TARHEEL

CONSULTANCY
SERVICES
Bangalore

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FIXED INCOME
SECURITIES

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 PART-06

Part-02
Bond & Bond Markets: An Introduction

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BASICS
 What is debt?
 It is a financial claim.
 Who issues it?
 The borrower of funds
 For whom it is a liability
 Who holds it?
 The lender of funds
 For whom it is an asset

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BASICS (CONT…)
 Difference between debt and equity?
 Debt does not confer ownership rights
 It is merely an IOU
 A promise to pay interest at periodic intervals
 And to repay the principal at a pre-specified maturity
date.

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BASICS (CONT…)
 It usually has a finite life span
 Perpetual debt is rare but happens
 The interest payments are contractual
obligations
 Borrowers are required to make payments irrespective
of their financial performance

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BASICS (CONT…)
 Interest payments to be made before any
dividends for equity holders.
 In the event of liquidation
 The claims of debt holders must be settled first
 Only then can equity holders be paid.

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FIXED INCOME SECURITIES
 Bonds and debentures are termed as Fixed
Income Securities
 Oncethe rate of interest is set at the onset of
the period for which it is due
 It is not a function of the profitability of the firm
 Failure
to pay the promised interest will
tantamount to default

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BASICS (CONT…)
 Bonds may be secured or unsecured
 Unsecured debt securities are termed as
Debentures in the US
 Unsecured means no specific assets have been
earmarked as collateral
 Secured debt requires the firm to earmark
specific assets as collateral
 Secured debt holders enjoy priority from the
standpoint of payments

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BASICS (CONT…)
 Debt securities may be negotiable or non-
negotiable
 Negotiable
securities can be traded in the
secondary market
 Can be endorsed by one party in favor of another
 Examples of non-negotiable debt securities
 National savings certificates
 Conventional Time or Fixed deposits

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PLAIN VANILLA & BELLS AND
WHISTLES
 The most basic form of a bond is called the
Plain Vanilla version.

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PLAIN VANILLA (CONT…)
 This is true for all securities, not just for bonds.
 More complicated versions are said to have
`Bells and Whistles’ attached.

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FLOATING AND VARIABLE RATE
BONDS
 These bonds are slightly different
 The interest rate does not remain fixed
 It varies each period based on the reference rate
 Short-term reference rate – maturity < 1 year
 Floating rate bonds
 Longer-term reference rate
 Variable or adjustable rate bonds

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BONDS WITH EMBEDDED
OPTIONS
 Convertible bonds can be converted to shares
of stock
 Callable bonds can be prematurely retired by
the issuer
 Putable bonds can be prematurely
surrendered by the holders

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FACE VALUE
 It is the principal value
 Amount payable by the borrower to the last
holder at maturity.
 Amount on which the periodic interest payments
are calculated.
 A.K.A as
 Par Value
 Redemption Value
 Maturity Value
 Principal Value

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TERM TO MATURITY
 It is the time remaining in the life of the
bond.
 The length of time for which interest has to be
paid as promised.
 The length of time after which the face value
will be repaid.
 A.K.A as
 Maturity
 Term
 Tenor

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COUPON

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COUPON
 The periodic interest payment that has to be
made by the borrower.
 Thecoupon rate multiplied by the face value
gives the rupee/dollar value of the coupon.

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COUPON (CONT…)
 Most bonds pays coupons on a semi-annual basis.
 True in UK/US/Australia/Japan
 In European and Eurobond markets annual
payments are the norm

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COUPON (CONT…)
 In earlier days bonds were accompanied by a
booklet of post-dated coupons
 Eachcoupon could be detached and redeemed
on the corresponding coupon payment date
 Even today bearer bonds come with coupons
 Thebearer certificate number is mentioned on
the coupon

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EXAMPLE OF COUPON
CALCULATION
 Bond with a face value of $1000.
 The coupon rate is 8% per annum paid semi-
annually.
 So the bond holder will receive
1000 x 0.08
___ = $40 every six months.
2

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YIELD TO MATURITY (YTM)
 The rate of return if an investor buys the
bond at the prevailing price and holds it
till maturity.
 In order to get the YTM, two conditions
must be satisfied.
 The bond must be held till maturity.
 All coupon payments received before maturity
must be reinvested at the YTM.

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YTM (CONT…)
 At any point in time the YTM may be
 Greater than
 Less than or
 Equal to the Coupon Rate
 YTM is the IRR of a bond

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YTM (CONT…)
 Bonds involve pure cash flows
 So only ONE REAL POSITIVE YTM
 Solution to a Non-Linear equation
 Solved iteratively

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VALUE OF A BOND
 A holder gets a stream of contractually
promised payments.
 The value of the bond is the value of this stream
of cash flows.
 Cash flows arising at different points in time
cannot be added
 Cash flows have to be discounted

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PRICE VERSUS YIELD
 It is a chicken and egg story
 Ifwe know the yield that is required we can
quote a price
 Once we acquire the asset at a certain price, we
can work out the corresponding yield.

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BOND VALUATION
 A bond will pay identical coupons every
period
 And will repay the face value at maturity.
The periodic cash flows constitute
an annuity.
The terminal face value is a lump
sum payment.

