Fixed income securities — the ground floor

The market nobody talks about

Investors love talking about shares. Yet the workbook points out the irony: the global market value of bonds is larger than that of equity. Government is generally the single largest issuer. Bonds also beat equity on the number of issues, because one company can have many different bonds outstanding at the same time, while it usually has one class of equity.

Who issues fixed income in India

• G-Secs are the largest segment of the Indian fixed income market. Corporate bonds are next.
• The corporate bond primary market is basically a private placement market — most issues go to wholesale investors such as banks, financial institutions, mutual funds and large corporates. Retail participation is very small.

A naming point from the workbook's footnote: long-term debt issued by the Government of India, State Governments, their undertakings, or development financial institutions is called a bond. Instruments issued by other entities are called debentures.

Who regulates what:

• RBI — Government securities, and securities issued by banks and NBFCs.
• SEBI — issues of non-government securities, basically corporate debt.

What makes a bond a bond

Bonds create fixed financial obligations for the issuer, which is why they are called fixed income. The issuer agrees to:

1. Pay a fixed amount periodically — the coupon.
2. Repay the principal — the face value — on the maturity date.

The coupon is always a fixed promised percentage of face value. Most bonds pay semi-annually; some pay annually, quarterly or monthly.

Special cases:

• Zero coupon bond — pays no coupons. Issued below face value; face value paid at maturity.
• Perpetual bond — no maturity date; exists forever.

By maturity:

• One year or less → money market securities.
• More than one year → capital market securities.
• So a long-term bond becomes a money market security as it approaches maturity.

The key features

The workbook says all G-Secs are normally coupon bearing, pay interest semi-annually, and have a tenor of 5 to 30 years.

Price, par, premium and discount

Face value is not the same as market price. The two differ whenever the market interest rate differs from the coupon.

All of a bond's features are recorded in the indenture. A new bond is always issued with a coupon that reflects the market rates prevailing at the time.

Bonds with embedded options

Why does a callable bond hurt the investor? The issuer calls only when interest rates for similar bonds have fallen. The investor gets face value back early and must reinvest at lower rates. That is reinvestment risk.

An option gives its buyer the right but not the obligation to buy or sell an asset at a price agreed today.

What makes a bond safe

All the bond maths assumes the bond is default risk free — coupons and principal paid in full and on time. Safety is really about the probability of default or delay. That is credit risk: the risk of loss when the issuer fails to make full and timely payments of interest or principal.

The indenture is the most important document. It is the legal agreement between issuer and bondholders, setting out par value, coupon, maturity, coupon frequency, collateral, seniority, any options — and covenants:

• Positive covenants — what the issuer must do.
• Negative covenants — what the issuer is prohibited from doing.

Secured versus unsecured.

• Secured bonds are backed by specified property. The value of that asset determines bond quality.
• Unsecured bonds rest on the issuer's promise. The issuer's creditworthiness determines quality.

Credit ratings

Rating agencies judge the issuer's ability and willingness to meet obligations on time. Key points:

• Ratings are alphanumeric symbols.
• A rating is given to an instrument, not to a firm. Two instruments from the same firm can carry different ratings.
• Higher rating → lower default risk.
• SEBI has standardised the rating symbols. Symbols carry the credit rating agency's first name as a prefix.
• Markets are split into investment grade and non-investment grade (speculative).

Long-term instruments (original maturity exceeding one year):

Modifiers "+" and "−" may be used for categories AA to C.

Short-term instruments (original maturity up to one year):

Only the "+" modifier may be used, for A1 to A4.

Valuing a bond

Because bond cash flows are pre-specified, value them with discounted cash flows. Intrinsic value = the sum of present values of all future cash flows, discounted at the investor's required rate of return.

Two equivalent ways to decide:

• Value route. Intrinsic value greater than market price → buy. Otherwise, if you already hold it → sell.
• Yield route. Yield at market price greater than your required return → buy. Less → sell.

Excel helps. In the PRICE function, "yield" means your required return, not the bond's YTM, and "price" means intrinsic value, not market price.

Where a bond's return comes from

1. Coupon payments.
2. Capital gain or loss on sale or maturity.
3. Reinvestment income — interest on interest.

Yield to Maturity (YTM) is the rate that makes the present value of all future cash flows equal to the current market price. It is the return expected if you buy at market price and hold to maturity. Also called the implied rate of return or internal rate of return. Excel's YIELD function calculates it.

Day count conventions

Day count decides the holding period for accrued interest. In India:

• Bond market: 30/360 — every month counts as 30 days, the year as 360.
• Money market (including T-Bills): actual/365.

Conventions differ across countries and even across markets within one country.

Why some bond prices swing more

A bond's price depends on four things: par value, coupon rate, years to maturity, prevailing market interest rate. The workbook's four rules:

1. Price and interest rates move inversely.
2. Volatility is inversely related to coupon. Lower coupon → bigger percentage swing. A zero coupon bond swings the most.
3. Volatility is directly related to maturity — longer bonds swing more — but it rises at a diminishing rate.
4. Price moves are not symmetrical. A fall in yield raises prices by more than an equal rise in yield lowers them.

Interest rate risk and reinvestment risk

Interest rate risk comes from changes in market rates. Higher rates raise the discount rate and lower the bond's value.

Reinvestment risk is the related danger that coupons cannot be reinvested at the yield prevailing when you bought. YTM assumes all coupons are reinvested at the YTM. If rates fall after purchase, coupons are reinvested below YTM; if rates rise, above it.

Duration

Macaulay duration — the weighted average time to recover the initial investment in present value terms, in years.

• It is always less than or equal to the bond's remaining life.
• Only a zero coupon bond has duration equal to its maturity.
• Greater duration → more price volatility for a given rate change.
• Excel: DURATION(Settlement, Maturity, Coupon, Yield, Frequency, Basis).

Modified duration measures price sensitivity to a change in rates:

% change in price = − Modified duration × Change in interest rates (in decimals)

The minus sign is the inverse relationship.