Debt- Fixed Income Basics

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Fixed Income
Characteristics of Bond
Types of Debt
Categories- Fixed, Floating , Zero
Callable , Putable bonds
Structured Debt Securities

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Debt- Fixed Income Basics

  1. 1. Debt Borrowers: Interest is the cost of having access to Funds for his needs – individual or Company or Government. Lender’s Perspective: Interest is compensation for Opportunity cost and risk Invested spent Interest is based on: Tenure – Longer the Loan – Higher risk – Opportunity Cost Risk the borrower – Credit Worthiness – Riskier the borrower Interest will be more Inflation – higher , interest will be more How do you raise debt: Loan through Banks and Financial Institutions Financial Markets or Debt Markets  Company or Government issued Securities called Debt Securities or Bonds Can issue more than one issue of Debt Securities
  2. 2. Debt Bond: A bond is a contract between the issue and the owners of the bonds (bond holders), that obligates the issuer to make specified payments over a specific period. Important Characteristics of Bond  Par value – Principal Value - Face Value  Coupon Rate  Maturity Rate
  3. 3. Debt Coupon Rate & Coupon Payments: Coupon Rate: It is the promised interest rate on bond ex: 5% coupon rate Coupon Payment: Coupon payments are linked to the bonds per value and bonds coupon rate. Ex: Bonds Coupon rates is 5% and Pay Value is Rs.100; then Coupon Payment is Rs.5 Most Debt instrument issued by Governments makes coupon payments as Semi – Annual basis Rs.2.50 is given – 2 times In general Debt securities are used with fixed coupon rate and paid fixed coupon payments; they are referred as fixed – income securities.
  4. 4. Maturity: Debt Securities – 1 year  Referred as bills 1 year – 10 years Referred as Notes 10 year Bonds Term bond is used irrespective of its Maturity. Maturity Date: The life of the Bond ends on its maturity date and the issuer is not responsible for any further payments after that date
  5. 5. Bond Indenture: Bond is governed by a legal contract between the bond issuer and the bond holders, which describes the key terms of the debt obligation. This legal contract is referred as the bond indenture Covenants: It describes actions the issuer must perform or is prohibited from performing. Ex:  Common covenant requires the issuer to pay interest on timely basis  To provide Quarterly Financial Statement to bond holder  No additional borrowing or No sale of Assets etc., A bond issuer failing to make the promised payments is referred to as a default.
  6. 6. Secured Debt securities: When Security is backed by asset or issuer pledges assets as collateral to bond holders. In the event of default, bond holders are legally entitled to take the possession of the assets.  Reduces the risk  So lower coupon Unsecured Debt Securities:  Not backed by collateral  Higher Risk of default  Higher coupon then secured
  7. 7. Subordinate Debt: A bond which has a lower priority (specified in contract) in the event of default. It is unsecured debt with a lower priority. Bond holders will receive payment only after higher priority debt claims are paid. Priority or Seniority Ranking of Debt Securities : Secured Debts >> Senior unsecured Debt >> Senior subordinate debt >> Subordinate Debt >> Junior subordinate Debt.
  8. 8.  Bonds issued by corporate –-> Corporate Bond  Bonds issued by Government - G Secs or GILTS(India)  Bonds issued by US Government - Treasury Securities or T- bills
  9. 9. Bond Markets Primary Market : Issue of new securities to investors. Investors buy directly from bond issuer. Secondary Markets : Investor later may sell their bonds to other investor in the secondary market at a market price Check link : http://primedatabase.com/debtsecurities.asp “ Price of the bond in Secondary market is reflecting of Credit quality, interest rate, market conditions Bond holder (primary purchase or secondary) is entitled to set promised coupon payments as principal
  10. 10. Categories Categories : Bonds are often categorized by their coupon rates :  Fixed – Rate bonds or straight bond  Floating – rate bonds  Zero – Coupon bonds
  11. 11. Fixed Rate Bond or Straight Bond : It pays a fixed periodic coupon payment over its life and returns the principal on the maturity date Coupon rate does not change over the life of the bond Par value does not change.