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BOND VALUATION (CONT…)
 Bond pays a semi-annual coupon of $C/2,
and has a face value of $M.
 Assume there are N coupons left
 And that we are standing on a coupon
date.
 We are assuming that the next coupon is exactly
six months away.
 The required annual yield is y
 Implies that the semi-annual yield is y/2.

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BOND VALUATION (CONT…)
 The present value of the coupon stream is:

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BOND VALUATION (CONT…)
 The present value of the face value is:

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BOND VALUATION (CONT…)
 So the price of the bond is:

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ILLUSTRATION
 IBM has issued a bond with a face value of
$1,000.
 The coupon is 8% per year to be paid on July
15 and January 15 every year.
 Today is 15 July 2013 and that the bond
matures on 15 January 2033.
 The required yield is 10% per annum.

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COUPON CODES
 JJ – 01/15
 FA – 01/15
 MS – 01/15
 AO – 01/15
 MN – 01/15
 JD – 01/15

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ILLUSTRATION (CONT…)

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PAR, DISCOUNT & PREMIUM
BONDS
 In the example the price is less than the
face value
 Such a bond is called a Discount Bond
 It is trading at a discount from the face value.
 The reason is that
 The yield is greater than the coupon

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PAR, DISCOUNT & PREMIUM
BONDS (CONT…)
 If the yield were to equal the coupon
 The bond would sell at PAR
 Such bonds are called PAR Bonds
 If the yield is less than the coupon
 The price will exceed the face value.
 Such bonds are called Premium Bonds

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PRICE EVOLUTION
 As we move from one coupon date to the
next, if the YTM were to remain constant
 Par bonds would continue to trade at PAR
 Premium bonds will steadily decline in price
 Discount bonds will steadily increase in price
 This is called the Pull to Par Effect
 At maturity – ALL BONDS WILL TRADE AT PAR

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PULL TO PAR
 As we approach maturity the number of
coupons reduces
 The contribution of coupons to price reduces
 The contribution of the PV of the face value
increases
 For premium bonds the first effect dominates
 Thus the price steadily declines
 For discount bonds the second effect
dominates
 Thus the price steadily increases

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PROOF

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PROOF (CONT…)

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PROOF (CONT…)
 For par bonds c = y and the change in price is
zero
 For premium bonds c > y and the change in
price is negative
 For discount bonds c < y and the change in
price is positive

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AMORTIZING BONDS
 A plain vanilla or Bullet Bond pays the entire
face value at maturity in a lump sum
 Amortizing bonds pay the principal in
installments
 The first payment occurs before maturity
 The last payment is made at maturity

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AMORTIZING BONDS (CONT…)
 Consider a 5 year amortizing bond with a
face value of $1,000 and an annual coupon of
8%.
 The annual cash flows are depicted below

Time Cash Flow

1 80
2 80
3 330
4 310
5 540

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AMORTIZING BONDS (CONT…)
 The first two cash flows represent interest on
a principal of $1,000
 The third cash flow is interest on $1,000 plus
a principal payment of $250
 The outstanding principal is $750
 The fourth cash flow is interest on $750 plus
a principal payment of $250
 The outstanding principal is $500
 The final cash flow is interest on $500 plus
the remaining principal of $500

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MOTIVATION
 Some companies issue such bonds because
the assets being funded have a similar cash
flow profile
 Second the coupon on such a bond may be
lower than that of a bullet bond
 In the case of a bullet bond the entire principal
is due at a single point in time
 There is greater default risk

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ZERO COUPON BONDS

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ZERO COUPON BONDS
 Plain Vanilla bonds pay coupons every
period and repay the face value at
maturity.
 A Zero Coupon Bond does not pay any
coupon interest.
 Issued at a discount from the face value
 Repays the principal at maturity.
 Face Value – Price, constitutes the interest
for the buyer.

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ILLUSTRATION
 Microsoft is issuing zeroes with 5 years to
maturity and a face value of $10,000.
 Therequired yield is 10% per annum
 What should be the price?
 Price is the PV of the face value
 Inpractice we discount on a semi-annual basis
 This will give a lower price than if we were to
use annual discounting

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ILLUSTRATION (CONT…)
 This is to facilitate comparisons with
conventional bonds

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ZERO COUPON BONDS (CONT…)
 A zero coupon bond can never sell at a
premium
 Itwill always trade at a discount prior to
maturity
 At maturity it will trade at par

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ZERO COUPON BONDS (CONT…)
 If held to maturity a ZCB will always give rise
to a capital gain
 If sold prior to maturity there may be a
capital gain or a capital loss
 Consider a bond with 10 years to maturity
 The YTM at the time of purchase was 10%
 The cost was $376.90
 A year later it is sold at a YTM of 12%
 The corresponding price is $350.35

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MOTIVATION
 For bonds with a given maturity ZCBs have
the highest price sensitivity
 Bullish speculators anticipating a rate
decline will fancy such bonds
 Investors seeking a locked in return over a
long-term – such as Pension Funds
 Likesuch bonds
 There is an assured return if held till maturity

