Fundamentals of Investment

Prof. Avanish Goel

UNIT 2: FIXED INCOME SECURITIES
FIXED INCOME SECURITIES - Introduction
• Fixed Income, as the name suggests, is an investment avenue wherein the investor gets
predictable returns at set intervals of time.
• This investment class is relatively safe with low volatility and forms an ideal investment
option for people looking at fixed returns with low default risk, e.g., retired individuals.
• Simply it is an investment that provides a return in the form of fixed periodic payments
and the eventual return of principal at maturity.
• Generally, these types of assets offer a lower return on investment because they
guarantee income.
• Fixed maturity period ranging from as low as 91 days to 30 years.
• Specified “coupon” or interest rate.
• Generally issued at a discount to face value and the investor profits from the difference in the
issue and redeemed price
• The payments of a fixed-income security are known in advance.
• Example - 5% fixed-rate government bond where a RS.1,000 investment would result in an annual
RS.50 payment until maturity when the investor would receive the RS.1,000 back
ADVANTAGES OF FIXED INCOME SECURITIES
• Lower volatility than other asset classes providing stable returns.
• Higher returns than traditional bank fixed deposits.
• Predictable and stable returns offer hedge against the volatility and
risk of equity investments, and thus allow an investor to create a
diversified portfolio
DISADVANTAGES OF FIXED INCOME SECURITIES
• Low liquidity: investors‟ money is locked for full maturity period
unless the security is traded in the secondary market.
• Not actively traded: this lack of competition prevents their prices
rising very high.
• Sensitivity to market interest rate: change in market interest rate
changes the yield on held securities.
Terms associated with Fixed Income Securities
• The issuer
• It is the entity (company or government) who borrows the money by issuing the bond, and is due to pay
interest and repay capital in due course.
• The principal of a bond
• It is also known as maturity value, face value, par value – is the amount that the issuer borrows which
must be repaid to the lender.
• The coupon
• It is the annual interest that the issuer must pay, expressed as a percentage of the principal.
• The maturity
• It is the end of the bond, the date that the issuer must return the principal.
PARTICIPANTS IN THE DEBT MARKETS
• Debt markets are pre-dominantly wholesale markets, with dominant institutional
investor participation.
• The investors in the debt markets concentrate in banks, financial institutions, mutual
funds, provident funds, insurance companies and corporates.
• Many of these participants are also issuers of debt instruments.
• Most debt issues are privately placed or auctioned to the participants.
• Secondary market dealings are mostly done on telephone, through negotiations.
• In some segments such as the government securities market, market makers in the form
of primary dealers have emerged, who enable a broader holding of treasury securities.
• Debt funds of the mutual fund industry, comprising of liquid funds, bond funds and gilt
funds, represent a recent mode of intermediation of retail investments into the debt
markets, apart from banks, insurance, provident funds and financial institutions, who
have traditionally been major intermediaries of retail funds into debt market products.
PARTICIPANTS IN THE DEBT MARKETS
1. Central Governments, raising money through bond issuances, to fund
budgetary deficits and other short and long term funding requirements.
2. 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.
3. 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.
PARTICIPANTS IN THE DEBT MARKETS
4. 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.
5. 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.
6. 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 market.
7. 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
OTHER PARTICIPANTS IN THE DEBT MARKETS
1. Mutual funds have emerged as another important player in the debt markets, owing
primarily to the growing number of bond funds that have mobilized significant
amounts from the investors. Most mutual funds also have specialized bond funds such
as gilt funds and liquid funds. 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.
2. Foreign Institutional Investors are permitted to invest in Dated Government Securities
and Treasury Bills within certain specified limits.
3. Provident funds are large investors in the bond markets, as the prudential regulations
governing the deployment of the funds they mobilize, 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
4. 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.
Types of bonds Based on Issuer
• Issuers of Corporate Bonds can be broadly classified in following
classes:
1. Bonds issued by Local Bodies
2. Bonds issued by Public Sector Units
3. Bonds issued by Financial Institutions
4. Bonds issued by Banks
5. Bonds issued by Corporates
Based on Maturity Period
• Short Term Maturity: - Security with maturity period less than one
year.
• Medium Term: - Security with maturity period between 1year and 5
year.
• Long Term Maturity: Such securities have maturity period more than
5 years
• Perpetual: - Security with no maturity. Currently, in India Banks issue
perpetual bond
Based on Coupon

• Fixed Rate Bonds:-have a coupon that remains constant throughout

the life of the bond.
• Floating Rate Bonds: - Coupon rates are reset periodically based on
benchmark rate.
• Zero-coupon Bonds:- No coupons are paid. The bond is issued at a
discount to its face value, at which it will be redeemed. There are no
intermittent payments of interest
Based on Option
• Bond with call option: - This feature gives a bond issuer the right, but
not the obligation, to redeem his issue of bonds before the bond's
maturity at predetermined price and date.

