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Debt - Investment Drivers & Approaches

The document discusses various aspects of debt investment including risks, yield curves, and portfolio structuring. It provides the following key points: - The two main risks of debt investment are market risk and credit risk. Market risk is the risk of fluctuations in bond yields affecting portfolio value, while credit risk is the risk of default by the issuer. - The yield curve shows the relationship between bond yields and maturity dates, and can be normal, flat, or inverted depending on the market's expectations of future interest rates. It is traditionally constructed using government bond yields to eliminate credit risk. - The spot or zero-coupon yield curve constructed from zero-coupon bond yields solves problems with coupon-bearing bonds and shows true

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Misba Khan
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33 views

Debt - Investment Drivers & Approaches

The document discusses various aspects of debt investment including risks, yield curves, and portfolio structuring. It provides the following key points: - The two main risks of debt investment are market risk and credit risk. Market risk is the risk of fluctuations in bond yields affecting portfolio value, while credit risk is the risk of default by the issuer. - The yield curve shows the relationship between bond yields and maturity dates, and can be normal, flat, or inverted depending on the market's expectations of future interest rates. It is traditionally constructed using government bond yields to eliminate credit risk. - The spot or zero-coupon yield curve constructed from zero-coupon bond yields solves problems with coupon-bearing bonds and shows true

Uploaded by

Misba Khan
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© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 26

DEBT - INVESTMENT

DRIVERS &
APPROACHES
Chapter 3

Risks from debt investment


Market risk
Risk of fluctuation in bond yields which will lead to change in value
of the bond portfolio
Risk measures such as modified duration are used to understand
the impact of changes in yields on the value of the portfolio
Credit risk
Risk of default by the issuer of the debt security

The Yield Curve


A graph of the yield to maturity and maturity dates of various

benchmark bonds is known as the yield curve


Shows the markets expectations regarding future interest
rates given current market conditions
Bonds of the same class of issuer or same degree of liquidity
are used to plot the yield curve
Generally constructed from government bonds because these
are default-free securities and have uniform credit-worthiness
Also government bonds are the most liquid bonds in any
country
Yield curve constructed from yields of government bonds is
known as the sovereign yield curve and is the benchmark for
setting yields in other areas of debt market

Shapes of the Yield Curve


The normal shape of the
yield curve is upward
sloping indicating that
investors expect higher
returns for investing for
longer maturities because
of the higher risk involved

A flat yield curve indicates


uncertainty regarding
future direction of interest
rates
Inverted yield curve may
signal beginning of an
economic slowdown

Constructing the Yield Curve


The yield curve is traditionally constructed using yields of coupon

bearing securities
Consider two securities issued by the same issuer at different points
of time
Security A: Coupon: 6%, term to maturity: 10 years
Security B: Coupon: 11%, term to maturity: 10 years
These securities are not comparable because
The pattern of cash flows is different
The tax treatment may be different

Because of these differences we cannot use Security A as a

benchmark for pricing Security B


Coupon-bearing securities also have re-investment risk which is
uncertainty regarding the rate at which interim cash flows can be reinvested

The spot rate curve


The problems of using coupon-bearing bonds to construct

the yield curve led to the creation of the spot rate curve
Also known as the zero-coupon yield curve
Constructed from the yields of zero-coupon securities
Two zero-coupon securities with the same maturity are
entirely comparable because of the absence of coupon
Zero-coupon securities do not present any re-investment
risk
There is no differential tax treatment in the hands of
investors

Construction of spot rate curve


In practice zero-coupon securities are generally issued

with a maturity of up to one year


Hence observed yields of zero-coupon securities and
coupon-bearing bonds are used to construct the spot rate
curve
This process is known as boot-strapping
Example: The following securities are traded in the market
Security

Coupon

Price (Rs)

YTM

6-month T-Bill

96.15

0.080

1-year T-Bill

92.19

0.083

1.5-year bond

0.085

99.45

0.089

2-year bond

0.09

99.64

0.092

Bootstrapping process
Given the traded prices of the 6-month T-Bill, 1-year T-bill

and the 1.5 year coupon-bond, the zero-coupon yield for


1.50 years is computed as:
Period

Cash flow Disc factor PV of


cash
flow

0.5 years

4.25

0.9615

4.09

1 year

4.25

0.9219

3.92

1.5 years

104.25

Each cash flow is discounted


at the zero-coupon yield for
that period
Since the market price of the
1.5 year bond is Rs.99.45, the
present value of its cash flows
should be equal to Rs.99.45