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STEP-UP COUPON
 A newly established issuer
 Or an issuer with a relatively virgin product
or service
 Or a restructured company due to a merger
or following a bankruptcy
 Willbe perceived as more risky
 Investors will demand a high coupon
 Such firms are unlikely to have high earnings
 Revenueswill peak only after the
product/service is established

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STEP-UP (CONT…)
 They can ill afford high coupons
 They may consider a step-up coupon bond
 Where the coupon increases as the bond ages
 Assume a company can issue a plain vanilla
at a coupon of 8% with a maturity of 5 years
 Instead it may opt for a bond
 With a coupon of 6% for the first three years
 And a coupon of 10% for the last two years
 This is a Deferred Interest Security
 Provides the issuer with breathing room in the
earlier years
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STEP-UP (CONT…)
 Step-ups usually are callable by the issuer on
each anniversary date
 In the case of one-step bonds the coupon will
reset once during the life of the bond
 In the case of multi-step bonds the coupon
will reset many times
 These bonds generally provide a greater
weighted average coupon than plain vanilla
bonds

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STEP-UP (CONT…)
 As the coupon rate on a step-up rises over
comparable rates the bond is likely to be
called
 The
investor will not receive these higher
payments
 As compensation for the right to redeem
early these bonds will provide a higher
coupon
 However the scheduled coupon increases
may not keep pace with prevailing market
rates

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STEP-UP (CONT…)
 These are suitable for investors who believe
rates will go up in the future
 andwho value the possibility of an increasing
income stream

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STEP-DOWN BONDS
 With these securities the bond will initially
pay a higher coupon and the coupon rate will
be reduced with the passage of time
 These are also callable in nature

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PAYMENT IN KIND (PIK) BONDS
 These pay coupons in the form of additional
securities and not cash
 Thisoffers the issuer time to prepare for cash
outlays
 The securities used to pay interest are
usually identical to the underlying securities
but may at times be different

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PIK BONDS (CONT…)
 They are used as Mezzanine Finance
 They rank between senior debt and equity in the
capital structure
 Investors take more risk as compared to buyers of
regular bonds – but get higher returns
 Issuers can conserve cash in earlier years when it
is at a premium
 These typically mature only after all other
more senior debt has matured
 Thus investors have to wait a long time for
their principal and compounded interest to
mature
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TREASURY SECURITIES

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TREASURY SECURITIES
 Fully backed by the federal government of
the issuing nation.
 Consequently they are virtually devoid of
credit risk or the risk of default.
 The yield on such securities is a benchmark
for setting rates on other kinds of debt.

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OBJECTIVES
 Treasury securities are issued
 To finance expenses in excess of current
revenues
 To pay interest on debt accumulated in earlier
years due to deficits in those years
 To repay past debt issues that are currently
maturing
 The US Treasuries market
 Is the largest bond market in the world
 Is the most liquid bond market in the world

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U.S. TREASURY SECURITIES
 The Treasury issues three categories of
marketable securities.
 T-billsare discount securities
 They are zero coupon securities
 T-notes and T-bonds are sold at face value and
pay interest periodically.

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U.S. TREASURY SECURITIES
(CONT…)
 T-bills are issued with a original time to
maturity of one year or less.
 They are Money market instruments.
 They have maturities of either 1, 3, 6, or 12
months at the time of issue.

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US. TREASURY SECURITIES
(CONT…)
 T-notes and T-bonds have a time to maturity
exceeding one year at the time of issue.
 They are capital market instruments.
 T-notes have maturities ranging from 1-10 years
 T-bonds have an original maturity in excess of 10
years, extending up to 30 years.

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U.S. TREASURY SECURITIES
(CONT…)
 An issue may be followed later by a further
issue
 With the same remaining time to maturity and
the same coupon
 The issuance of further tranches is termed as a
Re-opening.

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U.S. TREASURY SECURITIES
(CONT…)
 Six months ago a 10-year note was issued
with a coupon of 8% per annum.
 Today if a note with 9 ½ years to maturity
and a coupon of 8% issued it will add to the
pool that is already trading in the market
 Thus it is a re-opening of an existing issue

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PRIMARY DEALERS
 Who is a primary dealer?
A PD is a dealer who is authorized to deal
directly with the Central Bank of the country
 In the US, a PD is a bank or securities broker-
dealer that directly deals with the FRBNY
 Importance of FRBNY
 In India a PD deals directly with the RBI

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TREASURY AUCTIONS

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TREASURY AUCTIONS
 The Treasury sells bills, notes, and bonds by
way of a competitive auction process.
 Most of the treasury securities are bought by
primary dealers.
 Individual investors submit non-competitive bids
and participate on a much smaller scale.