• Bond with put option: - This feature gives bondholders the right but
not the obligation to sell their bonds back to the issuer at a
predetermined price and date. These bonds generally protect
investors from interest rate risk.
Based on redemption
• Bonds with single redemption: - In this case principal amount of
bond is paid at the time of maturity only.

• Amortising Bonds: - A bond, in which payment made by the borrower

over the life of the bond, includes both interest and principal, is called
an amortizing bond
Bond yields
1. Current yield
2. Yield to maturity (YTM)
3. Nominal Yield
4. Realized Yield
1. Current yield
• This is the yield or return derived by the investor on purchase of the
instrument (yield related to purchase price).
• It is calculated by dividing the coupon rate by the purchase price of
the bonds.
• Current Yield = Annual Interest / Market Price
• For example 10% interest bond selling at 80 has a current yield of
= 10/80x100 = 12.5%
2. Yield to maturity (YTM)
• The yield or the return on the instrument is held
till its maturity is known as the Yield-to maturity
(YTM).
• Given a pre-specified set of cash flows and a price,
the YTM of a bond is that rate which equates the
discounted value of the future cash flows to the
present price of the bond. It is the internal rate of
return of the valuation equation.
• When we compute YTM as the rate that discounts
all the cash flows from the bond, at the same YTM
rate, what we are assuming in effect is that each of • Where n = number of years
these cash flows can be re-invested at the YTM
rate for the period until maturity. • PV = Par value

