2. 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)
3. 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 bond
b) 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.
4. 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.
5. 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 bond
d) Investor is subject to CALL RISK and REINVESTMENT RATE RISK
e) 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.
6. 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 maturity
If a bond of FV = 100 is selling for Rs.90 Bond is trading at a
DISCOUNT
If a bond of FV = 100 is selling for Rs.110 Bond is trading at a
PREMIUM
7. CURRENT YIELD:
a) Reflects only the coupon rate
b) Does not consider the capital gain that the investor will
realise if the bond is purchased at a DISCOUNT and held till
maturity
c) Does not consider the capital loss that the investor will
realise if the bond is purchased at a PREMIUM and held till
maturity
d) Ignores the TVM
e) Incomplete and simplistic measure of yield
f) Formula:
Annual Interest
Price
8. YIELD TO MATURITY:
a) Popularly known as YTM
b) It is the discount rate that makes the PV of the cash flows (receivable
from owning the bond) equal to the price of the bond
c) Considers the current coupon and the capital gain/loss that the
investor will realise by holding the bond till maturity
d) It also takes into account the timing of the cash flows
e) 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
9. YIELD TO CALL:
a) Popularly known as YTC
b) Applies to CALLABLE BONDS
YIELD TO PUT:
a) Popularly known as YTP
b) Applies to PUTTABLE BONDS
11. 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
12. •Reflects the term structure of interest rates
•POSITIVE (ASCENDING) YIELD CURVE – Yield at the longer end is higher than the
yield at the shorter end
•NEUTRAL (FLAT) YIELD CURVE – More or less the same the same returns across
maturities
•NEGATIVE (DESCENDING) YIELD CURVE – Long term yield is lower than short term
yield – represents an impending downturn in the economy
13. 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
14. INTEREST RATE RISK
a) Interest rates tend to vary over time fluctuating with bond prices.
b) Rise in interest rate will depress the prices of outstanding bonds
c) Fall in interest rates will push the prices will push the market prices up
d) DURATION is a precise measure of interest rate sensitivity
e) It is a function of the MATURITY PERIOD and the COUPON RATE
f) 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 rate
LARGER THE COUPON RATE Lesser sensitivity of
price to changes in interest rate
15. 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 rate
b) REINVESTMENT RISK IS GREATER FOR BONDS WITH LONGER MATURITY AND
FOR BONDS WITH LARGER COUPON PAYMENTS
16. 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
17. 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
