Presentation on Indian Debt Market

Overview of Financial Markets

The Basic Premise of Financial Markets As we know, a market is where buyers and sellers meet to exchange goods, services, money, or anything of value. In a financial market, the buyers are investors, or lenders: the sellers are issuers, or borrowers. An investor / lender is an individual, company, government, or any entity that owns more funds than it can use. An issuer / borrower is an entity that has a need for capital. Each investor and issuer is active in a market that meets its needs. Needs are based on many factors, including a time horizon (short- or longterm), a cost / return preference, and type of capital (debt or equity). The third group of participants in the marketplace includes financial intermediaries called brokers and dealers. Brokers facilitate the buying and selling process by matching investors and issuers according to their needs. Dealers purchase securities from issuers and sell them to investors. Brokers and dealers may be referred to as investment bankers. Investment banking firms specialize in the financial markets.

What is a Security? Security is a generic term that refers to a debt or equity IOU issued by a borrower or issuer. - Debt security or bond an IOU promising periodic payments of interest and/or principal from a claim on the issuer's earnings - Equity or stock an IOU promising a share in the ownership and profits of the issuer

Types of Financial Markets There are two general classifications of financial markets: Money markets Capital markets Money Markets Money markets trade short-term, marketable, liquid, low-risk debt securities. These securities are often called "cash equivalents" because of their safety and liquidity. The liquidity of a market refers to the ease with which an investor can sell securities and receive cash. A market with many active investors and few ownership regulations usually is a liquid market; a market with relatively few investors, only a few securities, and many regulations concerning security ownership is probably less liquid.

Capital Markets Capital markets trade in longer-term, more risky securities. There are three general subsets of capital markets: bond (or debt) markets, equity markets, and derivative markets. Today, we will discuss debt markets in more detail and will have a cursory glance at equity markets and derivative markets Debt markets specialize in the buying and selling of debt securities. To illustrate how debt markets look, we will analyze a short example. Example

Suppose that HT Manufacturing Company needs new equipment for its operations. Most companies try to match assets and liabilities according to maturity (time left before the item is no longer useful). The company expects the new equipment to have a useful life of about 10 years and, therefore, after consulting with its financial advisors, HT Manufacturing decides to issue 10-year bonds to pay for the equipment. HT Manufacturing consults with investment bankers to find out what types of bonds investors are buying and to decide what interest rate the bonds will pay. The object is to make them attractive to investors, yet cost-efficient for HT Manufacturing.

After completing all of the details, HT Manufacturing issues the bonds to investors using two methods. 1) The investment banks use their brokers to find buyers for the bonds, and HT Manufacturing sells the bonds directly to the investors. 2) The investment banks also act as dealers by buying some of the bonds themselves, then selling them to investors. The original issue of bonds (or bills, or any other debt security) is called the primary market issue. A secondary market also exists where debt securities are bought and sold by investors. For example, suppose an investor who bought HT Manufacturing bonds one year ago has a change in investment plans and no longer needs 10-year bonds. S/he can sell the bonds in the secondary market (usually with the assistance of a broker) to another investor who wants 10-year bonds. Because this transaction has no effect on HT Manufacturing's finances or operations, it is considered a secondary market transaction.

Equity markets, also called stock markets, specialize in the buying and selling of equity securities (stocks) of companies. As in the debt markets, the equity markets have a primary and secondary market. The primary market is where companies originally issue stock in their companies, a process known as an initial public offering or "taking the company public." Investment bankers advise a company on the process and can also act as brokers and dealers for new stock issues. The secondary market is where investors buy and sell stocks at prices that reflect the investors' collective view of the future prospects of each individual firm. Derivative Markets A derivative instrument is a security that derives its value from an underlying asset, including financial assets such as stocks and bonds or other assets such as commodities and precious metals. Derivative instruments include future and forward contracts and options. These instruments are bought and sold in the market by investors needing to hedge risk exposure.

The Structure of Indian Debt Market

Market Participants In the Debt Market1. 2. Central Governments, raising money through bond issuances, to fund budgetary deficits and other short and long term funding requirements. Reserve Bank of India, as investment banker to the government, raises funds for the government through bond and t-bill issues, and also participates in the market through open-market operations, in the course of conduct of monetary policy. The RBI regulates the bank rates and repo rates and uses these rates as tools of its monetary policy. Changes in these benchmark rates directly impact debt markets and all participants in the market. Primary Dealers, who are market intermediaries appointed by the Reserve Bank of India who underwrite and make market in government securities, and have access to the call markets and repo markets for funds. State Governments, municipalities and local bodies, which issue securities in the debt markets to fund their developmental projects, as well as to finance their budgetary deficits. Public Sector Units are large issuers of debt securities, for raising funds to meet the long term and working capital needs. These corporations are also investors in bonds issued in the debt markets. Corporate treasuries issue short and long term paper to meet the financial requirements of the corporate sector. They are also investors in debt securities issued in the debt market.
(Continue)

3. 4. 5.

