ASSET CLASSES Fixed AlternativeEquities Income Asset Securities Classes
FIXED INCOME SECURITIESIt is a financial obligation of an entity that promises to pay a specified sum of money at specified future dates. Entity promising to make payment is called the issuer of the security.
Contd… FIXED INCOME SECURITIES Preferred Stock Debt Obligations Mortgage Asset Bank Bonds Backed Backed Loans Securities Securities
BONDS Bonds are debt instruments in which one party lends money to another party on predetermined terms. Terms Rate of interest to be paid Periodicity of payments Repayment of principal amount borrowed
FEATURES Indenture A document where the promises of issuer and rights of bond holder are set forth in detail is called indenture Covenants Affirmative covenants: Activities that borrower promises to do. Negative covenants : Set forth the restrictions on borrowers activities
Contd…. Principal It is the amount borrowed and also known as Par Value or Face Value of the bond Bond traded below par value -trading at a discount Bond traded above par value- trading at a premium Coupon Rate Interest rate that issuer agrees to pay It is represented as percentage of par value Coupon = Coupon Rate * Par value
Above par value premiumBelow par value Par value discount Bond Bond
Contd…. Maturity Short Term Bonds Intermediate Bonds Long term Bonds Why Maturity is important? Term to maturity indicates the time period over which bond holder can expect to receive interest. It indicates the no. of years before the principal will be paid in full Yield on bonds depends on term to maturity
TYPES OF BONDS Zero Coupon Bonds These bonds are not contracted to make periodic coupon payments These are sold at discount and interest is the difference between the par value and price paid for the bond Step-Up-Notes They have the coupon rate that increases over time Coupon Rate steps up and as such are called step up notes When only one change- Single Step Up Note When more than one change- Multiple Step Up Note
Contd…. Deferred Coupon Bonds Interest payment is deferred for specified number of years. Interest payments that are made after the deferred period are higher than the interest payments that would have been made had the issuer not deferred the interest payments. Fixed Rate Securities They provide fixed interest payment at each period for certain number of years upto maturity.
Contd…. Floating Rate Securities/ Variable-Rate Securities Coupon Rate= Reference Rate + Spread/Quoted Margin CAP and FlOOR Range Notes TIPS( Treasury Inflation Protection Securities) U.S Dept of the Treasury in January 1997 began issuing inflation adjusted securities known as TIPS. Reference rate is the rate of inflation.
Contd…. Inverse Floaters The issues whose coupon rate moves in opposite direction from the change in reference rate. It gives investor who believes that interest rates will decline an opportunity to obtain a higher coupon rate. Callable Bonds Issuer of the bond can alter the tenor of bond by redeeming it before maturity. The call option provides the issuer the option to redeem a bond, if interest rates decline, and re-issue the bonds at a lower rate. It carries an added set of risk to the investor.
Contd…. Puttable Bonds Investor has the right to ask for redemption of bonds before maturity. It carries added risk to the issuer of the bond. Convertible Bonds A convertible bond provides the investor the option to convert the value of the outstanding bond into equity of the borrowing firm, on pre-specified terms. Redemption of bond prior to maturity and replacement with equity. Conversion price and conversion ratio are specified in indenture.
YIELD RETURN TO INVESTOR IN BOND = Coupon, Return from reinvestment of coupons and capital gain or loss from selling or redeeming bonds. Yield is calculated by comparing cash inflows with cash outflows of the investor.
VARIOUS INTERPREATATIONS CURRENT YIELD Current Yield = Annual Coupon Receipts/ Market Price of bond Does not consider time value of money and complete series of expected future cash flows For example, if a 12.5% bond sells in the market for Rs. 104.50, current yield will be computed as Current Yield= (12.5/104. 5) * 100 = 11.96% 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 return.• It is considered a very simplistic and erroneous measure of yield.
