FIXED INCOME SECURITIES - INTRODUCTION. Ritesh Nandwani Faculty, NISM

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1 FIXED INCOME SECURITIES - INTRODUCTION Ritesh Nandwani Faculty, NISM

2 INTRODUCTION

3 WHAT IS FIXED INCOME SECURITY A contractual agreement between the investor and the issuer, wherein the investor loans money to the issuer that borrows the funds for a defined period of time at a fixed interest rate

4 WHAT IS FIXED INCOME SECURITY

5 WHAT IS FIXED INCOME SECURITY

6 BASIC FEATURES & TERMINOLOGIES Pricing Face Value / Principal Issue Price Redemption Value Interest Zero Coupon / Coupon bearing Bonds Coupon Rate (Fixed/Floating) Coupon Frequency Tenure Single Repayment Amortization Embedded Options Call / Put Conversion

7 TYPES OF FIS Issuer Maturity Coupon Option Redemptio n Govt. Short term Zero coupon Plain vanila Single Govt. Bodies Medium term Fixed Rate Conversion Amortising PSUs Long term Floating Rate Call Banks / FIs Perpetual Put Corporates

8 FIS VS. EQUITY PARAMETERS EQUITY DEBT Ownership Owners Lenders Risk High Risk Low Risk Return Variable Fixed (generally) Maturity Perpetual Fixed (generally) Liquidation Hierarchy Last preference First preference Voting Rights Yes No

9 KEY PARTICIPANTS Issuers Govt. & Govt. Bodies/Authorities Banks/FIs Corporates Investors Institutional Investors Banks, FIs., MFs, Insurance Companies, PFs, Pension Funds, FPIs, etc. Corporates Individual Investors Intermediaries Merchant Banks / Primary Dealers Stock Exchanges Debenture Trustees Credit Rating Agencies Brokers / Market makers

10 FIS ISSUERS IN INDIA Government Government Securities (G-Secs) Treasury bills (T-bills) Bonds issued by State Govt.s & UTs (SDLs) Government Authorities Bonds issued by Govt. Controlled Institutions and PSUs Bonds issued by Local Bodies and Municipalities (Municipal Bonds) Banks / Financial Institutions Bonds/NCDs CPs/CDs Corporates Bonds/Debentures Preference Shares

11 PRICING & YIELD

12 PRICING OF BONDS

13 YIELD TO MATURITY (YTM) YTM - An IRR or an interest rate that equates PV of all future CFs of a bond to the current price of the bond

14 PRICE YIELD RELATIONSHIP

15 PRICE YIELD RELATIONSHIP

16 FACTORS AFFECTING BOND PRICES Coupon Direct relationship between coupon and Bond price Interest rates on comparable bonds (Yield) Depends on various factors - Credit quality, Liquidity, Embedded options, Tenure, etc. Inverse relationship between interest rates and Bond price Tenor For zero coupon bonds, inverse relationship (assuming a flat or an upward sloping yield curve) For coupon bonds, relationship would depend on coupon rate and yield Embedded Option Value of a callable bond = Value of similar plain vanilla bond - Value of the call option Value of a putable bond = Value of similar plain vanilla bond + Value of the put option Value of bond with conversion option = Value of similar plain vanilla bond + Value of the conversion option

17 FACTORS AFFECTING YIELDS, & YIELD CURVE

18 WHY DIFFERENT YIELDS? Yield of a bond depends upon various factors: Type of issuer Perceived Credit risk Term of the issue Embedded options Tax aspects Expected liquidity 18

19 TERM STRUCTURE OF INTEREST RATES Term Structure of Interest Rates - Graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities

20 YIELD CURVES 20

21 A FLAT YIELD CURVE 21

22 BOND PRICE VOLATILITY & DURATION

23 NEED OF A PARAMETER TO MEASURE RISK

24 BOND PRICE VOLATILITY / INTEREST RATE RISK Price Volatility on account of changes in interest rates Refer Excel Illustration

25 BOND PRICE VOLATILITY - KEY CHARACTERISTICS Inverse relationship between price and yield (interest rates) For a small change in yield, price increase (on account of reduction in interest rates) and price decrease (on account of same increase in interest rates) are roughly same For a large change in yield, price increase (on account of reduction in interest rates) is higher than the price decrease (on account of same increase in interest rates) The higher the Maturity, the higher will be the price volatility The lower the Current yield, the higher will be the price volatility The lower the Coupon rate, the higher will be the price volatility

26 MEASURING BOND PRICE VOLATILITY Full Valuation Approach Duration and Convexity

27 FULL VALUATION APPROACH

28 FULL VALUATION APPROACH - FOR A PORTFOLIO

29 FULL VALUATION APPROACH

30 DURATION Duration of a Bond measures the sensitivity of bond s price to changes in interest rates or, more specific, to changes in Bond s YTM

31 MACAULAY DURATION A weighted average of time to receipts of bonds future cash flows, where the weights are present values of the future cash flows

32 MACAULAY DURATION - EXAMPLE

33 MACAULAY DURATION - VISUALISATION

34 MODIFIED DURATION Modified duration provides an estimate of % change in price for a given change in yield % change in price = (-Modified Duration * change in yield in %) Example: If a bond has a Modified Duration of 4.5, then a 1% increase/decrease in yield would result in 4.5% decrease/increase in price Modified duration provides only a linear estimate of % change in price and ignores the convexity of price curve

35 MODIFIED DURATION Modified duration (Duration) provides an estimate of % change in price for a given change in yield Duration is an approximation of risk. changes in prices for changes in yield P (as estimated using duration) captures the linear

36 MODIFIED DURATION

37 CONVEXITY

38 PROPERTIES OF DURATION Macaulay Duration of a Zero coupon bond is always same as its maturity For a coupon paying bond, Macaulay Duration would be lesser than its maturity The greater the coupon, the lower would be the Duration, and vice-versa The price estimated by the duration would always be an under-estimate, because of positive convexity of bonds For a small change in interest rate, the price estimated by duration would be closer to the actual price If interest rates changes are big, the price estimated by duration would be farther from actual price The lower the current yield of the bond, the higher would be the duration Further, as interest rates fall, the duration of the bond would rise

39 WHERE DOES DURATION COME FROM

40 WHERE DOES DURATION COME FROM

41 DOLLAR DURATION & PRICE VALUE OF A BASIS POINT

42 DOLLAR DURATION AND PVBP

43 DURATION & CONVEXITY OF A PORTFOLIO

44 ESTIMATING PRICE CHANGE USING DURATION & CONVEXITY Using Duration % change in price = (-Modified Duration * change in yield in %) Using Both Duration & Convexity % change in price = (-Modified Duration * change in yield in %) + (1/2 * Convexity Measure * (change in yield in %) 2 )

45 LIMITATIONS OF DURATION & CONVEXITY

46 LIMITATIONS OF DURATION & CONVEXITY

47 LIMITATIONS OF DURATION & CONVEXITY

48 BONDS WITH EMBEDDED OPTIONS PRICE YIELD RELATIONSHIP OF A CALLABLE BOND

49 BONDS WITH EMBEDDED OPTIONS PRICE YIELD RELATIONSHIP OF A PUTTABLE BOND

50 THANK YOU

BOND ANALYTICS. Aditya Vyas IDFC Ltd.

BOND ANALYTICS. Aditya Vyas IDFC Ltd. BOND ANALYTICS Aditya Vyas IDFC Ltd. Bond Valuation-Basics The basic components of valuing any asset are: An estimate of the future cash flow stream from owning the asset The required rate of return for