• For example
• A bond with a face value of RS.2000 is currently trading
at 1600.the coupon rate is 9%.maturity period is 8 years
.if we calculate the above problem using the above
formula the answer will be 13.2%
3. Nominal Yield
• The nominal yield on a bond is simply the percentage of interest to be
paid on the bond periodically.
• It is calculated by dividing the annual coupon payment by the par
value of the bond.
• It is important to note that the nominal yield does not estimate
return accurately unless the current bond price is the same as its par
value.
• E.g. If coupon rate is 10% then nominal yield is 10%.
4. Realized Yield
• The realized yield of a bond is calculated when an investor plans to
hold a bond only for a certain period of time, rather than to maturity.
In this case, the investor will sell the bond, and this projected future
bond price must be estimated for the calculation.
• Because future prices are hard to predict, this yield measurement is
only an estimation of return.
Bond Valuation
• The value of a financial instrument is well understood as the present value of the
expected future cash flows from the instrument.
• In case of a plain vanilla bond, which we will first see, before understanding the
variations, the cash flows are pre-defined.
• The cash flows expected from a bond, which is not expected to default are primarily
made up of
(i) coupon payments and
(ii) Redemption of principal.
• The actual dates on which these cash flows are expected are also known in advance, in
the case of a simple non-callable bond.
• Therefore, valuation of a bond involves discounting these cash flows to the present point
in time, by an appropriate discount rate.
• The key issue in bond valuation is this rate the rate we would use is the “required rate”
on the bond, representing a rate that we understand is available on a comparable bond
(comparable in terms of tenor and risk).
Risks of investing in a bond
• Interest rate risk
• Reinvestment Risk
• Call Risk
• Default Risk
• Inflation Risk
• Liquidity Risk
Interest rate risk
• The risk that bond prices will fall as interest rates rise.
• By buying a bond, the bondholder has committed to receiving a fixed
rate of return for a fixed period.
• Should the market interest rate rise from the date of the bond's
purchase, the bond's price will fall accordingly.
• The bond will then be trading at a discount to reflect the lower return
that an investor will make on the bond.
Reinvestment Risk
• The risk that the proceeds from a bond will be reinvested at a lower
rate than the bond originally provided.
• For example, imagine that an investor bought a Rs1,000 bond that had an
annual coupon of 12%.
• Each year the investor receives Rs120 (12%*Rs1,000), which can be
reinvested back into another bond.
• But imagine that over time the market rate falls to 1%. Suddenly, that Rs 120
received from the bond can only be reinvested at 1%, instead of the 12% rate
of the original bond
Call Risk
• The risk that a bond will be called by its issuer.
• Callable bonds have call provisions, which allow the bond issuer to
purchase the bond back from the bondholders and retire the issue.
• This is usually done when interest rates have fallen substantially since
the issue date.
• Call provisions allow the issuer to retire the old, high-rate bonds and
sell low-rate bonds in a bid to lower debt costs.
Default Risk
• The risk that the bond's issuer will be unable to pay the contractual
interest or principal on the bond in a timely manner, or at all.
• Credit ratings services such as Moody's, Standard & Poor's and Fitch
give credit ratings to bond issues, which helps to give investors an
idea of how likely it is that a payment default will occur.
• For example, most federal governments have very high credit ratings (AAA);
they can raise taxes or print money to pay debts, making default unlikely.
• However, small, emerging companies have some of the worst credit (BB and
lower).
• They are much more likely to default on their bond payments, in which case
bondholders will likely lose all or most of their investment.
Inflation Risk
• The risk that the rate of price increases in the economy deteriorates
the returns associated with the bond.
• This has the greatest effect on fixed bonds, which have a set interest
rate from inception.
• For example, if an investor purchases a 5% fixed bond and then inflation rises
to 10% a year, the bondholder will lose money on the investment because the
purchasing power of the proceeds has been greatly diminished.
• The interest rates of floating-rate bonds (floaters) are adjusted
periodically to match inflation rates, limiting investors' exposure to
inflation risk
Liquidity Risk
• While there is almost always a ready market for government bonds,
corporate bonds are sometimes entirely different animals.
• There is a risk that an investor might not be able to sell his or her
corporate bonds quickly due to a thin market with few buyers and
sellers for the bond.
• Low interest in a particular bond issue can lead to substantial price
volatility and possibly have an adverse impact on a bondholder's total
return (upon sale).
• Much like stocks that trade in a thin market, you may be forced to
take a much lower price than expected to sell your position in the
bond.
Bond rating
• A grade given to bonds that indicates their credit quality.
• The credit rating is a financial indicator to potential investors of debt
securities such as bonds
• Private independent rating services such as Standard & Poor's, Moody's
and Fitch provide these evaluations of a bond issuer's financial strength, or
its the ability to pay a bond's principal and interest in a timely fashion.
• Credit rating is a highly concentrated industry with the two largest rating
agencies — Moody's Investors Service, Standard & Poor's — having 80%
market share globally, and the "Big Three" credit rating agencies —
Moody's, S&P and Fitch Ratings — controlling approximately 95% of the
ratings business
 Bond rating
Standard &
Moody's Fitch Credit worthiness
Poor's
Aaa AAA AAA An obligor has EXTREMELY STRONG capacity to meet its financial commitments.
Aa1 AA+ AA+
An obligor has VERY STRONG capacity to meet its financial commitments. It differs from the highest rated obligors only in
Aa2 AA AA
small degree.
Aa3 AA- AA-
A1 A+ A+
An obligor has STRONG capacity to meet its financial commitments but is somewhat more susceptible to the adverse
A2 A A
effects of changes in circumstances and economic conditions than obligors in higher-rated categories.
A3 A- A-
Baa1 BBB+ BBB+
An obligor has ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing
Baa2 BBB+ BBB+
circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.
Baa3 BBB- BBB-
Ba1 BB+ BB+ An obligor is LESS VULNERABLE in the near term than other lower-rated obligors. However, it faces major ongoing
Ba2 BB BB uncertainties and exposure to adverse business, financial, or economic conditions which could lead to the obligor's
Ba3 BB- BB- inadequate capacity to meet its financial commitments.
B1 B+ B+ An obligor is MORE VULNERABLE than the obligors rated 'BB', but the obligor currently has the capacity to meet its
B2 B B financial commitments. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or
B3 B- B- willingness to meet its financial commitments
An obligor is CURRENTLY VULNERABLE, and is dependent upon favourable business, financial, and economic conditions to
Caa CCC CCC meet its financial commitments
Ca CC CC An obligor is CURRENTLY HIGHLY- VULNERABLE.
The obligor is CURRENTLY HIGHLY- VULNERABLE to nonpayment. May be used where a bankruptcy petition has been filed.
C C
C D D An obligor has failed to pay one or more of its financial obligations (rated or unrated) when it became due.
Preliminary ratings may be assigned to obligations pending receipt of final documentation and legal opinions. The final
e,p pr Expected rating may differ from the preliminary rating.
Rating withdrawn for reasons including: debt maturity, calls, puts, conversions, etc., or business reasons (e.g. change in the
WR size of a debt issue), or the issuer defaults.