6.

7.

8.

9.

Public Sector Financial Institutions regularly access debt markets with bonds for funding their financing requirements and working capital needs. They also invest in bonds issued by other entities in the debt markets. Banks are the largest investors in the debt markets, particularly the treasury bond and bill markets. They have a statutory requirement to hold a certain percentage of their deposits (currently the mandatory requirement is 25% of deposits) in approved securities (all government bonds qualify) to satisfy the statutory liquidity requirements. Banks are very large participants in the call money and overnight markets. They are arrangers of commercial paper issues of corporates. They are also active in the inter-bank term markets and repo markets for their short term funding requirements. Banks also issue CDs and bonds in the debt markets. Mutual Funds have emerged as another important player in the debt markets, owing primarily to the growing number of bond funds that have mobilised significant amounts from the investors. Most mutual funds also have specialised bond funds such as gilt funds and liquid funds. (Continue)

Mutual Funds are not permitted to borrow funds, except for very short-term liquidity requirements. Therefore, they participate in the debt markets pre-dominantly as investors, and trade on their portfolios quite regularly. 10. Foreign Institutional Investors FIIs can invest in Government Securities upto US $ 5 billion and in Coporate Debt upto US $ 15 billion. Provident Funds are large investors in the bond markets, as the prudential regulations governing the deployment of the funds they mobilise, mandate investments pre-dominantly in treasury and PSU bonds. They are, however, not very active traders in their portfolio, as they are not permitted to sell their holdings, unless they have a funding requirement that cannot be met through regular accruals and contributions. Charitable Institutions, Trusts and Societies are also large investors in the debt markets. They are, however, governed by their rules and byelaws with respect to the kind of bonds they can buy and the manner in which they can trade on their debt portfolios.

11.

12.

Participants and Instruments In Debt Markets

Instruments
Short term instruments Call/Notice Money (1-14 days) Term Money FDs (upto 1 year) Repo (1-14 days)- 1 yr CBLO (1 day to 3 months)-(Collateral Borrowing &Lending Obligation) Treasury Bills (91 day, 182 and 365 day) Fixed deposit Certificates of Deposits (upto 1 year) Commercial Paper (upto 1 year) Bills Rediscounting schemes (upto 6 months) Long term instruments Government of India dated securities (GOISECs) Inflation linked bonds Zero coupon bonds State government securities (state loans) Public Sector Undertaking Bonds (PSU Bonds) Corporate debentures Bonds of Public Financial Institutions (PFIs)

Instruments

Short term instruments Call/Notice Money (1-14 days) Term Money FDs (upto 1 year) Repo (1-14 days)- 1 yr CBLO (1 day to 3 months)-(Collateral Borrowing &Lending Obligation) Treasury Bills (91 day, 182 and 365 day) Fixed deposit Certificates of Deposits (upto 1 year) Commercial Paper (upto 1 year) Bills Rediscounting schemes (upto 6 months)

Money Market
Call / Notice Money

It is an important segment of the Indian money market. In this market, banks and primary dealers borrow and lend funds to each other on unsecured basis. If the period is more than 1 day and up to 14 days it is called notice money. Money lent for 15 days to 1 year is called term money. No brokers. Settlement is done between the participants through the current accounts maintained with the RBI. In general, the call money rate, referred to as the overnight MIBOR.

Repo
Repurchase agreements are contracts for the sale and future repurchase of a financial asset, most often sovereign securities. On the termination date, the seller repurchases the asset at the price agreed at inception of the repo. The difference between the sale and repurchase prices represents interest for the use of the funds. A repo is essentially a short term interest bearing loan against collateral. A repo transaction for the borrower is a reverse repo transaction for the lender.

Collateralized Borrowing and Lending Obligation (CBLO)

As an alternative to the call money market, CCIL has developed CBLO, a money market instrument recognized by RBI.
An instrument issued at a discount and in electronic book entry form, for initial maturities ranging from one day to one year. CBLO rates are generally comparable to market repo rates, both being secured transactions.

