Module–IV: Fixed Income Portfolio Management

Sources of Fixed Income Investment

What Is Fixed Income?
KEY TAKEAWAYS
● Fixed income is a class of assets and securities that pay out a set level of cash flows to
investors, typically in the form of fixed interest or dividends.
● Government and corporate bonds are the most common types of fixed-income products.
● They are known as fixed-income because they pay a fixed interest rate credited to
investors.
● At maturity for many fixed income securities, investors are repaid the principal amount
they had invested in addition to the interest they have received.
● In the event of a company's bankruptcy, fixed-income investors are often paid before
common stockholders.

Types of Fixed Income Products

● Treasury bills (T-bills) are short-term fixed-income securities that mature within one year
that do not pay coupon returns. Investors buy the bill at a price less than its face value
and investors earn that difference at maturity.
● Treasury notes (T-notes) come in maturities between two and 10 years, pay a fixed
interest rate, and are sold in multiples of $100. At the end of maturity, investors are
repaid the principal but earn semiannual interest payments until maturity.
● Treasury bonds (T-bonds) are similar to the T-note except that it matures in 20 or 30
years. Treasury bonds can be purchased in multiples of $100.
● Treasury Inflation-Protected Securities (TIPS) protect investors from inflation. The
principal amount of a TIPS bond adjusts with inflation and deflation.
● A municipal bond is similar to a Treasury since it is government-issued, except it is
issued and backed by a state, municipality, or county, instead of the federal government,
and is used to raise capital to finance local expenditures. Muni bonds can have tax-free
benefits to investors as well.
● Corporate bonds come in various types, and the price and interest rate offered largely
depend on the company’s financial stability and its creditworthiness. Bonds with higher
credit ratings typically pay lower coupon rates.
● Junk bonds—also called high-yield bonds—are corporate issues that pay a greater
coupon due to the higher risk of default. Default is when a company fails to pay back the
principal and interest on a bond or debt security.
● A certificate of deposit (CD) is a fixed income vehicle offered by financial institutions with
maturities of less than five years. The rate is higher than a typical saving account, and
CDs carry FDIC or National Credit Union Administration (NCUA) protection

Bond Portfolio Management Theory

Bond Meaning

Bonds refer to high-security debt instruments that enable an entity to raise funds and fulfil capital
requirements. It is a category of debt that borrowers avail from individual investors for a specified
tenure.Organisations, including companies, governments, municipalities and other entities, issue bonds
 Module–IV: Fixed Income Portfolio Management

for investors in primary markets. The corpus thus collected is used to fund business operations and
infrastructural development by companies and governments alike.

Investors purchase bonds at face value or principal, which is returned at the end of a fixed tenure. Issuers
extend a percentage of the principal amount as periodical interest at fixed or adjustable rates.

Individual investors acquiring bonds have legal and financial claims to an organisation’s debt fund.
Borrowers are therefore liable to pay the entire face value of bonds to these individuals after the term
expires. As a result, bondholders receive debt recovery payments before stakeholders in case a company
faces bankruptcy.

Characteristics of Bonds

Bonds have several features that investors should take into account. The popularity of this debt instrument
can be assigned to some intrinsic factors as mentioned below.

● Face Value : Face value implies the price of a single unit of a bond issued by an enterprise.
Principal, nominal, or par value is used alternatively to refer to the price of bonds. Issuers are
under a legal obligation to return this value to the investor after a stipulated period.

Bond example - an investor chooses to purchase a corporate bond at face value of Rs. 6,500. The
company issuing the bond is thus obliged to return Rs. 6,500 plus interest to the investor after maturity of
the tenor. Note that the face value of a bond is different from its market value as market operations
influence the latter.

● Interest or Coupon Rate : Bonds accrue fixed or floating rates of interest across their tenure,
payable periodically to creditors. Bond interest rates are also called coupon rates as per the
tradition of claiming interests on paper bonds in the form of coupons.Interest earned on a bond
depends on various aspects such as tenure, the issuer’s repute in the public debt market.

● Tenure of Bonds: Tenure or term refers to the period after which bonds mature. These are
financial debt contracts between issuers and investors. Financial and legal obligations of an issuer
to the investor or creditor are valid only until the tenure’s end.They can thus be segregated as per
the tenure applicable for them. Bonds with maturity periods below 5 years are called short-term
bonds, whereas a tenure of 5-12 years is attributed to intermediate-term bonds. Long-term bonds
refer to the ones with terms higher than 12 years. Also, longer tenures suggest the participation of
issuing companies in prevailing businesses in the trade market in the long-term.