  12. 12. Floating rate bonds : Sometimes referred as variable – rate bonds.  Coupon rate on Floating Rate Bond changes overtime  Coupon rate is linked to a reference rate  Reference rate is a interest rate paid by a highly credit worthy borrower  LIBOR – London interbank offered rate is widely used  MIBOR – Mumbai interbank offered rate is widely used in India  Floating rate is calculated by making on adjustment to the reference rate to reflect the riskiness (creditworthiness) of issuer.  Floating Rate= Reference percentage (which reflects Credit Worthiness and Bond features)  Percentage over Reference rate is called spread and is constant  Any change in Credit worthiness does not reflect at later stage  Percentage is referred in bps or bonus points 1%= 100bps  So it is stated as LIBOR +100 bps (spread is 1%)
  13. 13. Zero Coupon Bonds:  They don’t offer periodic interest payments.  Only cash flow offered by a Zero coupon bond is a single payment equal to the bonds par value that is paid on the bonds maturity date.  Bonds are issued at a discount to the bonds par value.  The difference between issue price and par value received at maturity is the return. Usually Government Securities are issued as Zero coupon securities. Ex: Book: IDBI issued deep discount bonds at maturity par value is 2 L, maturity period of 25 years and issued at 5300/- Use FV=PV(1+r)n (1+r) 23 = 200000/5300 = (37.73).0434 (1+r) 23= 1.1706= r=.1706 or 17%
  14. 14. Bonds with Embedded provisions B0nds can have provisions which give the issuer or the bond holder the right but not the obligation to take certain actions .  Callable Bonds  Putable Bonds  Convertible Bonds
  15. 15. Bonds with Embedded provisions Callable Bonds  Provides the issuer with the right to buy back (retire or call) the bond from the bond holders prior to maturity at are specified price referred to as a call price .  Call Price= par value + Call premium  Call provision is the right of the issuer  Issuer is of advantage over bond holder  To compensate the risk of bond retired early , callable bonds have higher coupon than coupon of comparable bond with our call option .  This risk is called call risk
  16. 16. Bonds with Embedded provisions Callable Bonds Issuer calls for the provision when interest rate are coming down , and he has option to raise capital at lower coupon . Ex : Let’s look again at that nice, safe Aaa-rated corporate bond that pays 4% a year. Imagine that Federal Reserve Bank begins cutting interest rates. Suddenly, the going rate for a 15-year, Aaa-rated bond falls to 2%. The issuer of your bond looks at the market and decides it’s in its best interest to pay off those old bonds and borrow again at 2%. You the investor will get back the original principal of the bond -- $1,000. But you won’t be able to reinvest that principal and match the return you were getting. Now you’ll have to either buy a lower-rated bond to get a 4% return or buy another Aaa-rated bond and accept at 2% return.
  17. 17. Bonds with Embedded provisions Putable Bonds  A putable bond provides the bondholders with the right to sell (put back ) their bonds to the issuer prior to the maturity date a at pre-specified price referred to as the put price .  Put provision is the right of the bond holder  Coupon rate of putable bond is generally lower than coupon of comparable bond .  It will help the bond holders from down side price protection in case of interest rates increase.  When a bind holder exercises the put provision , the pre specified put price at which binds are sold back t o the issuer is typically the binds par value .
  18. 18. Bonds with Embedded provisions Convertible Bonds  It has characteristics of both debt and equity  It gives the bond holder to right tot convert the bind in to a pre specified number of common shares of the issuing company at some point prior to bonds maturity date .  Conversion value is the value of the bond if it converted to stock .  Conversion ratio is the number of shares that the bond holder would receive from converting the bond to stock .  Conversion value is equal to the conversion ratio times the share price .  Coupon is lower than comparable bonds as additional feature of conversion is given .
  19. 19. Bonds with Embedded provisions Let’s look at an example. Acme Company issues a 5-year convertible bond with a $1,000 par value and a coupon of 5%. The “conversion ratio” – or the number of shares that the investor receives if he or she exercises the conversion – option is 25. The effective conversion price is therefore $40 per share, or $1000 divided by 25. The investor holds on to the convertible bond for three years and receives $50 in income each year. At that point, the stock has risen well above the conversion price and is trading at $60. The investor converts the bond and receives 25 shares of stock at $60 per share, a total value of $1,500. In this way, the convertible bond offered both income and a chance to participate in the upside of the underlying stock.  On the other hand, let’s say that Acme’s stock weakens during the life of the security – rather than rising to $60, it falls to $25. In this case, the investor wouldn’t convert – since the stock prices is less than the conversion price – and would hold on to the security until maturity as though it were a straight corporate bond. In this example, the investor receives $250 in income over the five year period, and then receives his or her $1000 back upon the bond’s maturity.