Treasury Bills
Promissory notes of the central government and therefore qualify as being free of credit risks. Issued to meet short term funding requirements of the government account with Reserve Bank.

Sale is by auction. Any individual, corporate, bank, primary dealer or other entity is free to buy T-Bill.
Denominations of 91, 182 and 364 days.

Commercial Paper (CP)

Promissory notes issued by the corporate sector for raising short term funds. Sold at a discount to face value. Maturity can range between a minimum of 7 days and a maximum of 1 year. CPs are required to be rated and the minimum rating eligibility is P2. Every CP issue has an Issuing and Paying Agent (IPA), which has to be a scheduled bank. Stamp duty is currently payable on CP issues, depending on the maturity and who the initial buyer is.

Certificate of Deposit (CD)

Similar to CPs except that the issuer is a bank. Minimum amount of a CD can be Rs. 1 lakh and maturity between 7 days and 1 year. Financial Institutions can issue CDs only for maturities between 1 and 3 years.

Bills Rediscounting Scheme

The RBI introduced the Bills Market Scheme (BMS) in 1952 which was later modified into the New Bills Market Scheme (NBMS). Under this scheme commercial banks can rediscount the bills which were originally discounted by them with approved institutions (viz., Commercial Banks, Development Financial Institutions, Mutual Funds, Primary Dealers etc.)

Cash Reserve Ratio (CRR)

Amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI uses this method (increase of CRR) to drain out the excessive money from the banks. Currently at 6.00 %.

Repo Rate Rate at which banks borrow from RBI. Currently at 5.25 %. Reverse Repo Rate at which RBI borrows from banks. Currently at 3.75 %. Statutory Liquidity Ratio (SLR) A percentage of time and demand liabilities banks have to invest in government bonds and other approved securities. Currently at 25 %. RBI empowered to increase the ratio up to 40 %.

Derived Instruments
Pass Through Certificate Fixed-income securities that represent an undivided interest in a pool of federally insured mortgages put together by the Government National Mortgage Association. Mortgage-backed certificates are the most common type of pass-through, where homeowners' payments pass from the original bank through a government agency or investment bank to investors.

Certificate of Participation A type of financing where an investor purchases a share of the lease revenues of a program rather than the bond being secured by those revenues. The authority usually uses the proceeds to construct a facility that is leased to the municipality, releasing the municipality from restrictions on the amount of debt that they can incur.

Hedging Mechanism
Interest Rate Swaps A swap is defined as a financial transaction in which two counterparties agree to exchange streams of payments, or cash flows, overtime on the basis agreed at the inception of the contract.

Interest payment streams of differing character, on an agreed, or notional, principal, are periodically exchanged.

Interest Rate Options An agreement between two parties in which one grants to the other the right to buy (call option) or sell (put option) an asset under specified conditions (price, time) and assumes the obligation, to sell or buy it.

The party who has the right, but not the obligation, is the buyer of the option, and pays a fee, or premium, to the writer or seller of the option.
The asset could be a currency, bond, interest rate, share, commodity or a futures contract. No Interest Rate options in the INR market at present.

Long term instruments Government of India dated securities (GOISECs) Inflation linked bonds Zero coupon bonds State government securities (state loans) Public Sector Undertaking Bonds (PSU Bonds) Corporate debentures Bonds of Public Financial Institutions (PFIs)

Government of India dated securities (GOISECs):

GOISECs are issued by the Reserve Bank of India on behalf of the Government of India. These form a part of the borrowing program approved by Parliament in the Finance Bill each year (Union Budget). They have maturity ranging from 1 year to 30 years. GOISECs are issued through the auction route. The RBI pre specifies an approximate amount of dated securities that it intends to issue through the year

Inflation linked bonds:

These are bonds for which the coupon payment in a particular period is linked to the inflation rate at that time - the base coupon rate is fixed with the inflation rate (consumer price index-CPI) being added to it to arrive at the total coupon rate. Investors are often loath to invest in longer dated securities due to uncertainty of future interest rates. The idea behind these bonds is to make them attractive to investors by removing the uncertainty of future inflation rates, thereby maintaining the real value of their invested capital.

 Zero coupon bonds:

These are bonds for which there is no coupon payment. They are issued at a discount to face value with the discount providing the implicit interest payment. In effect, these can be construed as long duration T - Bills or as bonds with cumulative interest payment.

