TYPES OF BONDS

BONDS

Treasury bills, or "T-bills," have the shortest maturities - 13 weeks, 26 weeks, and one year. You buy them at a discount to their $10,000 face value and receive the full $10,000 at maturity. The difference reflects the interest you earn. - Treasury notes mature in two to 10 years. Interest is paid semiannually at a fixed rate. Minimum investment: $1,000 or $5,000, depending on maturity. - Treasury bonds have the longest maturities at 10 years. As with Treasury notes, they pay interest semiannually, and are sold in denominations of $1,000. - Corporate bonds pay taxable interest. Most are issued in denominations of $1,000 and have terms of one to 20 years, though maturities can range from a few weeks to 100 years. Because their value depends on the creditworthiness of the company offering them, corporates carry higher risks and, therefore, higher yields than super-safe Treasuries. Top-quality corporates are known as "investment-grade" bonds. Corporates with lower credit quality are called "high-yield," or "junk," bonds. Junk bonds typically pay higher yields than other corporates. - Municipal bonds, or "munis," are one of America's favorite tax shelters. They are issued by state and local governments and agencies, usually in denominations of $5,000 and up, and mature in one to 30 or 40 years. Interest is exempt from federal taxes and, if you live in the state issuing the bond, state and possibly local taxes as well. (Note that there are exceptions). The capital gain you may make if you sell a bond for more than it cost you to buy it is just as taxable as any other gain; the tax-exemption applies only to your bond's interest. Munis generally offer lower yields than taxable bonds of similar duration and quality. Because of their tax advantages, though, their after-tax returns are often higher than equivalent taxable bonds for people in the 28% federal tax bracket or above
Floating Rate Bonds In some bonds, fixed coupon rate to be provided to the holders is not specified. Instead, the coupon rate keeps fluctuating from time to time, with reference to a benchmark rate. Such types of bonds are referred to as Floating Rate Bonds.

Callable Bonds The issuer of a callable bond has the right (but not the obligation) to change the tenor of a bond (call option). The issuer may redeem a bond fully or partly before the actual maturity date. These options are present in the bond from the time of original bond issue and are known as embedded options. A call option is either a European option or an American option. Under an European option, the issuer can exercise the call option on a bond only on the specified date, whereas under an American option, option can be exercised anytime before the specified date.

This embedded option helps issuer to reduce the costs when interest rates are falling, and when the interest rates are rising it is helpful for the holders. Puttable Bonds The holder of a puttable bond has the right (but not an obligation) to seek redemption (sell) from the issuer at any time before the maturity date. The holder may exercise put option in part or in full. In riding interest rate scenario, the bond holder may sell a bond with low coupon rate and switch over to a bond that offers higher coupon rate. Consequently, the issuer will have to resell these bonds at lower prices to investors. Therefore, an increase in the interest rates poses additional risk to the issuer of bonds with put option (which are redeemed at par) as he will have to lower the re-issue price of the bond to attract investors. Convertible Bonds The holder of a convertible bond has the option to convert the bond into equity (in the same value as of the bond) of the issuing firm (borrowing firm) on pre-specified terms. This results in an automatic redemption of the bond before the maturity date. The conversion ratio (number of equity of shares in lieu of a convertible bond) and the conversion price (determined at the time of conversion) are pre-specified at the time of bonds issue. Convertible bonds may be fully or partly convertible. For the part of the convertible bond which is redeemed, the investor receives equity shares and the non-converted part remains as a bond

Definition of 'Secured Bond'

A type of bond that is secured by the issuer's pledge of a specific asset, which is a form of collateral on the loan. In the event of a default, the bond issuer passes title of the asset or the money that has been set aside onto the bondholders. Secured bonds can also be secured with a revenue stream that comes from the project that the bond issue was used to finance.

Definition of 'Registered Bond'

A bond whose owner is registered with the bond's issuer. The owner's name and contact information is recorded and kept on file with the company, allowing it to pay the bond's coupon payment to the appropriate person. If the bond is in physical form, the owner's name is printed on the certificate. Most registered bonds are now tracked electronically, using computers to record owners' information. .Triple option convertible bonds: Here the investor get the fully transfer option at the maturity of the bonds or go for non transferable option or get third one transfer the half portion into the equity shares and remaining in nonconvertible portion get the interest on that.

