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)

b)

Refers to the periodic interest payments that are made by the borrower (issuer of the bond) to the lender (subscriber of the bond). Is represented as a percentage of the par value of the bond.

TERM
a)

TO MATURITY:

b)
c)

Is called the term or tenor of the bond Number of years remaining for the bond to mature. Changes everyday from the date of issue of a bond until its maturity. date on which the borrower has agreed to repay (redeem) the principal amount to the lender.

MATURITY: Refers to the date on which the bond matures or the


a) b) c)

STRAIGHT BOND/PLAIN VANILLA BOND: ZERO COUPON BOND:

Pays a fixed periodic coupon over its life and returns the principal on the maturity date No coupons are paid. Issued at a discount to the par value. Interest is the difference between the FV and the discounted price at which the bond is bought. In case of a very long tenure, the bond is issued at a very steep discount to the FV Deep Discount Bond

d)

a) b) c)

FLOATING RATE BOND:

Coupon rate is not fixed, but reset with reference to a benchmark rate. Some FRBs have caps and floors. Cap represents the maximum interest that the borrower will pay should the benchmark rate move above such a level. Floor represents the minimum interest that the lender should receive should the benchmark rate fall below the threshold.

d)


a) b) c) d) e) f)

CALLABLE BOND:
Allows the issuer to alter the tenor of the bond, by redeeming it prior to the original maturity rate. Call option enables the issuer to redeem a bond if interest rates decline and re-issue it at a lower rate. Investor looses the opportunity to stay invested in a high coupon bond Investor is subject to CALL RISK and REINVESTMENT RATE RISK Call option can be a European option, where the issuer specifies the date on which the option should be exercised. Call option can be a American option, giving the issuer the right to call the bond on or anytime before a pre-specified date.

a) b) c)

PUTTABLE BOND:
Allows the investor to seek redemption from the issuer prior to the maturity rate. Put option enables the investor to redeem a low coupon paying bond and invest in a high coupon paying bond (if interest rates rise). 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) b) c) d) Coupon rate is fixed for the term of the bond Coupon payments are made every year Next coupon payment is receivable exactly a year from now Bond will be redeemed at par on maturity
Bond is trading at a DISCOUNT Bond is trading at a PREMIUM

If a bond of FV = 100 is selling for Rs.90 If a bond of FV = 100 is selling for Rs.110

CURRENT YIELD:
a) b)

c)

d) e) f)

Reflects only the coupon rate Does not consider the capital gain that the investor will realise if the bond is purchased at a DISCOUNT and held till maturity Does not consider the capital loss that the investor will realise if the bond is purchased at a PREMIUM and held till maturity Ignores the TVM Incomplete and simplistic measure of yield Formula: Annual Interest Price

YIELD TO MATURITY:
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
a)

YIELD TO CALL:
a) b)

Popularly known as YTC Applies to CALLABLE BONDS

YIELD TO PUT:
a) b)

Popularly known as YTP 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 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

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


a) b) c) d) e) f)

INTEREST RATE RISK

Interest rates tend to vary over time fluctuating with bond prices. Rise in interest rate will depress the prices of outstanding bonds Fall in interest rates will push the prices will push the market prices up DURATION is a precise measure of interest rate sensitivity It is a function of the MATURITY PERIOD and the COUPON RATE Measured as the % change in the price (value) of the bond in response to a % change in interest rate.

LONGER THE MATURITY PERIOD price to changes in interest rate

Greater sensitivity of

LARGER THE COUPON RATE price to changes in interest rate

Lesser sensitivity of

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: When a bond pays periodic interest there is a risk that the interest payment mat have to be reinvested at a lower rate REINVESTMENT RISK IS GREATER FOR BONDS WITH LONGER MATURITY AND FOR BONDS WITH LARGER COUPON PAYMENTS

a)

b)

Measure of the weighted average life of a bond which considers the size and timing of each cash flow Measures sensitivity of a bonds price to change in yield INTEREST RATE SENSITIVITY

Duration and Coupon are inversely related

For a given maturity, a bonds duration is higher when its coupon rate is lower For a given coupon rate, a bonds 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. 2. Industry and Business Analysis Financial Analysis

Debt ratings are supposed to:

1. 2. 3. 4. 5. Provide superior information Offer low cost information Serve as a basis for a proper risk-return tradeoff Impose healthy discipline on corporate borrowers Greater credence to financial and other representations

Thank You