State government securities (state loans) :

These are issued by the respective state governments but the RBI coordinates the actual process of selling these securities. Each state is allowed to issue securities up to a certain limit each year. State Government issue such securities to fund their developmental projects and finance their budgetary defictis

Public Sector Undertaking Bonds (PSU Bonds) :

These are long term debt instruments issued by Public Sector Undertakings (PSUs). The term usually denotes bonds issued by the central PSUs (ie PSUs funded by and under the administrative control of the Government of India). The issuance of these bonds began in a big way in the late eighties when the central government stopped/reduced funding to PSUs through the general budget. Typically, they have maturities ranging between 5-10 years and they are issued in denominations (face value) of Rs.1,000 each. Most of these issues are made on a private placement basis to a targeted investor base at market determined interest rates. These PSU bonds are transferable by endorsement and delivery and no tax is deductible at source on the interest coupons payable to the investor (TDS exempt).

 Bonds of Public Financial Institutions (PFIs) :

Apart from public sector undertakings, Financial Institutions are also allowed to issue bonds, that too in much higher quantum. They issue bonds in 2 ways - through public issues targeted at retail investors and trusts and also through private placements to large institutional investors. Usually, transfers of the former type of bonds are exempt from stamp duty while only part of the bonds issued privately have this facility. On an incremental basis, bonds of PFIs are second only to GOISECs in value of issuance.

Corporate debentures:
These are long term debt instruments issued by private sector companies. These are issued in denominations as low as Rs.1,000 and have maturities ranging between one and ten years. Long maturity debentures are rarely issued, as investors are not comfortable with such maturities. Generally, debentures are less liquid as compared to PSU bonds and the liquidity is inversely proportional to the residual maturity. A key feature that distinguishes debentures from bonds is the stamp duty payment. Debenture stamp duty is a state subject and the quantum of incidence varies from state to state. There are two kinds of stamp duties levied on debentures viz issuance and transfer. Issuance stamp duty is paid in the state where the principal mortgage deed is registered. Over the years, issuance stamp duties have been coming down and are reasonably uniform. Stamp duty on transfer is paid to the state in which the registered office of the company is located. Transfer stamp duty remains high in many states and is probably the biggest deterrent for trading in debentures resulting in lack of liquidity.

Bond Basics & Valuation of Bonds

Bonds represent loans by investors to a company. In a bond contract, the investor purchases a certificate from the issuer in exchange for a stream of interest payments and the return of a principal amount at the end of the contract. In this section we will discuss the terminology of the bond market and the methodology for calculating the price (present value) of a bond. Bond Terminology There are several terms that are commonly used by investors and issuers when dealing with bonds. Coupon The periodic interest payment made by the issuer. When bonds were first developed, the bond certificate had detachable coupons that the investor would send to the issuer to receive each interest payment. The term still applies to payments, even though coupons are no longer used to redeem them. Coupon rate The interest rate used to calculate the coupon amount the bond will pay. This rate is multiplied by the face value of the bond to arrive at the coupon amount.

Face (par) value The amount printed on the certificate. The face value represents the principal in the loan agreement, which is the amount the issuer pays at maturity of the bond. Maturity date The date the loan contract ends. At this time, the issuer pays the face value to the investor who owns the bond. Bonds are often referred to as fixed income securities because they have a fixed payout to the investor. Since the coupon rate is set before the sale of the bond, the investor knows the amount of the interest payments.

Process for Issuing Bonds A simple example will illustrate the process for issuing bonds. Example ABC Company needs capital to purchase a new piece of equipment for its operations. The company meets with financial advisors and investment bankers to discuss the possibilities of raising the necessary capital. They decide that a bond issue is the least expensive method for the company. The process is as follows: 1. ABC Company sets the maturity date and face value of the bonds. The bonds will have a maturity date of ten years from the date of issue and a face value of Rs.1,000. The company will issue as many bonds as it needs for the equipment purchase if the equipment costs Rs.10,000,000 fully installed, then the company will issue 10,000 bonds.

2. Investment bankers set the coupon rate for the bonds.

The investment bankers attempt to gauge the interest rate environment and set the coupon rate commensurate with other bonds with similar risk and maturity. The coupon rate dictates whether the bonds will be sold in the secondary market at face value or at a discount or premium. If the coupon rate is higher than the prevailing interest rate, the bonds will sell at a premium; if the coupon rate is lower than the prevailing interest rate, the bonds will sell at a discount. 3. Investment bankers find investors for the bonds and issue them in the primary market. The investment bankers use their system of brokers and dealers to find investors to buy the bonds. When investment bankers complete the sale of the bonds to investors, they turn over the proceeds of the sale (less the fees for performing their services) to the company to use for the purchase of equipment. The total face value of the bonds appears as a liability on the company's balance sheet.

