) Bond will be redeemed at par on maturityIf a bond of FV = 100 is selling for Rs.90 Bond is trading at aDISCOUNTIf a bond of FV = 100 is selling for Rs.110 Bond is trading at aPREMIUM
CURRENT YIELD:a) Reflects only the coupon rateb) Does not consider the capital gain that the investor will realise if the bond is purchased at a DISCOUNT and held till maturityc) Does not consider the capital loss that the investor will realise if the bond is purchased at a PREMIUM and held till maturityd) Ignores the TVMe) Incomplete and simplistic measure of yieldf) Formula: Annual Interest Price
YIELD TO MATURITY:a) Popularly known as YTMb) It is the discount rate that makes the PV of the cash flows (receivable from owning the bond) equal to the price of the bondc) Considers the current coupon and the capital gain/loss that the investor will realise by holding the bond till maturityd) It also takes into account the timing of the cash flowse) Can be interpreted as • Internal rate of return (IRR) on an investment in the bond • Compound rate of return over the life of the bond, assuming that all the coupons can be reinvested at a rate of return equal to the YTM • Return the investor will receive if the bond is held till maturity
YIELD TO CALL:a) Popularly known as YTCb) Applies to CALLABLE BONDSYIELD TO PUT:a) Popularly known as YTPb) Applies to PUTTABLE BONDS
Relationship between bond price and YTM is CONVEX
BOND PRICES and YIELDS have an inverse relationship Increase in yield causes a proportionately smaller price change than a decrease in yield of the same magnitude Prices of LT bonds are more sensitive to interest rate changes than prices of ST bonds Prices of low-coupon bonds are more sensitive to interest rate changes than prices of high coupon bonds
•Reflects the term structure of interest rates•POSITIVE (ASCENDING) YIELD CURVE – Yield at the longer end is higher than theyield at the shorter end•NEUTRAL (FLAT) YIELD CURVE – More or less the same the same returns acrossmaturities•NEGATIVE (DESCENDING) YIELD CURVE – Long term yield is lower than short termyield – represents an impending downturn in the economy
Commonly known as ZCYC Depicts the relationship between interest rate and maturity for zero coupon instruments Differs from the YIELD CURVE because it does not plot the YTM - Represented against TERM TO MATURITY are the YIELDS on zero coupon instruments across maturities Generally positively sloped Widely used measure for BOND VALUATION Used: • For estimating the premium to be charged for DEFAULT RISK • As a benchmark yield for risk free securities
INTEREST RATE RISKa) Interest rates tend to vary over time fluctuating with bond prices.b) Rise in interest rate will depress the prices of outstanding bondsc) Fall in interest rates will push the prices will push the market prices upd) DURATION is a precise measure of interest rate sensitivitye) It is a function of the MATURITY PERIOD and the COUPON RATEf) Measured as the % change in the price (value) of the bond in response to a % change in interest rate.LONGER THE MATURITY PERIOD Greater sensitivity of price to changes in interest rateLARGER THE COUPON RATE Lesser sensitivity of price to changes in interest rate
DEFAULT RISK: Risk accruing from the fact that a borrower may not pay principal and/or interest on time CALL RISK: Bonds are typically called for repayment when interest rates have fallen. Investors will not find a comparable investment vehicle LIQUIDITY RISK: Barring GOI securities which are traded actively, most of the debt instruments do not seem to have a very liquid market. Investors may have to accept a discount while selling and pay a premium while buying. INFLATION RISK: Inflation risk is greater for long term bonds. REINVESTMENT RISK:a) When a bond pays periodic interest there is a risk that the interest payment mat have to be reinvested at a lower rateb) REINVESTMENT RISK IS GREATER FOR BONDS WITH LONGER MATURITY AND FOR BONDS WITH LARGER COUPON PAYMENTS
Measure of the weighted average life of a bond which considers the size and timing of each cash flow Measures sensitivity of a bond’s price to change in yield - INTEREST RATE SENSITIVITY Duration and Coupon are inversely related • For a given maturity, a bond’s duration is higher when its coupon rate is lower • For a given coupon rate, a bond’s duration increases with maturity Duration of a ZCB is same as its maturity Useful tool for immunising against INTEREST RATE RISK and REINVESTMENT RATE RISK and MATURITY RISK
Default Risk or Credit Risk are normally gauged by the rating assigned to the bond by an independent credit rating agency Rating Agencies in India – CARE, CRISIL, ICRA, Fitch Ratings, Phelps & Duff Rating Methodology: 1. Industry and Business Analysis 2. Financial Analysis Debt ratings are supposed to: 1. Provide superior information 2. Offer low cost information 3. Serve as a basis for a proper risk-return tradeoff 4. Impose healthy discipline on corporate borrowers 5. Greater credence to financial and other representations