  20. 20. Bonds with Embedded Provisions Inflation – Linked Bonds  Bonds contain a provision that adjusts the bonds par value for inflation .  Inflation reduces the purchasing power from bond cash flows.  For most inflation linked bonds , the par value of the bond is adjusted at each payment date to reflect changes in inflation .  Coupon payments get adjusted with this as it equal to coupon multiplied by the inflation adjusted par value .
  21. 21. Bonds with Embedded Provisions In US they are called Treasury inflation protected securities .(TIPS) In UK – index linked gilts Hongkong – iBonds  India recently launched a new kind of bond to give individual investors some protection against inflation, but they don’t make sense for everyone.  The new bonds, officially called the Inflation Indexed National Savings Securities, are available for sale to individuals until Dec. 31.  Unlike a traditional bond where the interest rate is fixed, in the inflation-linked bonds, the government will pay an interest of 1.5% per year above the rate of inflation as measured by the Consumer Price Index.  The interest rate will be reset every six months, to reflect any changes in inflation
  22. 22. Bonds with Embedded Provisions Structured Debt Securities Securitization :  Creation and issuance of new debt securities , called structured debt securities that are backed by a pool of other debt securities .  It is pooling of financial assets and issuing debt securities against this pool .  It creates Liquidity and option to raise money from illiquid assets .
  23. 23. Bonds with Embedded Provisions Structured Debt Securities Securitization : Securitization turns mortgages into liquid assets. The process works like this: A bank or other institution gathers hundreds or thousands of mortgages into a "pool." It then divides that pool into shares and sells those shares as securities. Buyers of these securities gain the right to collect mortgage payments made by the hundreds or thousands of homeowners whose mortgages have been pooled, which is why they're called "mortgage- backed securities.“ Securitization allows banks to convert their mortgages to cash, which they can then use to lend money to more home buyers. This ensures that there is a steady supply of credit available to the housing market. And as long as the homeowners whose loans were pooled make their payments on time, buyers of the securities get a nice return on their investment. Disadvantages Unfortunately, securitization can also encourage lenders to lend money to high-risk people who are unlikely to pay it back. That's because once a mortgage has been securitized and sold off to investors, the lender no longer has any money at stake; all the risk has been passed off to the investors. This is what happened in the housing bubble of the early to mid-2000s. When homeowners began defaulting on loans in record numbers, the securities backed by those mortgages lost their value.
  24. 24. Bonds with Embedded Provisions Structured Debt Securities Mortgage backed Securities : Debt Securities are issued against a pool of underlying residential mortgage loans (home loans) or on a pool of underlying commercial mortgage loans. Asset backed Securities : Similar to Mortgage backed securities except that the types of loans underlying are debt obligations such as credit card receivables , auto loans , corporate bonds etc. Investors who buy structured debt securities receive a portion of the pooled monthly loan payments .
  25. 25. Risk of Investing in debt Securities Debt securities is considered less risky , still bind holders still face a number of risks  Credit Risk  Interest rate Risk  Inflation Risk  Liquidity Risk  Reinvestment Risk  Call Risk
  26. 26. Risk of Investing in debt Securities Credit Risk : It is referred to as default risk , is the risk of bond issuer failing to make full and timely payments of interest and principal . Risk of decline in price of the bond in case of suspect of default by issuer .
  27. 27. Risk of Investing in debt Securities Credit Risk of a bond can be assessed by reviewing credit rating . Credit ratings agencies assess the credit quality of the bond and assign them ratings . Highest ratings are assigned to bonds that are considered to have low risk of default Credit rating is assigned at issue and also reviewed over the time . Better the credit rating , better the access to capital at lower rate .
  28. 28. Risk of Investing in debt Securities Investment grade bonds Non Investment grade binds  High degree of credit worthiness  Invested by insurance companies , pension funds  Lower coupon or yield  Less credit worthy  Also referred as Junk bonds  Higher yield -high risk  Invested by hedge funds etc
  29. 29. Risk of Investing in debt Securities Interest Rate Risk :  Interest rate changes . Risk resulting due interest rate .  Bond price decrease with increase of interest rate .  Bond prices are inversely proportional to interest rates  It adversely effects fixed rate binds and zero coupon bonds  Floating rate bonds coupon are set to current market interest rates at each payment date , so interest rate risk is minimal when interest rate increase. But when Interest rates decline bind holders receive less coupon payment as coupon rate is reset as per market.
  30. 30. Risk of Investing in debt Securities Inflation Risk : Promised interest payment and principal payment does not count or change with inflation . Purchasing power of cash flows comes down. Inflation linked bonds can protect from inflation.