4. The bonds become available in the secondary market.

Once the bonds are sold in the primary market to investors, they become available for purchase or sale in the secondary market. hese transactions usually take place between two investors one investor who owns bonds that are no longer needed for his/her investment portfolio and another investor who needs those same bonds.

Pricing Bonds
Pricing a bond involves finding the present value of the cash flows from the bond throughout its life. The formula for calculating the present value of a bond is: V = C[1 / (1+R)]1+ C[1 / (1+R)]2+ ... + C[1 / (1+R)]T+ F[1 / (1+R)]T Where:

V = Present value of the bond

C = Coupon payment (coupon rate multiplied by face value) R = Discount rate (current prevailing rate)

F = Face value of the bond

T = Number of compounding periods until maturity

Example:
What is the present value of a bond with a two-year maturity date, a face value of Rs.1,000, and a coupon rate of 6%? The current prevailing rate for similar issues is 5%. To apply the formula, C = Rs.60 (Rs.1,000 x 0.06), R = 0.05, T = 2, and F = Rs.1,000. V = C[1 / (1+R)]1 + C[1 / (1+R)]2 + F[1 / (1+R)]2 V = Rs.60[1 / (1+0.05)] + Rs.60[1 / (1+0.05)]2 + Rs.1,000[1 / (1+0.05)]2 V = Rs.60[0.95238] + Rs.60[0.90703] + Rs.1,000[0.90703] V = Rs.57.14 + Rs.54.42 + Rs.907.03

V = Rs.1,018.59

The present value of Rs.1,018.59 is the price that the bond will trade for in the secondary bond market. You will notice that the price is higher than the face value of Rs.1,000. In the time since these bonds were issued, interest rates have fallen from 6% to 5%. Investors are willing to pay more for the Rs.60 interest payments when compared with new bond issues that are only paying Rs.50 in interest per Rs.1,000 face value. This inverse relationship is important. As interest rates fall, bond prices rise; As interest rates rise, bond prices fall.

A bond with a coupon rate that is the same as the market rate sells for face value. A bond with a coupon rate that is higher than the prevailing interest rate sells at a premium to par value; a bond with a lower rate sells at a discount.

Current Yield, YTM & Duration of a Bond

Bond structure

Serial Number Name of bond e.g. GOI 2020

BOND
Nominal/Par Value e.g. Rs.100.00

Coupon rate 12 % pa. Interest Rs.12.25 Redemption date e.g. Dec 2020

Current Yield, in contrast to the Coupon Yield or Nominal Yield, is a Bond Yield that is determined by dividing the fixed coupon amount (that is paid as a percentage on the face or original value of the specific bond) by the current price value of the particular bond. In other words, Current Bond Yield = Coupon amount / current price of a bond. For example: The market price for a 8.24% G-Sec 2018 is Rs.118.85. The current yield on the security will be 0.0824 x 100 / 118.85 = 6.93 percent. Yield to Maturity is the most popular measure of yield in the Debt Markets. YTM refers to the percentage rate of return paid on a bond, note or other fixed income security if the investor buys and holds the security till its maturity date. The calculation for YTM is based on the coupon rate, the length of time to maturity and the market price of the bond. YTM is basically the Internal Rate of Return on the bond. It can be determined by equating the sum of the cash-flows throughout the life of the bond to zero. One of the major assumptions underlying the YTM is that the coupon interest paid over the life of the bond is assumed to be reinvested at the same rate.

The concept of Yield to Maturity assumes that the future cash flows are reinvested at the same rate at which the original investment was made.

Market price =

I/2 I/2

I/2

I/2+FV (1+r)n

---- + ---- + ---- ........... -----(1+r) (1+r)2 (1+r)3

where I/2 = annual interest rate payable half yearly r = discount rate or YTM n = number of half years remaining to maturity

The approximate Yield to Maturity (YTM) can be computed as per the formula given below:

YTM* ---------- =
*(Approx.)