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TREASURY AUCTIONS (CONT…)
 Bids may be:
 Competitive
 Indicate price & quantity or yield & quantity
 Non-competitive
 Indicate only quantity
 Small investors and individuals
generally submit non-competitive bids
 A non-competitive bidder may not bid for more than
$5MM worth of securities in a bill or bond auction

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TREASURY AUCTIONS (CONT…)
 Primary dealers bid for their accounts and
on behalf of their clients
 They usually submit large competitive
bids
 Bids indicate the maximum price that the bidder
is prepared to pay if it is a price based auction
 Or the minimum yield that the bidder is
prepared to accept if it is a yield based auction

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TREASURY AUCTIONS (CONT…)
 The Treasury will net out the total
amount of non-competitive bids
 Thebalance will be allocated to competitive
bidders.
 There are two ways in which securities
can be allotted
 The multiple price/yield auction mechanism
 French Auctions
 The uniform price/yield auction mechanism
 Dutch Auctions

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ILLUSTRATION
 Assume that the Treasury is offering 25
billion dollars worth of T-bonds.
2 billion dollars worth of non-competitive bids
have been received.
 So 23 billion dollars worth of bonds are available
to be offered to the competitive bidders.

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ILLUSTRATION (CONT…)
 There are six competitive bidders who have
submitted the following yields.
 The bids have been arranged in ascending order
of yield.
 In a price based auction the bids would have
been arranged in descending order of price.

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 ILLUSTRATION (CONT…)

Bidder Bid Yield Bid Aggregate

Amount Amount
Alpha 5.370 3.0 bn 3.0 bn
Beta 5.372 5.0 bn 8.0 bn
Gamma 5.373 4.0 bn 12 bn
Delta 5.375 8.0 bn 20 bn
Charlie 5.375 12.0 bn 32 bn
Tango 5.380 3.0 bn 35 bn

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ILLUSTRATION (CONT…)
 The aggregate demand equals the amount on
offer at a yield of 5.375.
 A multiple yield auction will lead to the
following allocation.
 Alpha will get 3 bn at a yield of 5.370
 Beta will get 5 bn at 5.372
 Gamma will get 4 bn at 5.373

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ILLUSTRATION (CONT…)
 At a yield of 5.375 we have only 11 bn left to
allocate.
 There is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from Charlie.
 Thus we will allocate 11/20 = 55% to each
bidder at this yield
 There will be pro-rata allocation
 0.55 of 8 bn or 4.40 bn will go to Delta
 0.55 of 12 bn or 6.6 bn will go to Charlie

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ILLUSTRATION (CONT…)
 The highest accepted yield is called the Stop
Yield or High Yield
 In this case it is 5.375
 The ratio of bids received to the amount
awarded is known as the bid to cover ratio
 The higher the ratio the stronger is the auction

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ILLUSTRATION (CONT…)
 The second type of auction is called a
uniform price/yield auction.
 Aggregate demand is equal to the supply at a
yield of 5.375%.
 Thus everyone who bid less will be allotted
the quantities sought at this yield.
 The two bidders at 5.375 will also be
awarded at this yield but on a pro-rata basis.

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ILLUSTRATION (CONT…)
 Those who bid more than 5.375 will get
nothing and are said to be shutout of the
auction.
 Since 1999 the U.S. Treasury has been
conducting only uniform yield auctions.

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WHEN ISSUED (WI) TRADING
 WI stands for – When, As, and If Issued
 The when issued market is a market for
forward trading of a bond
 Which has been announced but not yet issued
 Trades take place from the date of
announcement until the actual issue date
 Helpsbidders to gauge the market’s interest
before the actual auction

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WI TRADING (CONT…)
 WI trading has ramifications for the bidding
strategies of market participants
 Traders can take both long and short
positions
 Settlement is scheduled for the issue date

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WI TRADING (CONT…)
 It has a bearing on the outcome of the
auction
 It affects the strategy used by a bidder because
it has an impact on his prior position
 Bidders who are long in the WI market enter the
auction with a Long Position
 Those who are short in the WI market enter the
auction with a short position

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WI TRADING (CONT…)
 The WI market helps in price discovery
 It provides important information on
 The strength of demand for the security
 And on the disparity of bidders’ views
 This helps potential bidders to formulate
their strategies
 At times a dealer may believe that he has
very important private information
 Ifso he may not participate in the WI market and
will directly enter the auction with bids based on
his knowledge

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WI TRADING (CONT…)
 On or before the date of the auction the
issues trade on a yield basis
 Theactual price can be established only after
the coupon is set
 Starting with the day after the auction
 Securities
are quoted on a price basis because
the coupon is known

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ZERO COUPON TREASURY
SECURITIES
 The Treasury per se does not issue zero
coupon securities.
 But zero coupon securities can be created
which are backed by conventional bonds
 Take a large quantity of a T-note or bond and
separate all the cash flows from each other
 Sell the entitlement to each cash flow
separately.

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ZERO…(CONT…)
 Take the case of a two-year T-note.
 It can be separated into five zero coupon
securities maturing after:
6 months
 12 months
 18 months
 24 months

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ZERO…(CONT…)
 Earlier investment banks used to buy bonds
from the Treasury and separate the cash
flows
 Each cash flow was then sold separately as a
zero coupon bond.
 Such issues are called trademarks.

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ZERO…(CONT…)
 The issue of trademarks has now ceased.
 Because investment banks can now create
such instruments
 In concert with the Treasury itself.
 These ZCBs are known as STRIPS –
 Separate Trading of Registered Interest and
Principal of Securities.
 These are not issued or sold by the Treasury
 The market is made by investment banks.

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ZERO… (CONT…)
 What is the motivation to create such
products?
 In practice arbitrage is possible when a
coupon security is purchased at a price
 That is lower than what could be obtained by
selling each cash flow separately.