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RISKS IN FIXED INCOME SECURITIES

1. Interest Rate Risk Interest rates and bond prices carry an inverse relationship; as interest rates fall, the price of bonds trading in the marketplace generally rises. Conversely, when interest rates rise, the price of bonds tends fall. This happens because when interest rates are on the decline, investors try to capture or lock in the highest rates they can for as long as they can. To do this, they will scoop up existing bonds that pay a higher rate of interest than the prevailing market rate. This increase in demand translates into an increase in bond price.On the flip side, if the prevailing interest rate were on the rise, investors would naturally jettison bonds that pay lower rates of interest. This would force bond prices down. 2. Reinvestment Risk Another risk that bond investors face is reinvestment risk, which is the risk of having to reinvest proceeds at a lower rate than the rate the funds were previously earning. One of the main ways this risk presents itself is when interest rates fall over time and callable bonds are exercised by the issuers. The callable feature allows the issuer to redeem the bond prior to maturity. As a result, the bondholder receives the principal payment, which is often at a slight premium to the par value. However, the downside to a bond call is that the investor is then left with a pile of

cash that he or she may not be able to reinvest at a comparable rate. This reinvestment risk can have a major adverse impact on an individual's investment returns over time. In order to compensate for this risk, investors receive a higher yield on the bond than they would on a similar bond that isn't callable. Active bond investors can attempt to mitigate reinvestment risk in their portfolios by staggering the potential call dates of their differing bonds. This limits the chance that many bonds will be called at once. (For more on callable bonds, read Callable Bonds: Leading A Double Life.)

3. Inflation Risk
When an investor buys a bond, he or she essentially commits to receiving a rate of return, either fixed or variable, for the duration of the bond or at least as long as it is held. But what happens if the cost of living and inflation increase dramatically, and at a faster rate than income investment? When that happens, investors will see their purchasing power erode and may actually achieve a negative rate of return (again factoring in inflation). Put another way, suppose that an investor earns a rate of return of 3% on a bond. If inflation grows to 4% after the purchase of the bond, the investor's true rate of return (because of the decrease in purchasing power) is -1% Credit/Default Risk When an investor purchases a bond, he or she is actually purchasing a certificate of debt. Simply put, this is borrowed money that must be repaid by the company over time with interest. Many investors don't realize that corporate bonds aren't guaranteed by the full faith and credit of the U.S. government but are dependent on the corporation's ability to repay that debt. Investors must consider the possibility of default and factor this risk into their investment decision. As one means of analyzing the possibility of default, some analysts and investors will determine a company's coverage ratio before initiating an investment. They will analyze the corporation's income statement and cash flow statement, determine its operating income and cash flow, and then weigh that against its debt service expense. The theory is the greater the coverage (or operating income and cash flow) in proportion to the debt service expenses, the safer the investment. 5. Rating Downgrades

A company's ability to operate and repay its debt (and individual debt) issues is frequently evaluated by major ratings institutions such as Standard & Poor's or Moody's. Ratings range from 'AAA' for high credit quality investments to 'D' for bonds in default. The decisions made and judgments passed by these agencies carry a lot of weight with investors. (To learn more, read What Is A Corporate Credit Rating?) If a company's credit rating is low or its ability to operate and repay is questioned, banks and lending institutions will take notice and may charge the company a higher rate of interest for future loans. This can have an adverse impact on the company's ability to satisfy its debts with current bondholders and will hurt existing bondholders who might have been looking to unload their positions. 6. 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.

Dirty price The price of a bond is calculated by discounting all future cash flows. The concept of "dirty" price is relevant for bond prices in the secondary market as they are not always traded on the coupon payment date and hence the seller needs to be compensated for the number of days he/she has held the bond in between coupon payments. For example, let's consider a bond pays interest semi-annually and the payment dates are June 30 and December 31; if it gets sold on, say, March 21, then the seller would have forgone the coupon payment due on June 30. The "dirty" price of the bond includes the interest due but not paid up to March 31. So basically, in the secondary market, it is the bond price that reflects the present value of future cash flows and includes the accrued interest (since it is not paid out yet) for the number of days the seller has the bond before the coupon payment date. Clean price This is the price that doesn't include any accrued interest. Immediately after any coupon payment date, clean price or bond is equal to the dirty price.

Definition of 'Duration'
A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.

Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations. in summary, duration is decreasing as time moves closer to maturity, but duration also increases momentarily on the day a coupon is paid and removed from the series of future cash flows - all this occurs until duration, eventually converges with the bond's maturity Bonds with high coupon rates and, in turn, high yields will tend to have lower durations than bonds that pay low coupon rates or offer low yields. This makes empirical sense, because when a bond pays a higher coupon rate or has a high yield, the holder of the security receives repayment for the security at a faster rate

Macaulay Duration The formula usually used to calculate a bond\'s basic duration is the Macaulay duration, which was created by Frederick Macaulay in 1938, although it was not commonly used until the 1970s. Macaulay duration is calculated by adding the results of multiplying the present value of each cash flow by the time it is received and dividing by the total price of the security. The formula for Macaulay duration is as follows:

n = number of cash flows t = time to maturity C = cash flow i = required yield M = maturity (par) value P = bond price

Remember that bond price equals:

So the following is an expanded version of Macaulay duration:

Example 1: Betty holds a five-year bond with a par value of $1,000 and coupon rate of 5%. For simplicity, let's assume that the coupon is paid annually and that interest rates are 5%. What is the Macaulay duration of the bond?

= 4.55 years Fortunately, if you are seeking the Macaulay duration of a zero-coupon bond, the duration would be equal to the bond's maturity, so there is no calculation required. Modified Duration Modified duration is a modified version of the Macaulay model that accounts for changing interest rates. Because they affect yield, fluctuating interest rates will affect duration, so this modified formula shows how much the duration changes for each percentage change in yield. For bonds without any embedded features, bond price and interest rate move in opposite directions, so there is an inverse relationship between modified duration and an approximate 1% change in yield. Because the modified duration formula shows how a bond's duration changes in relation to interest rate movements, the formula is appropriate for investors wishing to measure the volatility of a particular bond. Modified duration is calculated as the following:

OR

Let's continue to analyze Betty's bond and run through the calculation of her modified duration. Currently her bond is selling at $1,000, or par, which translates to a yield to maturity of 5%. Remember that we calculated a Macaulay duration of 4.55.

= 4.33 years Our example shows that if the bond's yield changed from 5% to 6%, the duration of the bond will decline to 4.33 years. Because it calculates how duration will change when interest increases by 100 basis points, the modified duration will always be lower than the Macaulay duration. Effective Duration The modified duration formula discussed above assumes that the expected cash flows will remain constant, even if prevailing interest rates change; this is also the case for option-free fixed-income securities. On the other hand, cash flows from securities with embedded options or redemption features will change when interest rates change. For calculating the duration of these types of bonds, effective duration is the most appropriate. Effective duration requires the use of binomial trees to calculate the option-adjusted spread (OAS). There are entire courses built around just those two topics, so the

calculations involved for effective duration are beyond the scope of this tutorial. There are, however, many programs available to investors wishing to calculate effective duration.

Convexity For any given bond, a graph of the relationship between price and yield is convex. This means that the graph forms a curve rather than a straight-line (linear). The degree to which the graph is curved shows how much a bond's yield changes in response to a change in price. Convexity is also useful for comparing bonds. If two bonds offer the same duration and yield but one exhibits greater convexity, changes in interest rates will affect each bond differently. A bond with greater convexity is less affected by interest rates than a bond with less convexity. Also, bonds with greater convexity will have a higher price than bonds with a lower convexity, regardless of whether interest rates rise or fall. This relationship is illustrated in the following diagram:

Bond immunization is an investment strategy used to minimize the interest rate risk of bond investments by adjusting the portfolio duration to match the investor's investment time horizon. It does this by locking in a fixed rate of return during the amount of time an investor plans to keep the investment without cashing it in. Immunization locks in a fixed rate of return during the amount of time an investor plans to keep the bond without cashing it in. Normally, interest rates affect bond prices inversely. When interest rates go up, bond prices go down. But when a bond portfolio is immunized, the investor receives a specific rate of return over a given time period regardless of what happens to interest rates during that time. In other words, the bond is "immune" to fluctuating interest rates. To immunize a bond portfolio, you need to know the duration of the bonds in the portfolio and adjust the portfolio so that the portfolio's duration equals the investment time horizon. For example, suppose you need to have $50,000 in five years for your child's education. You might decide to invest in bonds. You can immunize your bond portfolio by selecting bonds that will equal exactly $50,000 in five years regardless of interest rate changes. You can buy one zero-coupon bond that will mature in five years to equal $50,000, or several coupon bonds each with a five year duration, or several bonds that "average" a five-year duration.

