Debt basics

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TUTORIAL ON DEBT BASICS- BY FIDELITY

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Debt basics

  1. 1. Understanding Fixed Income Concepts
  2. 2. Basic structure of a bond The year in which the The institution that bond ‘matures’ – the ‘issues’ a bond, or lender receives the last ‘borrows’ from the ISSUER coupon and the public principalYEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 @ x% @ x% @ x% @ x% @ x% – number COUPON pay all returns COUPONCOUPON Tenor COUPON of years the bond has toCOUPON + Regular pre-specified Rate at which the payments, based on the coupon is generated PAR interest rate 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.
  3. 3. Par value, premium and discount PREMIUM 108 If the bond trades at a premium, the investor pays more than the face value of the bondParValue 100 If the bond trades at a discount, the investor pays less than the face value of the bond DISCOUNT 95
  4. 4. 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 backThe ratings do not convey other risks: change in liquidity, or interest rates Bond ratings are carried out by agencies
  5. 5. What goes into a bond rating? Character Capacity The Four C’s of Corporate Credit Capital Conditions
  6. 6. What are bond ratings? CRISIL Long Term Short Term Ratings RatingsLow Risk AAA P-1 AA P-2 A P-3 BB P-4 B P-5High Risk C DSource: Crisil
  7. 7. What are bond ratings? ICRA Long Term Medium Term Short Term Ratings Ratings RatingsLow Risk LAAA MAAA A1 LAA MAA A2 LA MA A3 LBBB MBBB A4 LBB MBB A5High Risk LB MB LC MC LD MDSource: ICRA
  8. 8. Understanding yield to maturity Yield to Maturity What the investor gets if bond is held to maturity Assumes all cash flows reinvested at the YTM Bond price is the sum of all cash flows discounted at YTM Terminal cash flow: coupon + Math Check Individual cash flows par value of bond CPN CPN CPN + PAR Bond Price = 1 + 2 + …+ n 1+r 1+r 1+rPresent value Number of times discount of the bond Discount rate: Yield to occurs: based on time period Maturity
  9. 9. The term structure – normal yield curve 1. Economy stable. 2. No inflationary shocks expected. 3. Longer maturities generate higher risk expectation. 4. Greater risk demands greater yield.Yield 10 Yr 5 Yr 3 Yr 1 Yr Maturity
  10. 10. The term structure – steep yield curve 1. Economy about to boom. 2. Inflation expected to rise. 3. Long term investors demand higher returns to avoid getting locked into lower rates. 10 Yr 5 YrYield 3 Yr 1 Yr Maturity
  11. 11. The term structure – flat yield curve 1. Flat yield curves mark a transition between economic cycles. 2. Flatness occurs through a combination of rising short term rates and falling long terms rates.Yield 1 Yr 3 Yr 5 Yr 10 Yr Maturity
  12. 12. The term structure – inverted yield curve 1. An inverted curve means that the market expects interest rates to fall in future. 2. This could signal an economic slowdown, as interest rates are lowered to stimulate growth.Yield 1 Yr 3 Yr 5 Yr 10 Yr Maturity
  13. 13. The concept of yield spread In a positive economic The high yield, or speculative grade, bond environment, the spread market is not yet prevalent in India. between corporates and g-secs contract, reflecting lower long- term default possibility in a High - yield lower interest rate environment. AAA CorporateYield 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
  14. 14. Risks associated with fixed income investment
  15. 15. Credit Risk Default Risk Issuer could fail to meet debt obligations in a timely manner. Risk premium required for particular corporate Credit Spread Risk 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
  16. 16. Interest Rate Risk Prices and yields have inverse relationships Yields are influenced by interest ratesYIELD ABOVE COUPON PRICE AT DISCOUNT YIELD = COUPON PRICE = PAR PAR VALUEYIELD 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
  17. 17. 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
  18. 18. Math Check: Approximate price change using duration The delta sign denotes ‘change’. This means change in yield. - Duration x Δy x 100 = Approx. percentage price change The negative sign is because of the inverse relationship between price change and yield change
  19. 19. Math Check: Approximate price change using duration - 3.33 x 0.015 x 100 = - 5%
  20. 20. 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
  21. 21. Reinvestment Risk 8% 7.5% 7% 6.5%10% 10% 10% 10% 6.5% 6.5% 6.5% 6.5% EXISTING BOND NEW BOND ROLLOVER
  22. 22. Liquidity RiskThe 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 Number of market Comfort level withinterest rate changes makers security
  23. 23. Securitisation – What is it all about ? Loan Pmt Obligors Originator Issues loan Sale of assets Proceeds of rated securities Fees Credit SPV Enhancement Credit Enhancement Issuance of rated securities Payment for rated securities Underwriter Issuance of rated securities Payment for rated securities Investors
  24. 24. Key Macro-economic indicators for fixed income
  25. 25. Liquidity indicators Liquidity Indicators 100000 25 80000 Net LAF amount (LHS) Call (RHS) 60000 20 40000 20000 15Rs. crore 0 -20000 10 -40000 -60000 5 -80000 -100000 -120000 0 01/01/2008 12/02/2008 28/03/2008 15/05/2008 30/06/2008 12/08/2008 26/09/2008 18/11/2008 Source: Bloomberg, Fidelity. 20th November 2008
  26. 26. 0 2 4 6 8 10 12 14 06/01/07 24/02/2007 Key rates 14/04/2007 WPI 02/06/2007 21/07/2007 10-yr G-Sec 08/09/2007Source: Bloomberg, Fidelity. 20th November 2008 27/10/2007 CRR 15/12/2007 Key rates 02/02/2008 Repo 22/03/2008 10/05/2008 28/06/2008 16/08/2008 04/10/2008
  27. 27. Other key macro indicators  Fiscal deficit  Government borrowings  Credit growth  Deposit growth  GDP  Rupee
  28. 28. QUESTIONS ??
  29. 29. Thank You.

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