● Credit Quality:The credit quality of a bond refers to the creditors’ consensus on the performance
of a company’s assets in the long-term. It is determined by the degree of confidence that investors
have in an organization’s bonds. Credit rating agencies classify bonds based on the risk of a
company defaulting on debt repayment.These agencies assign risk grading to private players in
the market and categorize bonds into investment grade and non-investment grade debt
instruments. Investment grade securities are susceptible to lower yields due to a steady market
risk factor, whereas non-investment grade securities offer high returns at considerable risks.
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● Tradable Bonds:Bonds are tradable in the secondary market. The ownership can thus shift
among various investors within a given tenure. These creditors often sell their bonds to other
entities when market prices exceed the nominal values as they have an option to secure bonds
with high yield and appropriate credit ratings.

Kinds of Bonds

Bonds are classified into different categories as per the model of return and validities of legal obligations.
The prevailing types of bonds in the public debt market are -

Fixed-interest Bonds: Fixed-interest bonds are debt instruments which accrue consistent coupon rates
throughout their tenure. These predetermined interest rates benefit investors with predictable returns on
investment irrespective of alterations in market conditions.Creditors have the benefit of being aware of
the receivable interest amount periodically within the long term investment schedule.

Floating-interest Bonds : These bonds incur coupon rates which are subject to market fluctuations and
elastic within their tenures.The return on investment through interest income is thus inconsistent as it is
determined by market factors such as inflation, condition of the economy, and confidence of investors in
an entity’s bonds.

Inflation-linked Bonds: Inflation-linked bonds are special debt instruments designed to curb the impact
of economic inflation on the face value and interest return. The coupon rates offered on inflation-linked
bonds are usually lower than fixed-interest bonds.
ILBs thus aim to reduce the negative consequences of inflation by adjusting coupons concerning
prevailing rates in the debt market.

Perpetual Bonds: Perpetual bonds are fixed-security investment options whereby issuers do not have to
return the principal amount to the purchaser. This investment type does not have any maturity period, and
customers benefit from steady interest payments for perpetuity.These debt instruments are also called
‘consol bonds’ or ‘perp’.

Other types of objective-specific bonds offered by corporations and governments include war and climate
bonds.

Advantages of Bonds

Investment in bonds is advantageous to customers in extensive ways. Due to the dependability of interest
and principal returns, bonds have proved to be a stable investment option for customers averse to
excessive risk in the market.

The advantages thus include-

● Stability - Bonds are long-term investment tools that accrue assured returns in comparison to
other investment options. They provide a low-risk avenue to investors apprehensive of the
volatility of returns from equity. Even though dividend incomes from equities are traditionally
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higher than coupon returns, bonds are comparatively inelastic as compared to cyclical market
fluctuations.
● Indentures - Bonds grant a legal guarantee that binds borrowers to return the principal amount to
the creditors in due time. They serve as financial contracts which contain details such as the par
value, coupon rates, tenure, and credit ratings.

Companies that attract massive investments in their bonds are highly unlikely to default on
interest payments due to their reputation in the securities market. Besides, bondholders precede
shareholders in receiving debt repayment in the event of an entity’s bankruptcy.
● Portfolio Diversification – Investors massively rely on investment in fixed-income debt
instruments such as bonds to diversify their investment portfolio as they offer superior
risk-adjusted returns on investment. Consequently, portfolio diversification reduces the possibility
of short-term losses due to increased allocation of investment funds to fixed-income resources
instead of solely depending on equities.

Limitations of Bonds

Even though bonds are a low-risk investment option, they come with specific limitations that investors
should be acquainted with. The disadvantages include -

● Inflation’s Influence - Bonds are susceptible to inflation risks when the prevailing rate of
inflation exceeds the coupon rate offered by issuers. Debt instruments which accrue fixed
interests face risks of devaluation too due to the impact of inflation on the principal value
invested.

● Limited Liquidity- Bonds, although tradable, are mostly long-term investments with withdrawal
restrictions on the investment amount. Shares precede bonds in terms of liquidity, as bonds are
liable to several fees and penalties if creditors decide to withdraw their debt amount.

● Lower Returns – Issuers offer coupon rates on bonds which are usually lower than returns on
stocks. Investors receive a consistent amount as interest over the tenure in a low-risk investment
environment. However, returns are much lower than on other debt instruments.

Things to Consider Before Investing in Bonds

Investors have to consider the following factors before investing in secure and fixed-investment options
such as bonds.

● Investment Objectives:Investors have to take into account their return expectations on

investment according to the nominal value, coupon rates and tenure of an entity’s bonds. They
can further achieve stability of their investment portfolio by parking their funds in bonds.

● Tenure of the Bond:Consideration of the tenure is essential when it comes to investment in these
debt instruments. Bond interest rates are usually higher for the ones invested for a long term and
can benefit investors with a steady interest income. Customers purchasing long-term bonds imply
long term capital commitment through this debt instrument.Contrarily, bonds of medium or short
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term offer better liquidity to investors and are thus suitable for meeting immediate as well as
extended financial requirements.