I+(F-M)/N --------(F+M)/2

where I = Annual interest Rate F = Face value of bond M = Market price of the bond N = Number of years to maturity

Suppose Ramesh buys 12% GOI-2008 at Rs 102 and Suresh buys the same instrument at Rs 104 then the yield to maturity using approximation is For Ramesh, YTM = 12+(100-102)/7 --------------- = 11.59% (100+102)/2

For Suresh, 12+(100-104)/7 YTM = -------------- = 11.20% (100+104)/2

Relationship between prices & yield

Bond Prices Bond Prices

Yields

Yields

Example

YTM = 10% Coupon = 10% Bond price = Rs100 Flat yield = 10% --------------------------------YTM = 12% Bond price = Rs83 Flat yield = 12 %

YTM = 12% Coupon = 10% Bond price = Rs 83 Flat yield = 12% --------------------------------YTM = 12% Bond price = Rs100 Flat yield = 10 %

Price Interest rate relationship:

The price of a government security is inversely related to the market interest rate. As the interest rate increases price decreases and therefore, the yield increases. However, if the interest rates fall the G-Sec become expensive and therefore, the yield falls. Therefore, if the market price is equal to face value of the government security, then the current yield, coupon yield and Yield to maturity will all be equal to the coupon rate or interest payable on government security. Coupon rate = Yield to maturity if, Market price = Face value If Market Price is less than the face value of the government security the current yield and yield to maturity will be higher than the coupon yield than the coupon rate. Coupon rate < Yield to maturity if, Market price < Face value In cases where the market price of the government security/bond is more than its face value the current yield and Yield to maturity will be lower than the coupon rate. Coupon rate > Yield to maturity if, Market price > Face value

Average MaturityAverage Maturity is the weighted Average of the maturities of all the instruments in a portfolio.

Duration of a Bond Duration is the measure we use to estimate the average maturity of a bond's cash flows. It represents the weighted average life of the bond, where the weights are based on the present value of the individual cash flows relative to the present value of the total cash flows (current price of the bond). Duration measures the sensitivity of a bonds or portfolios, price to changes in interest rates. - A three year duration portfolio will approximately rise ( fall ) 3% if interest rates fall (rise) by 100 bps (1%) - A six year duration portfolio will rise (fall) 6% if interest rates fall (rise) by 100 bps (1%)

Relation of Duration with Maturity Date,YTM and Coupon Rate:

A bond's duration generally increases with the time to maturity, holding the coupon rate constant. The duration of a coupon bond is higher when the bond's yield to maturity is lower.

The higher the coupon rate, the lower the duration.

Term Structure of Interest Rates

There are three main patterns created by the term structure of interest rates:
Normal Yield Curve: Remember that as general current interest rates increase, the price of a bond will decrease and its yield will increase. Flat Yield Curve: Sends mixed signalsthat short-term interest rates will rise and other signals that long-term interest rates will fall.

Inverted Yield Curve :The inverted yield curve indicates that the market currently expects interest rates to decline as time moves farther into the future, which in turn means the market expects yields of longterm bonds to decline. Remember, also, that as interest rates decrease, bond prices increase and yields decline.

The Credit Spread

The credit spread, or quality spread, is the additional yield an investor receives for acquiring a corporate bond instead of a similar federal instrument.
When inflation rates are increasing (or the economy is contracting) the credit spread between corporate and Treasury securities widens. This is because investors must be offered additional compensation (in the form of a higher coupon rate) for acquiring the higher risk associated with corporate bonds. When interest rates are declining (or the economy is expanding), the credit spread between Federal and corporate fixed-income securities generally narrows. The lower interest rates give companies an opportunity to borrow money at lower rates, which allows them to expand their operations and also their cash flows. When interest rates are declining, the economy is expanding in the long run, so the risk associated with investing in a long-term corporate bond is also generally lower.

Yield Curve Analysis

Yield Curve theory Pure expectations theory - Argues that yields differ with maturities because of market expectations of future changes in interest rates. - For example, the 2-year yield is higher than the 1-year yield because the expectations about the 1-year yield 1-year from now, is factored in the 2-year yield is ruling now. Liquidity preference theory - If YTMs were equal across maturities, investors will prefer shorter maturity bonds because longer the maturity, greater the uncertainties, about the future inflation and interest rates. - As compensation for the higher uncertainties, investors demand a higher yield (or liquidity premium) to invest in longer term securities. -Weakness of the theory is that, on first principles, liquidity premium should go up with maturity. Market Segmentation Theory - Different investors in different maturity segments, depending on their maturity preference and asset liability management needs, and the yields are independent of each other.

Risks in Bond Investing

Interest rate risk ( price risk ) - Impact on price of a bond due to changes in interest rate changes

Credit risk - Impact due to credit migration or default risk

Reinvestment risk - Coupons get reinvested at different rates, impacting the total return of the portfolio Liquidity risk Event risk Yield curve risk - Yield curve shifts may not be parallel