Fixed Income Securities — the ground floor

The bigger market nobody talks about

Investors love talking about shares. Bonds feel dull. The workbook calls this an irony, because the bond market is bigger. As of 2020, global equity market capitalisation was USD 105.8 trillion, while global bonds outstanding were USD 123.5 trillion.

Bonds also win on the number of issues. A company usually has one class of equity share. But it can have many different bonds outstanding at the same time, each with its own coupon and maturity. Government is generally the single largest issuer of bonds.

Who issues, and who regulates, in India

The Indian fixed income market is classified by issuer:

A naming point from the workbook: 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.

Government securities (G-Secs) are the largest segment. The corporate bond market is the next largest, and has grown substantially. But the corporate primary market is basically a private placement market — most issues go to wholesale investors like banks, financial institutions, mutual funds and large corporates. So the retail share is very small.

Regulators:

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

What makes a bond a bond

A bond creates fixed obligations for the issuer. That is why it is called a fixed income security. The issuer agrees to:

1. pay a fixed amount periodically — the coupon, and
2. repay a fixed principal — the face value — on the maturity date.

Some key features:

• Most bonds pay coupons semi-annually; some pay annually, quarterly or monthly.
• The coupon is always a fixed percentage of the face value.
• Zero coupon bonds pay no coupon. They are issued below face value and repay face value at maturity.
• Perpetual bonds have no maturity date.
• Maturity of one year or less = money market securities. More than 1 year = capital market securities. So a long bond becomes a money market security as it nears maturity.
• All G-Secs are normally coupon-bearing, with semi-annual coupons and a tenor of 5 to 30 years.
• Maturity period is also called tenor or tenure.
• Occasionally a corporate bond promises a premium on redemption, so its redemption value differs from its face value.

Why price and interest rates move in opposite directions

The workbook's example: a ₹1,000 bond, one year, 12% coupon paid at maturity. It pays ₹1,120 at the end of the year.

• An investor wanting 12% will pay ₹1,000 (₹1,120 ÷ 1.12).
• An investor wanting 15% will pay only ₹973.91 (₹1,120 ÷ 1.15).
• An investor happy with 8% will pay more than ₹1,000 (₹1,120 ÷ 1.08).

The bond itself never changed. Only the required return changed. When many investors bid, one consensus rate emerges. It is not directly visible, so the market reverse-calculates it from the traded price. That implied rate is the yield.

This gives the core bond theorem: "with all other things remaining the same, an increase in the market interest rates would decrease the prices of fixed income securities."

Bonds with embedded options

• Callable bond — the issuer can redeem early. Good for the issuer. The issuer calls only when rates have fallen, so the investor must reinvest at lower rates. That is reinvestment risk, and callable bonds carry more of it.
• Puttable bond — the bondholder can sell the bond back to the issuer at a pre-set price on specified dates. Good for the investor.
• Optionally convertible bond — a plain vanilla bond plus an embedded equity call option. The holder can exchange it for a set number of the issuer's shares.

How safe is the bond?

All the price and return maths assumes the bond is default risk free. In reality there is credit risk: "the risk of loss resulting when the issuer fails to make full and timely payments of interest and/or repayments of principal."

The key document is the indenture — the legal agreement between issuer and bondholders. It sets out par value, coupon, maturity, coupon frequency, collateral, seniority, and covenants:

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

A secured bond's quality depends on the value of the asset backing it. An unsecured bond's quality depends on the creditworthiness of the issuer.

Credit ratings

Rating agencies judge the ability and willingness of issuers to pay on time. Three rules the exam likes:

• A rating is given to an instrument, not a firm. Two bonds of the same company can have different ratings.
• Higher rating = lower default risk.
• SEBI has standardised the rating symbols, and each symbol carries the CRA's first name as a prefix.

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

Modifiers + and − may be used from AA to C.

Short-term instruments (original maturity up to one year): A1 (very strong safety, lowest credit risk), A2 (strong), A3 (moderate), A4 (minimal safety, very high credit risk), D (default). Only the + modifier, for A1 to A4.

Bonds are also split into investment grade and non-investment grade (speculative).

Valuing a bond

A bond's intrinsic value is the present value of all its future cash flows, discounted at the required rate of return. Then compare:

• Intrinsic value > market price — you can buy. If holding and it is below, you could sell.
• Or compare yield with required return: yield > required return — buy; yield < required return — sell.

When coupons are paid more than once a year, divide the rate by the frequency and multiply the years by it.

Three yield measures

• Coupon yield = coupon ÷ face value.
• Current yield = annual coupon ÷ current market price.
• Yield to maturity (YTM) = the rate that makes the present value of all cash flows equal the current market price. It is the return if you buy at today's price and hold to maturity. It is the bond's internal rate of return. Finding it needs trial and error (or Excel's YIELD function).

For callable bonds there is also yield to call — the same formula, but with the call price in place of redemption value and time to the first call date.

A bondholder's return comes from three sources: coupons, capital gain or loss, and interest-on-interest from reinvesting coupons.

Day count conventions

• Indian bond market: 30/360 — every month 30 days, every year 360.
• Money market (including T-Bills): actual/365.

What makes bond prices swing

Market price depends on four factors: face value, coupon rate, years to maturity, and market interest rate. And four relationships:

1. Price and interest rates move inversely.
2. Higher coupon = smaller percentage price change. A zero coupon bond moves most.
3. Longer maturity = larger price change — but volatility rises at a diminishing rate.
4. Price moves are not symmetrical: a fall in yield raises price by more than an equal rise in yield lowers it.

Interest rate risk is the risk from changing market rates. Reinvestment risk is the risk that coupons cannot be reinvested at the original yield. YTM assumes all coupons are reinvested at the YTM.

Duration

Macaulay duration is measured in years. It is the weighted average time to recover the investment in present value terms. It is always less than or equal to the bond's maturity. Only a zero coupon bond has duration equal to its maturity. The greater the duration, the more volatile the price.

Modified duration turns this into a price sensitivity measure:

Modified duration = Macaulay duration ÷ (1 + YTM per coupon period)

% change in price ≈ − Modified duration × change in yield (in decimals)

Modified duration has no unit — it works like an elasticity. Macaulay duration is in years.