● Analyze Risk Factor:Investors should analyze the credit rating of a company to acquire the best
bonds in the market. High-yielding bonds are often offered by companies with high-risk factors as
graded by credit rating agencies and vice versa. Choice of a bond should thus also depend on an
investor’s risk-taking capacity.

● Call Risk:Investors should also measure the possibility of companies retracting their bonds
before the maturity period due to increasing market prices and faltering interest rates. They
should thus examine annual reports and market trends to predict call risks by enterprises.

Individuals can invest in bonds for financial security and corpus growth in the long-term. As
issuers return the principal amount invested in their bonds after a specific tenure, investors have
the option to earn periodic interests on the nominal value of bonds, making them viable
investment options in corporate and government debt instruments.

Suitability of Investments in Bonds

Although there is no particular time to invest in bonds due to predominantly consistent interest cycles,
investors who are risk-averse should consider bonds. Individuals are met with several options while
investing in bonds as per their financial inclination. Investors inclined towards safe debt instruments
should accumulate bonds from high-rated companies.

What is the rate of return?

Rate of return (ROR) is the loss or gain of an investment over a certain period, expressed as a
percentage of the initial cost of the investment. A positive ROR means the position has made a
profit, while a negative ROR means a loss. You will have a rate of return on any investment you
make.

To calculate the rate of return for an investment, subtract the starting value of the investment
from its final value (remember to include dividends and interest). Then, divide this amount by
the starting value of the investment, and multiply that figure by 100. This will give you the RoR,
expressed as a percentage.

Examples rate of return calculation for bonds

Alternatively, if you own a $100,000 bond with a 5% interest rate, which reaches maturity after
four years, you will earn $5000 income every year (bond value multiplied by interest rate). If you
sell the bond for $120,000 after one year, the appreciation – or growth – of the bond is $20,000
(subtract original bond value from new bond value).

The calculation of the rate of return is the interest plus appreciation, divided by original bond
price – expressed as a percentage. The rate of return after one year is therefore 25% ($5000
plus $20,000, divided by $100,000, multiplied by 100).

Forecasting Interest Rates

 Module–IV: Fixed Income Portfolio Management

Check this PPT https://www.slideshare.net/pawankawan/determination-of-interest-rate

Price Volatility of Bonds (Refer to class notes)

What Is an International Bond?

KEY TAKEAWAYS
● An international bond is generally a debt obligation that is issued by a non-domestic
entity in its native currency.
● Most international bonds are corporate bonds but some government bonds are
investable assets.
● International bonds offer portfolio diversification but are subject to currency risk.

Types of International Bonds

Eurobonds
Eurobonds are issued in a currency other than the native currency of the corporation or other
issuer.

For example, a company that is based in Switzerland that plans to build a manufacturing plant in
Mexico might issue a bond that is denominated in pesos. The company is getting direct access
to the Mexican pesos it will need for the project, probably at a lower cost than borrowing from a
Mexican bank. Mexican investors are getting an investment that does not involve the currency
risk of exchanging Swiss francs for pesos.

It can get more complicated. For example, a French company might issue a bond in Japan that
is denominated in U.S. dollars rather than euros. This also is a Eurobond or, more specifically, a
eurodollar bond.

Other common types of Eurobonds are Euroyen bonds, issued in Japanese yen, and Euroswiss
bonds, issued in Swiss francs.

Global Bonds
Global bonds are similar to Eurobonds, but they can also be traded and issued in the country
whose currency is used to value the bond.

For example, a global bond could be issued by a French company, denominated in U.S. dollars,
and offered to investors in both Japan and America.

Brady Bonds
Brady bonds are sovereign debt securities denominated in U.S. dollars and backed by U.S.
Treasury bonds, but they are issued by other nations. Classified by the Federal Reserve as a
type of emerging markets bond, they were created by the U.S. to help developing nations with
burdensome foreign debts.1
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Part of a program developed in 1989 and named after then-Treasury Secretary Nicholas Brady,
the bonds are meant to help emerging nations restructure their debts and reach financial
stability.

Most Brady bonds are rated below investment grade.1

International Bonds vs. Foreign Bonds

Although the terms are sometimes used interchangeably, international bonds and foreign bonds
are not the same.

Foreign bonds are issued in one market and denominated in its currency but issued by a foreign
company. For example, a U.S. company that does business in Canada might issue a bond in
Canada that is valued in Canadian dollars.

Often, foreign bonds bear cute names that reflect the local currency or country in which they're
issued. The bond in the example above would be referred to as a Maple bond. Other types of
foreign bonds include:

● Samurai bonds (issued in Japanese yen)

● Yankee bonds (issued in U.S. dollars)
● Matilda bonds (issued in Australian dollars)
● Bulldog bonds (issued in British pounds sterling)

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