Contd…. Yield To Maturity Given a pre-specified set of cash flows and a price, the YTM of a bond is that rate which equates the discounted value of the future cash flows to the present price of the bond. It is the internal rate of return of the valuation equation.• For example, if we find that an 11.99% 2009 bond is being issued at a price of Rs. 108 in 2000, we can state that, 108 = 5.995/(1+r) + 5.995/ (1+r)2 +……….105.995/(1+r)18 The value of r that solves the above equation can be found to be5.29%,which is the semi-annual rate. The YTM of the bond is 10.58%.• Yield to maturity represents the yield on the bond, provided the bond is held to maturity and the intermittent coupons are re-invested at the same YTM rate.
YIELD PRICE REALTIONSHIP Value of bond P =C1/ (1+r) + C2 / (1+r)2 +…….Cn/ (1+r )nwhere P is the value of bond and C1, C2 ….Cn are cash flows expected from bond over n periods and r is the required rate of return for discounting cash flows. Yield and price are inversely related Price of the bond changes in opposite direction from change in the required yield.
PRINCIPLES Price-yield relationship between bonds is not a straight line, but is convex. This means that price changes for yield changes are not symmetrical, for increase and decrease in yield. The sensitivity of price to changes in yield in not uniform across bonds. Therefore for a same change in yield, depending on the kind of bond one holds, the changes in price will be different. Higher the term to maturity of the bond, greater the price sensitivity. Price sensitivities are higher for longer tenor bonds, while in the short-term bond, one can expect relative price stability for a wide range of changes in yield. Lower the coupon, higher the price sensitivity. Other things remaining the same, bonds with higher coupon exhibit lower price sensitivity than bonds with lower coupons.
YIELD CURVE Yield curve is drawn from the YTM of bonds. When we obtain a plot of these relationships between YTMs and term of bonds, functional relationship between time and yield can be identified by fitting a curve through plotted points.
RISKS ASSOCIATED WITH BONDS Interest rate risk Coupon Rate= Yield required by market Price =Par value Coupon Rate< Yield required by market Price< Par value(discount) Coupon Rate> Yield required by market Price> Par Value (premium)
Call and Repayment Risk The cash flow pattern of a callable bond is not known with certainty because it is not known when the bond will be called. Investor is exposed to reinvestment risk. Reinvestment Risk Suppose an investor purchases 20-year bond with a yield of 6%, to realize the yield of 6% every time a coupon interest payment is made, it is necessary to reinvest the payment at an interest rate of 6% until maturity. The risk that coupon payments will be invested at less than 6% is reinvestment risk.
Default Risk Risk that issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and principal. The percentage of a population of bonds that is expected to default is called default rate. If an default occur, this does not mean that investor will lose entire amount invested. He can expect to recover a certain percentage of the investment called recovery rate.
GLOBAL BOND MARKETS BOND MARKET SECTOR INTERNAL BOND EXTERNAL BOND MARKET MARKETDOMESTIC FOREIGN BOND BOND MARKET MARKET
Contd…. INTERNAL BOND MARKET It is also called as national bond market It includes domestic bond market and foreign bond market DOMESTIC BOND MARKET It is where the issuers domiciled in the country issue bonds and where those bonds are subsequently traded. FOREIGN BOND MARKET It is where the issuers not domiciled in the country issue bonds and where those bonds are subsequently traded.
Contd…. Bonds traded in U.S Foreign Bond Market are termed as YANKEE BONDS Foreign Bonds in U.K are termed as BULLDOG BONDS In Japan Yen denominated bonds are issued by British Corporation and subsequently traded in Japan’s bond market is a part of Japanese Foreign Bond Market and is nicknamed as SAMURAI BONDS Bonds traded in Netherlands Foreign Bond Market are termed as REMBRANDT BONDS Bonds traded in Spain Foreign Bond Market are termed as MATADOR BONDS
Contd…. Issuers of Foreign Bonds Central Governments and their subsidiaries Corporations Supranationals: An entity formed by two or more Central Governments through international treaties. International Bank For Reconstruction And Development Inter-American Development Bank
Contd…. EXTERNAL BOND MARKET It is also called as International Bond Market, The Offshore Bond Market, or, The Euro Bond Market These bonds are underwritten by an international syndicate. At issuance, they are offered simultaneously to investors in number of countries. They are issued outside the jurisdiction of any single country. They are in unregistered form. They are classified based on the currency in which they are denominated. Euro Bonds denominated in U.S dollars- Eurodollar bonds Euro Bonds denominated in Japanese Yen- Euroyen bonds. A Global Bond is one that is issued in several bond markets throughout the world.