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TRADEMARKS A PRECURSOR
 Coupon stripping reflects a case of financial
engineering
 Creating
a risk-return profile that is not
otherwise available
 An investment bank would buy a large
quantity of a Treasury security
 The securities would be placed with an SPV

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SPV
 The SPV is a single-purpose dedicated trust
 It has the powers to own the bonds and
collect payments
 It cannot sell or lend the bonds
 It cannot write options on the bonds
 Or use them as collateral for borrowing
 The SPV is empowered to issue zero coupon
bonds
 Where each security represents the ownership of
a single cash flow from the mother bond

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SPV (CONT…)
 Assume that 100MM USD of 15 year bonds
with a coupon of 8% are placed with the SPV
 The SPV can issue 6M, 12M, 18M, extending up to
14 ½ year zeroes with a total face value of 4MM
USD each
 And 15 year zeroes with a total face value of
104MM


04/22/2020 95
TRADEMARKS (CONT…)
 Merrill Lynch pioneered the concept by
introducing TIGRS
 Treasury Investment Growth Receipts
 Salomon followed with CATS
 Certificates of accrual on Treasury securities
 Lehman came up with LIONS
 Lehman Investment Opportunity Notes
 These are known as Animal Products
 This segment of the market was termed as the
Zoo

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TREASURY STRIPS

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STRIPS
 The Treasury launched this program in 1985
to facilitate the stripping of designated
securities.
 Allnew T-bonds and notes with a maturity of 10
years or more are eligible.
 The zeroes created in the process are direct
obligations of the U.S. government.

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STRIPS (CONT…)
 The mechanism is as follows.
A dealer who owns a bond or note can ask the
FRB where it is held
 To replace it with an equivalent set of STRIPS
representing each payment as a separate security.
 Each of these securities can be traded independently
of others.

04/22/2020 99
STRIPS (CONT…)
 In 1987 the Treasury started to allow dealers
to reverse the process
 This is called STRIPS RECONSTUTUTION
 If a dealer owns STRIPS representing all the
coupon and principal payments of a bond
 The FED can on request convert these holdings into a
single position in the corresponding bond

04/22/2020 100
STRIPS (CONT…)
 Each coupon and principal cash flow from a
Treasury security is assigned a CUSIP
 The mother bond is also assigned a CUSIP
 The stripped coupons are known as C-STRIPS
 The stripped principal is known as P-STRIPS
 Supply of a C-STRIP increases over time
 because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective of
which mother bond it has come from
 The original coupon rate is irrelevant

04/22/2020 101
STRIPS (CONT….)
 Consider a 30 year bond issued on 15 FEB
2010 with a coupon of 5%
 It will pay a coupon on 15 FEB 2020
 A 5 year note issued on 15 FEB 2018 with a
coupon of 4% will also pay a coupon on 15
FEB 2020
 The C-STRIPS corresponding to these two
coupon payments will have the same CUSIP

04/22/2020 102
STRIPS (CONT…)
 P-STRIPS always correspond to the original
security
 They have a unique CUSIP
 Their supply is fixed at the time of issuance
 In practice the prices of long-dated P-STRIPS
are a bit higher than those of C-STRIPS with
the same maturity date
 One reason is that P-STRIPS are more liquid due to
greater availability
 A $100 face value bond with a coupon of 8% will
generate C-STRIPS with a face value of $4 but P-
STRIPS with a face value of $100
04/22/2020 103
STRIPS (CONT…)
 Another reason why P-STRIPS are in higher
demand is that they allow reconstitution
activities more easily
 Assume that the sum of the STRIPS is cheaper than
the mother bond
 If a dealer already has the P-STRIPS only the C-
STRIPS need to be acquired
 However if he owns some of the C-STRIPS he needs
to acquire the P-STRIPS and the remaining C-STRIPS
 The facility to reconstitute when profitable is priced
into the P-STRIPS
 Note: Buy and hold investors will prefer C-STRIPS
since they are priced lower and give a higher yield
04/22/2020 104
STRIPS (CONT…)
 Strips are mainly acquired by institutional
investors
 However they are not inaccessible to
individuals
 Strips also constitute a part of the portfolio
held by certain mutual funds
 Consequently this offers an indirect avenue for
investment

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CALLABLE BONDS
 The issuer has the right to call back the
bond prematurely.
 Theybuy back from the holders before maturity
by paying the face value.
 The option is with the issuer, and so it has
to pay a price
 Thisprice will manifest itself as a lower price for
the bond as compared to a Plain Vanilla Bond.

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CALLABLE BOND (CONT…)
 A lower price means a higher yield.
Thus buyers of callable bonds demand a
higher yield
 This
is because a buyer of a callable bond is
exposed to cash flow uncertainty.
 He can never be sure as to when a bond will be
recalled.

04/22/2020 107
CALLABLE BONDS (CONT…)
 When will a callable bond be recalled?
When interest rates or required yields
are falling.
The issuer can call back the bonds and
issue fresh bonds with a lower coupon
 Insuch a scenario holders would like to hold on
 They are getting a higher rate of interest.