  31. 31. Risk of Investing in debt Securities Liquidity Risk : Risk of unable to sell a bind prior to the maturity date with out having to accept a significant discount to market value . Bonds that don’t trade very frequently face this risk . Reinvestment Risk : In falling interest rates scenario , the cash flows on bonds have to be invested at lower coupon . Call Risk : Risk that issuer might buy back the bind prior to maturity or exercise call option if interest rates are falling . Bind holders will than have to invest proceeds at a lower interest rate .
  32. 32. Valuation of Debt Securities  The value of a debt security is estimated using a discounted cash flow approach.  Value of a bond is the present value of all the future coupon payments and final principal payment .  Once an estimate of the value of a bond is calculated , it is compared with the current price of the bond to determine whether the bond is over valued , undervalued or fairly values .
  33. 33. Valuation of Debt Securities
  34. 34. Valuation of Debt Securities  Bond valuation is only one of the factors investors consider in determining whether to invest in a particular bond. Other important considerations are: the issuing company's creditworthiness, which determines whether a bond is investment-grade or junk; the bond's price appreciation potential, as determined by the issuing company's growth prospects; and prevailing market interest rates and whether they are projected to go up or down in the future.
  35. 35. Valuation of Debt Securities  Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. In our example we'll assume that coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in six months. Here are the steps we have to take to calculate the price: 1. Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten years, we will have a total of 20 coupon payments. 2. Determine the Value of Each Coupon Payment: Because the coupon payments are semi-annual, divide the coupon rate in half. The coupon rate is the percentage off the bond's par value. As a result, each semi-annual coupon payment will be $50 ($1,000 X 0.05). 3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. If we left the required yield at 12%, our bond price would be very low and inaccurate. Therefore, the required semi-annual yield is 6% (0.12/2). 4. Plug the Amounts Into the Formula:  From the above calculation, we have determined that the bond is selling at a discount; the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. The bond must sell at a discount to attract investors, who could find higher interest elsewhere in the prevailing rates. In other words, because investors can make a larger return in the market, they need an extra incentive to invest in the bonds.
  36. 36. Valuation of Debt Securities  Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. In our example we'll assume that coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in six months. Here are the steps we have to take to calculate the price: 1. Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten years, we will have a total of 20 coupon payments. 2. Determine the Value of Each Coupon Payment: Because the coupon payments are semi-annual, divide the coupon rate in half. The coupon rate is the percentage off the bond's par value. As a result, each semi-annual coupon payment will be $50 ($1,000 X 0.05). 3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. If we left the required yield at 12%, our bond price would be very low and inaccurate. Therefore, the required semi-annual yield is 6% (0.12/2). 4. Plug the Amounts Into the Formula:  From the above calculation, we have determined that the bond is selling at a discount; the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. The bond must sell at a discount to attract investors, who could find higher interest elsewhere in the prevailing rates. In other words, because investors can make a larger return in the market, they need an extra incentive to invest in the bonds.
  37. 37. Valuation of debt sec Discount rate (required rate on the bond given its riskiness) affects the bonds value relative to the par value  If bonds coupon rate and discount rate are same the bonds value is its par value .  If bonds coupon rate is lower than the discount rate bond value is less than its par value and will trade at a discount .  If bonds coupon rate is higher than the discount rate bond value is more than its par value and will trade at a premium .
  38. 38. Yield to Maturity  The discount rate that equates the present value of a binds promised cash flows to its market price is the bonds yield to maturity or yield.  An investor can compare this yield to maturity with the required rate of return on the bond given its riskiness to decide whether or not to purchase it .
  39. 39. Yield to Maturity
  40. 40. Yield to Maturity  Yield is a function of its maturity , liquidity and risk  Low risk bonds such as govt bonds trade at relatively lower yield to maturity , which imply relatively at higher prices.  High risk bonds , trade at higher yield to maturity ,which imply relatively lower prices.  Bond prices and bond yields to maturity are inversely related .
  41. 41. Current Yield  A bonds current yield is calculated as the annual coupon payment divided by current market price .  Current yield provides bond holders with an estimate of the annualized return from the coupon income only Ex : Coupon of 4% , and lets the bond is trading at 914.70 . Current yield = 40(coupon payment)/914.70 = 4.37%
  42. 42. Yield Curve  A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth. US treasury yield curve Bond with comparable features can be considered
  43. 43. Credit Spreads  Difference between a risky bonds yield and the yield on a government bond with same maturity is referred as risky bond’s credit spread .  Credit Spread tells the investor how much extra yield is being offered for investing in a bond that has higher probability of default.

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