CLASSIFICATION IN TERMS OF TRADING BLOCS DOLLAR BLOC It includes United States, New Zealand, Canada and Australia. EURO BLOC It includes Euro Zone Market Bloc and Non- Euro Zone Market Bloc. Euro Zone Market Bloc: Which has the common currency, Euro. Germany, France, Holland, Belgium, Austria, Italy, Spain Finland, Portugal, Greece. Non- Euro Zone Market Bloc: Norway , Denmark and Sweden Japan Emerging Markets
NON-U.S SOVEREIGN BOND ISSUERS GERMAN GOVERNMENT BUNDS: Maturities of 8-30 years BUNDESOBLIGATIONEN, BOBLS: Notes with maturity of 5 years These have fixed-rate coupons and are bullet structures Ten year Bunds are the largest sector of German government securities
Contd…. UNITED KINGDOM GILT – EDGED STOCKS or GILTS: Largest sector of the gilt market is straight fixed rate coupon bonds. Second major sector is index-linked issues-LINKERS. Issues of outstanding gilts called IRREDEMABLES. Issues with no maturity date called UNDATED GILTS.
Contd…. FRENCH TREASURY OBLIGATION ASSIMILABLE DU TRESOR(OATS) Long dated bonds with maturities upto 30 years They are not callable Mostly have fixed-rate coupon BONS DU TRESOR A TAUX FIXE A INTERET ANNUEL (BTANs) Notes with maturities between 2 and 5 years
Contd…. ITALIAN GOVERNMENTBUONI DEL TRESORO POLIENNALI(BTPs) Bonds with fixed rate coupon that are issued with maturities of 5,10 and 30 years. CERTIFICATI DI CREDITO DEL TRESORO(CCTs) Floating rate notes with 7 year maturityCERTIFICATI DI TRESORO A ZERO COUPON( CTZs) 2 year Zero coupon notesCERTIFICATI DEL TRESORO COB OPZIONE(CTOs) Bonds with put option
Contd…. CANADIAN GOVERNEMNT Bonds have fixed coupon rate except for the inflation protection bonds(Real return bonds) AUSTRALIAN GOVERNMENT About three-quarters consists of fixed rate bonds and inflation protection bonds called “Treasury indexed bonds” The balance of the market consists of floating rate issues called as “Treasury adjustable bonds” that have a maturity between 3to 5 years and the reference rate is the Australian Bank Bill Index.
Contd…. JAPANESE GOVERNMENT SECURITIES(JCBs) Two types: Medium term bonds Bonds with coupons ( maturities of 2,3 and 4 years) Zero coupon bonds 5 year zero coupon bond Long dated bonds are interest bearing
Contd…. EMERGING MARKETS Financial markets of Latin America, Asia(except Japan) and Eastern Europe are viewed as emerging markets. Investing in government bonds of emerging market countries are more risky than that of industrialized countries.
HOW TO READ A BOND TABLEColumn 1: Issuer - This is the company, state (orprovince) or country that is issuing the bond.Column 2: Coupon - The coupon refers to thefixed interest rate that the issuer pays to thelender.Column 3: Maturity Date - This is the date onwhich the borrower will repay the investors theirprincipal.Column 4: Bid Price - This is the price someoneis willing to pay for the bond. It is quoted inrelation to 100, no matter what the par value is.Column 5: Yield - The yield indicates annualreturn until the bond matures. Usually, this is theyield to maturity, not current yield. If the bond iscallable it will have a "c--" where the "--" is theyear the bond can be called. For example, c10means the bond can be called as early as 2010
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