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CALLABLE BOND (CONT…)
 The call provision works in favor of the
borrower and against the lender.
 Hence callable bonds command a lower price.
 The way to look at it is as follows
 At the time of issue a callable bond has to carry
a higher coupon
 Subsequently a callable with a given coupon will
have a lower price
 than a Plain Vanilla with the same coupon.

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CALLABLE BONDS (CONT…)
 A bond may be discretely callable or
continuously callable
 A discretely callable bond may be recalled
only at certain pre-specified dates
 Forinstance the coupon dates over a period of
the bond’s life
 A continuously callable bond may be called
at any time after it becomes callable

04/22/2020 110
CALLABLE BOND (CONT…)
 Freely callable bonds can be called at any
time.
 Thus they offer the lender no protection.
 Deferred Callable Bonds on the other hand
do offer some protection.
 They have a Call Protection Period

04/22/2020 111
CALLABLE BOND (CONT…)
 In practice when a bond is recalled, the
issuer will pay the lender a Call Premium
 Thisis normally half-year’s or one year’s coupon
 The call premium acts as a sweetener
 That is it makes such bonds more attractive to
potential investors.

04/22/2020 112
CALLABLE BOND (CONT…)
 One of the risks in a callable bond is
reinvestment risk
 The bond will be called back when market rates
are low
 And consequently the proceeds will have to be
invested at a lower rate of interest.

04/22/2020 113
CALLABLE BOND (CONT…)
 The price appreciation potential for a
callable bond
 In a declining interest rate environment is
limited.
 The market will increasingly expect the bond to
be redeemed at the call price as rates fall.
 This is referred to as Price Compression.

04/22/2020 114
CALLABLE BOND (CONT…)
 Given the reinvestment risk and price
compression
 Why would any investor want to hold such a
bond?
 If there is sufficient compensation in the form of
a higher yield he may be willing to take the risk.

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PUTTABLE BONDS
 The bondholder has the right to return the
bond prematurely, and take back the face
value.
The option is with the bondholders and
hence they have to pay an option
premium.
 This will manifest itself as a higher bond price
 As compared to that of an otherwise similar plain
vanilla bond.

04/22/2020 116
PUTTABLE BONDS (CONT…)
 When will such a put option be exercised?
When interest rates are rising.
Holders can return the bonds and buy
fresh bonds with a higher coupon
 At such times the issuers would prefer that the
holders hold on to the bonds.

04/22/2020 117
PUTTABLE BONDS (CONT…)
 Since the put option works in favour of the
holder and against the issuer
 Such bonds are characterized by higher prices or
lower yields.
 At the time of issue a puttable will carry a lower
coupon than an equivalent Plain Vanilla
 Subsequently a puttable will carry a higher price
than a Plain Vanilla with the same coupon.

04/22/2020 118
PUTTABLE BONDS (CONT…)
 The price at which a bond can be put by the
holder acts as a floor price
 In a rising rate environment
 Since the holders can always surrender the
bonds at this price
 They will never sell at a lower price.

04/22/2020 119
CONVERTIBLE BONDS
 They grant the holder the right to convert
the bond into a predetermined # of shares
 Itis a Plain Vanilla corporate bond with a call
option to buy the common stock of the issuer.

04/22/2020 120
CONVERTIBLE BONDS (CONT…)
 The number of shares receivable on
conversion is called
 The Conversion Ratio.
 The conversion privilege may extend for all
or only a portion of the bond’s life.
 The conversion ratio may also decline over time.
 The conversion ratio is adjusted proportionately
for stock splits and stock dividends.

04/22/2020 121
CONVERTIBLE BONDS (CONT…)
ILLUSTRATION
 ABC Corporation has issued the following
bond
 Maturity = 10 years
 Coupon rate = 8%
 Conversion ratio = 40
 Face value = $1,000
 Current market price = $900
 Current share price = $20

04/22/2020 122
CONVERTIBLE BONDS (CONT…)
 The conversion price = 1000
------- = $25
40
 The conversion value of a convertible bond is
the value if it is converted immediately.
 Conversion
value = Share price x
Conversion Ratio

04/22/2020 123
CONVERTIBLE BOND (CONT…)
 The minimum price of a convertible bond is
the greater of:
 Its conversion value or
 Its value as a bond without the conversion
option.
 This is also called the straight value of the bond.

04/22/2020 124
CONVERTIBLE BOND (CONT…)
 To estimate the straight value we need the
required yield on a non-convertible bond
 withthe same credit rating and similar
investment characteristics.

04/22/2020 125
CONVERTIBLE BOND (CONT…)
 In our case the conversion value is
 $20 x 40 = $800
 Assume the YTM of a comparable straight
bond is 10%.
 Straight value = 40PVIFA(5,20)+1000PVIF(5,20)
= $875.38

04/22/2020 126
EXCHANGEABLE BONDS
 These are convertible bonds where the holder
gets the shares of a different company
 For instance if IBM were to issue convertible bonds, the
holders would get shares of IBM
 If IBM were to issue exchangeable bonds, the holders
would get shares of another firm say Hewlett Packard.
 In practice when an exchangeable bond is converted
holders will get shares issued by a subsidiary of the
issuing company

04/22/2020 127
EXCHANGEABLE BONDS
(CONT…)
 Such bond’s do not lead to dilution for the
parent company’s shareholders
 Convertiblebonds lead to such dilution when
they are converted

04/22/2020 128
 RISKS INHERENT IN BONDS
 What is risk?
 Risk
is the possibility of loss arising due to the
uncertainty regarding the outcome of a transaction.
 All bonds are exposed to one or more sources of
risk.