Solving for z, we get z = 4.465%


Doubling this we get the 1.5 year zero-coupon yield as 8.93%

Uses of the Spot rate curve


The yield on a zero-coupon bond of n years to maturity is

viewed as the true n-year interest rate because there is


no re-investment risk involved
The spot rate or the zero-coupon rate is the annualized
rate receivable on maturity for a deposit starting from
today
The spot rate curve can be used for:
Computing implied forward rates
Determining the relative value of traded bonds
Pricing new issues

Term structure of interest rates


The spot rate curve is also known as the term structure of

interest rates
Year

Spot
Rate %

8.00

8.50

9.00

9.50

10.00

The table shows the spot rates for


various maturities
An investment for a period of 3
years starting today will return 9%

What will be the return on a oneyear investment made 1 year


from today?

Return on 1-year investment starting 1 year from


today
A person who wants to invest for 2 years can either
Invest directly for two years starting from today (at the 2-year spot
rate of 8.50%) or
He can first invest for one year at the 1-year spot rate of 8% and
then roll over this investment for a further period of one year
The return from both these strategies should be equal otherwise
there is an arbitrage opportunity
It means
Hence = 0.09
We can verify that
Thus we can work out the forward rates for different

periods

Forward rates
Forward rates are simply rates for a period starting in the

future
Thus if we know the 2-year spot rate and 3-year spot rate
we can work out the 1-year rate starting 2 years from now
This means
Hence = 10%
The table shows the rate for a oneyear investment starting 1 year from
today, 2 years from today, 3 years
from today and 4 years from today

Portfolio duration

Portfolio weightage
Durati Portfolio1
Portfolio Portfolio 3
on
2
0.0833
14%
2%
6%
0.25
13%
2%
0.5
11%
2%
1
11%
2%
2
15%
25%
3
25%
65%
5
14%
7
10%
10
14%
7%
29%
12
12%
6%
15
10%
5%
Portfol
4.85
4.86
4.85
io
Durati
on

The duration of each portfolio is the


weighted average of the duration of all
securities in that portfolio
The SUMPRODUCT function in Excel
can be used to calculate the portfolio
duration

The duration of 4.85 means that the value of each portfolio will
change by 4.85% if market yields of all securities change by 1%

Different portfolio structures


The portfolio duration is a correct measure of sensitivity

only if the yields of all bonds move by the same number of


basis points
This is known as a parallel shift in the yield curve
More often the yield curve shifts in a non-parallel manner,
i.e. it either steepens or flattens
The impact of change in yields of a particular maturity on
the portfolio value can be worked out by multiplying the
duration of that security by its weight in the portfolio

Portfolio structures

Portfolio weightage Weightage X Duration


Durati Portfol Portfol Portfoli Portfoli Portfoli Portfoli
on
io1
io 2
o3
o1
o2
o3
0.0833
14%
2%
6%
0.01
0.00
0.00
0.25
13%
2%
0.03
0.01
0.00
0.5
11%
2%
0.06
0.01
0.00
1
11%
2%
0.11
0.02
0.00
2
15%
25%
0.30
0.50
0.00
3
25%
65%
0.00
0.75
1.95
5
14%
0.00
0.70
0.00
7
10%
0.00
0.70
0.00
10
14%
7%
29%
1.40
0.70
2.90
12
12%
6%
1.44
0.72
0.00
15
10%
5%
1.50
0.75
0.00
Portfol
4.85
4.86
4.85
4.85
4.86
4.85
io
Durati
on

Portfolio 1 is biased towards the longterm and will have a big impact if longterm yields change
This is known as a bullet portfolio
The impact on portfolio 2 will be evenly
distributed across all maturities
This is a ladder portfolio
Portfolio 3 is concentrated in 2
maturities 3-year and 10-year
This is a barbell portfolio

Debt fund managers change the structure of the portfolio according to


anticipated changes in the yield curve structure

Credit Risk
Credit risk can arise from
Holding of sovereign bonds
Holding of debt issued by private sector entities
Assessment of credit risk requires assessment of the

ability of the issuer to service the debt

Debt-servicing ability of sovereign entities


Can be assessed from the economic strength of the

country indicated by
Countrys Gross Domestic Product (GDP)
Income distribution
Political stability
Economic stability, law and order
Budget deficit as percentage of GDP
Balance of Payments
Current Account deficit as percentage of GDP
Foreign exchange reserves
Demographics