Beta vs standard deviation

The difference between Standard deviation vs Beta of a stock can be understood by starting asking few basic questions. Let us say you have 2 choices, one to pick investment A and other B. A is positioned such a way that the expected return, which is the probability of different expected returns due to various factors, is calculated as E(A) = p(x) * E(x) + p(y) * E(y) + p(z) * E(z) Note that sum of the above probabilities is 1. A similar calculation can be done for E(B). Any average person would pick either A or B, whichever is higher. An educated investor would like to find the risk he/she is taking. Risk can be measured by calculating standard deviation. Mathematically, std dev is the square root of variance. If an investment's return varies like a roller-coster to provide the return calculated above, it more sounds like a gamble. On the other hand, if the investment has a smaller variance, it is a relatively stable investment where one can lay back and not worry too much on the odds. How to calculate Std Dev/Risk? Std dev = sqrt(Variance) where Variance = (p(x) * (E(x) - E(A))^2) + (p(y) * (E(y) - E(A))^2) + ( p(z) * (E(z) E(A))^2 Okay, now that we have a better sense of what the risk is and what the corresponding return is, it makes life easy since the investment with higher return and lower risk wins. No Brainer !! Let us assume that the return and risk for Investment A than those of B. Now it is logical that A being risky will yield higher return, but is that the best that one can choose. Since we have been comparing oranges and apples, its time to calculate risk for an unit of return. This is called Coefficient of variance. Calculation is simple .. Just divide Std Dev (A) / E(A). Lets call it C(A). The investor would pick C(A) or C(B), whichever is lower since the risk to earn an unit of return needs to be lower. With the above detailed explanation of the basics, one should recall the standard deviation as the risk of a particular investment. Shifting gears to Beta. Beta of a stock/investment is the risk of the stock relative to its market risk. While standard deviation measures the standalone risk, Beta measures the relative risk to the market. Eg: Std dev of investment A could be lower than std Dev of B, however B's Beta could be better. To understand this better, let us explore the Beta concept further.

If the entire market in which you trade stock consist of only 1 stock. Then the Beta of the stock will be same as the market risk, meaning when the stock return is of the same proportion and direction as the market return. In contrast, let us assume you have 5 stocks forming a market. When the market return goes up, let us say one of the stock goes down, then the stock is negatively correlated with the market. Ideally if you have an equal weightage of all stocks forming the market, the unsystematic or stock risk can be nullified. The systematic risk, which is the market risk due to economy and non-company related factors affecting returns cannot be controlled by diversification or effective asset allocation of investments within a portfolio

8.8.1 Sharpe Ratio Sharpe ratio or excess return to variability measures the portfolio excess return over the sample period by the standard deviation of returns over that period. This ratio measures the effectiveness of amanager in diversifying the total risk ( ). Thismeasure is appropriate if one is evaluating the total portfolio of an investor or a fund, in which case the Sharpe ratio of the portfolio can be compared with that of the market. The formula for measuring the Sharpe ratio is: Sharpe Ratio (rp rf ) / p This will be compared to the Shape ratio of the market portfolio. A higher ratio is preferable since it implies that the fund manager is able to generate more return per unit of total risks. However, managers who are operating specific portfolios like a value tilted or a style tilted portfolio generally takes a higher risks, and thereforemay not be willing to be evaluated based on this measure. 8.8.2 Treynor Ratio Treynors measure evaluates the excess return per unit of systematic risks ( ) and not total risks. If a portfolio is fully diversified, then becomes the relevant measure of risk and the performance of a fund manager may be evaluated against the expected return based on the SML (which uses to calculate the expected return). The formula for measuring the Treynor Ratio is: Theynor Ratio (rp rf ) / p 8.8.3 Jensen measure or (Portfolio Alpha) The Jensen measure, also called Jensen Alpha, or portfolio alpha measures the average return on the portfolio over and above that predicted by the CAPM, given the portfolios beta and the average market returns. It is measured using the following formula: 88 p rp [rf p (rM rf )]

The returns predicted fromthe CAPM model is taken as the benchmark returns and is indicated by the formula within the brackets. The excess return is attributed to the ability of themanagers for market timing or stock picking or both.