04/22/2020 129
CREDIT RISK

04/22/2020 130
CREDIT RISK
 AKA default risk
 Refers to the possibility of default by the
borrower.
 The risk that coupon payments and/or
principal payments may not be made as
promised.
 Treasury securities are backed by the full
faith and credit of the Federal government
 All other debt securities are exposed to credit
risk of varying magnitudes.

04/22/2020 131
CREDIT EVALUATION
 At the time of issue, the issuer provides
information
 About his financial soundness and
creditworthiness.
 This is provided in the Offer Document or
the Prospectus.
 But every investor cannot decipher such a
document
 Thusin practice we have credit rating
agencies.

04/22/2020 132
RATING AGENCIES

04/22/2020 133
CREDIT RATING AGENCIES
 They specialize in evaluating the credit
quality of a bond at the time of issue.
 They also monitor the issuing company,
throughout the life of the bond
 And modify their recommendations if
required.
 The main rating agencies in the U.S. are
 Moody’s Investors Service
 Standard and Poor’s Corporation
 and Fitch Ratings.

04/22/2020 134
INVESTMENT GRADE RATINGS
Credit Moody’s S&P’s Fitch’s
Risk Ratings Ratings Ratings
Highest Aaa AAA AAA
Quality
High Aa AA AA
Quality
Upper A A A
Medium
Medium Baa BBB BBB

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 NON INVESTMENT GRADE RATINGS
Credit Risk Moody’s S&P Fitch
Somewhat Ba BB BB
Speculative
Speculative B B B
Highly Caa CCC CCC
Speculative
Most Ca CC CC
Speculative
Imminent C C C
Default
Default C D D

04/22/2020 136
INVESTMENT GRADE RATINGS IN
INDIA

Credit FITCH CRISIL CARE ICRA

Risk
Prime AAA AAA AAA LAAA

High AA AA AA LAA
Grade
Upper A A A LA
Medium
Lower BBB BBB BBB LBBB
Medium
04/22/2020 137
 NON INVESTMENT GRADE RATINGS
IN INDIA
Credit Risk FITCH CRISIL CARE ICRA
Non- BB BB BB LBB
investment
Grade
Highly B B B LB
Speculative
Dangerously C C C LC
Speculative
Default D D D LD

04/22/2020 138
JUNK BONDS
 Non-investment grade bonds are also known
as
 Speculative grade bonds
 Or High Yield Bonds
 Or JUNK Bonds
 JUNK bonds may be
 Originalissue junk
 Or Fallen Angels

04/22/2020 139
CHANGES IN RATINGS
 Ratings can change over the course of time.
 If a rating change is being contemplated, the
agency will signal its intentions.
 S&P will place the security on Credit Watch.
 Moody’s on Under Review.
 Fitch on Rating Watch.

04/22/2020 140
CREDIT RATINGS
 It measures the ability of the issuers to meet
its commitments on time
 It depends on
 Analysisof the issuer’s financial condition and
management
 The features of the debt security .
 The specified revenue sources backing the issue

04/22/2020 141
RATINGS (CONT…)
 Agencies consider the following
 Ability of the issuer to generate cash flows in the
future
 The level and predictability of future cash flows
relative to the commitments on debt
 Survey done by Moody’s using data for the period
1920 to 2001
 Showed that the average one year default rate for
Aaa bonds was zero
 However for B rated bonds it was 6.8%
 In a 10-year period only 0.82% of Aaa bonds missed a
payment
 For B rated bonds however the figure was 43.90%

04/22/2020 142
BOND INSURANCE
 A company can have its issue insured to
enhance its credit quality.
 An insurance premium will have to be paid, but
the coupon rate will come down.
 The insurance company will guarantee the
timely payment of the principal and interest.

04/22/2020 143
INSURED BONDS
 Insured bonds will receive a rating based on
the insurer’s capital and claims-paying
ability.
 In the U.S., the buyer of an uninsured bond
can buy insurance for his portfolio

04/22/2020 144
INSURED BONDS (CONT…)
 The guarantee provided by insurance
companies is unconditional and irrevocable
 There
will be no repercussions if the issue gets
downgraded subsequently
 Issuers of insured bonds
 Get funds at reduced rates
 Get a diversified pool of investors
 Investors in such bonds
 Get an assurance of timely payments
 Benefit of extensive credit analysis
 Due diligence by the insurer
 Post issuance monitoring by the insurer

04/22/2020 145
INSURED BONDS (CONT…)
 Insurance facilities provide debt market
access to less well known issuers
 The broaden the market for issuers with
better credit ratings
 They facilitate cross-border fund raising

04/22/2020 146
LIQUIDITY RISK

04/22/2020 147
LIQUIDITY RISK
 The possibility that the market may be
illiquid or thin
 When the asset holder wants to buy or sell the
security.
 A liquid market is characterized by a sizeable
number of buyers and sellers

04/22/2020 148
ILLIQUID MARKETS
 In illiquid markets, buyers will have to offer
a large premium over the fair value
 Whereas sellers will have to accept large
discounts at the time of sale.
 Illiquid markets are characterized by large
bid-ask spreads
 Because trades will be few and far between.