Debt-servicing ability of private entities


Can be assessed from information contained in financial

statements
Analysis of key financial ratios
Parameters to be assessed
Solvency
Coverage
Financial structure

Solvency ratios
Assets

2015

2014

Inventories

7837

7360

Sundry Debtors

1722

2165

Cash & Bank Balance

7589

3289

17148

12814

Quick Assets ( b)

9311

5454

Current liabilities (c)

7214

6922

Current Ratio

2.38

1.85

1.29

0.79

Total current assets (a)

(a) / (c)

Quick ratio (b)/(c)

Current ratio defined as ratio of current


assets to current liabilities
Acceptable ratio: 1.33:1

Quick ratio defined as ratio of current assets excluding


inventories and prepaid expenses to current liabilities
Acceptable ratio: 1:1

Coverage ratios

P&L Head

2015

2014

15017

13562

(a)

EBITDA

(b)

Depreciation

957

900

(c)

Amortization

57

(d)
Interest
( e) = (a-b-cd)
EBIT
Interest Coverage ratio

( e/d)
Debt Service Coverage

ratio (a/d)

14055

12662
4220.6
246.58
7
4520.6
263.46
7

Debt service coverage ratio is the ratio of


Earnings before Interest, depreciation, tax and
amortization (EBIDTA) to total interest and
principal payment obligation
Acceptable ratio: 1:1

Interest coverage ratio is


defined as the ratio of
Earnings before Interest
and tax (EBIT) to total
interest payments
Acceptable ratio: 1.5 to 2
times

Financial structure ratios

(a)

Secured and Unsecured loans

(b)

Net Worth

Debt-Equity ratio (a)/(b)

2015

2014

39

51

30683

26210

0.0013 0.0019

(c)

Current liabilities

7214

6922

(d)

Total Debt (a) + (c)

7253

6973

(e)

Capitalization (a) + (b)


30722 26261
Total Debt to Capitalization (d)/
(e)
0.2361 0.2655

Debt-equity ratio is the


ratio of loans to net
worth
Acceptable ratio is up to
2 times

Total debt to capitalization is the ratio of total debt (secured


and unsecured loans and current liabilities) to total funds
employed (net worth and loan funds)
Should not be more than 1

Operating funds cycle

(a)
(b)
(c)
(d)
(e)

(f)
(g)

(h)
(i)

Inventories
Sundry Debtors
Current liabilities
Sales
Average sales (d)/365
Debtors'collection period (b)/
(e)
Cost of sales
Average cost of sales (f)/365
Inventory holding period (a)/
(g)
Expenses
Average expenses (h)/365
Creditors' Payment period (c)/
(i)

2015
7837
1722
7214
50389
138.05

2014
7360
2165
6922
33239
91.07

12
24268
66.49

24
21815
59.77

118
23249
63.70

123
20912
57.29

113

121

Creditors payment period shows the time


taken to settle the dues; longer period may
indicate a strong competitive position vis-vis suppliers

Debtors collection period


measures the speed with
which sales are converted
into cash; shorter the
period the better
Inventory holding
period measures the
time taken for
inventory to be
converted into sales;
again the shorter the
better

Operating funds cycle

2015 2014

(a)

Debtors'collection period

12

24

(b)

Inventory holding period

118

123

(c)

Creditors' Payment period


Operating funds cycle
(a)+(b)-(c)

113

121

17

26

Shorter the ratio, better is the working


capital management

The operating funds cycle


measures the combined
effect of all the three
ratios

Factors determining debt servicing ability


Financial ratios and balance sheet strength
Quality of management
Competitive position in industry
General economic situation
Changes in business environment

Credit rating
Creditworthiness is assessed on an ongoing basis by

credit rating agencies


Credit rating is for the particular borrowing program and
not for the company as a whole
Credit rating is a forward-looking opinion
Structured obligations

Yield spreads & changes in credit risk


Domestic sovereign debt securities in a country have the

lowest yield because of their default-free status


All other non-government debt securities have to pay a higher
yield than the sovereign bonds
The difference between the non-sovereign bond yield and the
sovereign bond yield is the yield spread or credit spread
Higher the credit risk of the borrower, higher will be the yield
spread
Yield spreads tend to expand during difficult economic
situations
This pushes up yields and pulls down the prices of lowerrated non-government bonds and leads to a flight to safety

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