FIXED INCOME SECURITIES - INTRODUCTION Ritesh Nandwani Faculty, NISM
INTRODUCTION 25-05-2018 2
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 25-05-2018 3
WHAT IS FIXED INCOME SECURITY 25-05-2018 4
WHAT IS FIXED INCOME SECURITY 25-05-2018 5
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 25-05-2018 6
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 25-05-2018 7
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 25-05-2018 8
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 25-05-2018 9
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 25-05-2018 10
PRICING & YIELD 25-05-2018 11
PRICING OF BONDS 25-05-2018 12
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 25-05-2018 13
PRICE YIELD RELATIONSHIP 25-05-2018 14
PRICE YIELD RELATIONSHIP 25-05-2018 15
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 25-05-2018 16
FACTORS AFFECTING YIELDS, & YIELD CURVE 25-05-2018 17
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
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 25-05-2018 19
YIELD CURVES 20
A FLAT YIELD CURVE 21
BOND PRICE VOLATILITY & DURATION 25-05-2018 22
NEED OF A PARAMETER TO MEASURE RISK 25-05-2018 23
BOND PRICE VOLATILITY / INTEREST RATE RISK Price Volatility on account of changes in interest rates Refer Excel Illustration 25-05-2018 24
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 25-05-2018 25
MEASURING BOND PRICE VOLATILITY Full Valuation Approach Duration and Convexity 25-05-2018 26
FULL VALUATION APPROACH 25-05-2018 27
FULL VALUATION APPROACH - FOR A PORTFOLIO 25-05-2018 28
FULL VALUATION APPROACH 25-05-2018 29
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 25-05-2018 30
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 25-05-2018 31
MACAULAY DURATION - EXAMPLE 25-05-2018 32
MACAULAY DURATION - VISUALISATION 25-05-2018 33
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 25-05-2018 34
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 25-05-2018 35
MODIFIED DURATION 25-05-2018 36
CONVEXITY 25-05-2018 37
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 25-05-2018 38
WHERE DOES DURATION COME FROM 25-05-2018 39
WHERE DOES DURATION COME FROM 25-05-2018 40
DOLLAR DURATION & PRICE VALUE OF A BASIS POINT 25-05-2018 41
DOLLAR DURATION AND PVBP 25-05-2018 42
DURATION & CONVEXITY OF A PORTFOLIO 25-05-2018 43
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 ) 25-05-2018 44
LIMITATIONS OF DURATION & CONVEXITY 25-05-2018 45
LIMITATIONS OF DURATION & CONVEXITY 25-05-2018 46
LIMITATIONS OF DURATION & CONVEXITY 25-05-2018 47
BONDS WITH EMBEDDED OPTIONS PRICE YIELD RELATIONSHIP OF A CALLABLE BOND 25-05-2018 48
BONDS WITH EMBEDDED OPTIONS PRICE YIELD RELATIONSHIP OF A PUTTABLE BOND 25-05-2018 49
THANK YOU 25-05-2018 50