04/22/2020 149
MEASURING IMPACT COST
 We usually define the fair price of a security
as the average of the best bid and the best
ask
 For we know it falls somewhere between
 The impact cost measures the extent by
which an order of a given size moves the
market

150
IMPACT COST (CONT…)
 When an order is executed we compute the
weighted average price.
 Assume that a buy order for 1000 shares got
executed as follows
 200 shares at 100
 300 shares at 101.50
 500 shares at 101
 The WAP is 100.95

151
IMPACT COST (CONT…)
 Assume that prior to entry the best bid was
99 and the best ask was 100
 The fair price is 99.50
 The impact cost is defined as (WAP – FP) ÷ FP
 Had it been a sell order we would have
defined it as (FP – WAP) ÷ FP

152
IMPACT COST (CONT…)
 The impact cost depends on the direction of
the order
A sell order for 500 shares will usually not have
the same impact as a buy order for 500 shares
 It also depends on the order size
A buy order for 500 shares will have a different
impact than a buy order for 1000 shares
 Higher the liquidity in the market lower will
be the impact of an order of a specified size

153
INTEREST RATE RISK

04/22/2020 154
INTEREST RATE RISK
 The interest rate or yield is the key variable
of interest in debt markets.
 Interest rate risk is the risk that rates may
move in an adverse fashion

04/22/2020 155
INTEREST RATE RISK
 Interest rate risk impacts fixed income
securities in two ways.
 All
bonds with the exception of zeroes pay
coupons
 These have to be reinvested.
 Reinvestment risk is the risk that market rates
of interest may decline before a coupon is
received.
 If so, the coupon will have to be reinvested at a
lower than anticipated rate of interest.

04/22/2020 156
INTEREST RATE RISK (CONT…)
 Secondly a bond may not be held to
maturity.
 Ifit is sold prior to maturity, it will have to be at
the prevailing market price
 This will be inversely related to the prevailing yield.

04/22/2020 157
INTEREST RATE RISK (CONT…)
 Market Risk or Price Risk, is the risk that
interest rates may be higher than anticipated
 in
which case the bond will have to be sold at a
lower than anticipated price.
 The two risks work in opposite directions.
Reinvestment risk arises because rates
may fall subsequently
Market risk arises because rates may rise
subsequently.

04/22/2020 158
INFLATION RISK

04/22/2020 159
INFLATION RISK
 Inflation is the erosion in the purchasing
power of money.
 Most bonds promise fixed cash flows in dollar
terms.
 Inflationrisk is the risk that the purchasing
power may have eroded more than expected
 By the time the cash flow from the bond is
received.

04/22/2020 160
INFLATION RISK (CONT…)
 High inflation will reduce the effective or
Real rate of interest.
 The interest rate in monetary terms is called the
Nominal Rate of interest.
 The Real Rate, is the nominal rate adjusted for
changes in the purchasing power.

04/22/2020 161
INFLATION RISK (CONT…)
 From the Fisher Equation:
(1+R) = (1+r)(1+)
R  Nominal rate
r  real rate
  inflation rate

04/22/2020 162
INDEXED BONDS
 These are bonds whose coupons are linked to
a price index.
 Price indices are a barometer of changes in the
purchasing power of a currency.
 If inflation is high, so will be the index level and
vice versa.

04/22/2020 163
INDEXED BONDS (CONT…)
 Thus indexed bonds will offer higher cash
flows during times of high inflation
 And relatively lower cash flows during
periods of lower inflation
 Thiswill ensure that the cash flow in real terms
is kept at a virtually constant level.

04/22/2020 164
TIMING RISK

04/22/2020 165
TIMING RISK
 For Plain Vanilla bonds, there is no
uncertainty about the timing of inflows
 However, callable bonds can be recalled
at any time.
 For a callable bond holder there is cash
flow uncertainty
 He is unsure as to how many coupons he is going
to get
 And also as to when the face value will be
repaid.

04/22/2020 166
TIMING RISK (CONT…)
 Thus holders of callable bonds will demand a
premium for bearing this risk.
 Thatis why callable bonds trade at a lower price
than comparable plain vanilla bonds.

04/22/2020 167
FOREX RISK

04/22/2020 168
FOREIGN EXCHANGE RISK
 This risk arises when the cash flows from a
bond are denominated in a foreign currency.
 If the foreign currency depreciates in value
with respect to the home currency
 The returns will be lower than anticipated.

04/22/2020 169
ILLUSTRATION
 A bond promises to pay a coupon of $10
every six months.
 Assume that the rate of exchange is Rs 65
per dollar.
 So an Indian bondholder will expect to receive Rs
650 every six months.
 However, what if the exchange rate at
the time of the coupon payment is Rs 55.
 If so, he will receive only Rs 550.

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