ACKNOWLEDGEMENT

For successful completion of any task co-operation and co-ordination are very important so
was there. I would like to express my special thanks of gratitude to all my faculty members
who gave me the golden opportunity to do this wonderful project on the in Types of Bond in
India, which also helped me in doing a lot of Research and I came to know about so many
new things
I would like to specially thank Prof. Jay Desai (HOD) granting me to undergo the training at
Kotak Mutual Fund Ltd. and giving the opportunity to learn about various new things.

During my 45 days association with Kotak Mutual Fund, I have always been able to learn new
things and obtained enormous amount of exposure of investment. Therefore I am personally
thankful to Mr. Mann Sir and Mr. Karan Sir who continuously guided and directed me
towards successful completion of my work.

I also gratefully acknowledge the contribution from Mr. Nisarg Joshi , my project guide for
his continuous cooperation and suggestions for successful completion of the project and all
my Faculty Members who have always offered their warmest support for completion of this
project at Ahmedabad Institute of Technology,

During this project we learn how to conduct study, how to think logically, how to work and
behave in a professional environment, and practical implication of the knowledge in the real
world which we have been taught at institutions.

PREFACE

The Bond Market in India with the liberalization has been transformed
completely. The opening up of the financial market at present has
influenced several foreign investors holding upto 30% of the financial in
form of fixed income to invest in the bond market in India.
The bond market in India has diversified to a large extent and that is a
huge contributor to the stable growth of the economy. The bond market has
immense potential in raising funds to support the infrastructural
development undertaken by the government and expansion plans of the
companies.

Sometimes the unavailability of funds become one of the major problems

for the large organization. The bond market in India plays an important role
in fund raising for developmental ventures. Bonds are issued and sold to
the public for funds.

Bonds are interest bearing debt certificates. Bonds under the bond market
in India may be issued by the large private organizations and government
company. The bond market in India has huge opportunities for the market
is still quite shallow. The equity market is more popular than the bond
market in India. At present the bond market has emerged into an important
financial sector.

EXECUTIVE SUMMARY

Bonds have many characteristics such as the way they pay their interest, the market they are
issued in, the currency they are payable in, protective features and their legal status.
Bond issuers may be governments, corporations, special purpose trusts or even non-profit
organizations.
Usually it is the type of issuer or the particular nature of a bond that sets it apart in its own
category. We briefly discuss some of the main types of bonds below:
1. CORPORATE BONDS
2. GOVERNMENT BONDS
3. ASSET-BACKED SECURITIES
4. EUROBONDS
5. EXTENDIBLE/RETRACTABLE BONDS
6. FOREIGN CURRENCY BONDS
7. CONVERTIBLE BONDS
8. HIGH YIELD OR "JUNK" BONDS
9. INFLATION-LINKED BONDS
10. U.S. TREASURY INFLATION PROTECTED SECURITIES (TIPS)
11. MORTGAGE-BACKED SECURITIES
12. ZERO COUPON OR "STRIP" BONDS

The Major Reforms In The Bond Market In India

The system of auction introduced to sell the government securities.

The introduction of delivery versus payment (DvP) system by the Reserve

Bank of India to nullify the risk of settlement in securities and assure the
smooth functioning of the securities delivery and payment.
The computerization of the SGL.
The launch of innovative products such as capital indexed bonds and zero
coupon bonds to attract more and more investors from the wider spectrum
of the populace.
Sophistication of the markets for bonds such as inflation indexed bonds.
The development of the more and more primary dealers as creators of the
Government of India bonds market.
The establishment of the a powerful regulatory system called the trade for
trade system by the Reserve Bank of India which stated that all deals are to
be settled with bonds and funds.
A new segment called the Wholesale Debt Market (WDM) was established
at the NSE to report the trading volume of the Government of India bonds
market.
Issue of ad hoc treasury bills by the Government of India as a funding
instrument was abolished with the introduction of the Ways And Means
agreement.

1.

CORPORATE BONDS

A corporate bond is a bond issue by a corporation. It is a bond that a

corporation issues to raise money effectively in order to expand its
business. The term is usually applied to longer-term debt instruments,
generally with a maturity date falling at least a year after their issue date.
(The term "commercial paper" is sometimes used for instruments with a
shorter maturity.)

Sometimes, the term "corporate bonds" is used to include all bonds except
those issued by governments in their own currencies. Strictly speaking,
however, it only applies to those issued by corporations. The bonds of local
authorities and supranational organizations do not fit in either category.

Corporate bonds are often listed on major exchanges (bonds there are
called "listed" bonds) and ECNs, and the coupon (i.e. interest payment) is
usually taxable. Sometimes this coupon can be zero with a high redemption
value. However, despite being listed on exchanges, the vast majority of
trading volume in corporate bonds in most developed markets takes place
in decentralized, dealer-based, over-the-counter markets.

Some corporate bonds have an embedded call option that allows the issuer
to redeem the debt before its maturity date. Other bonds, known as
convertible bonds, allow investors to convert the bond into equity.

Corporate Credit spreads may alternatively be earned in exchange for

default risk through the mechanism of Credit Default Swaps which give an
unfunded synthetic exposure to similar risks on the same 'Reference
Entities'. However, owing to quite volatile CDS 'basis' the spreads on CDS
and the credit spreads on corporate bonds can be significantly different.
Corporate debt fall into several broad categories:
secured debt vs unsecured debt
senior debt vs subordinated debt

Generally, the higher one's position in the company's capital structure, the
stronger one's claims to the company's assets in the event of a default.

Risk analysis

Compared to government bonds, corporate bonds generally have a higher

risk of default. This risk depends on the particular corporation issuing the
bond, the current market conditions and governments to which the bond
issuer is being compared and the rating of the company. Corporate bond
holders are compensated for this risk by receiving a higher yield than
government bonds. The difference in yield reflects the higher probability of
default, the expected loss in the event of default, and may also reflect
liquidity and risk premia.

Other risks in Corporate Bonds

-Default Risk has been discussed above but there are also other risks for
which corporate bondholders expect to be compensated by credit spread.
This is, for example why the Option Adjusted Spread on a Ginnie Mae MBS
will usually be higher than zero to the Treasury curve.

-Credit Spread Risk. The risk that the credit spread of a bond (extra yield to
compensate investors for taking default risk), which is inherent in the fixed
coupon, becomes insufficient compensation for default risk that has later
deteriorated. As the coupon is fixed the only way the credit spread can
readjust to new circumstances is by the market price of the bond falling
and the yield rising to such a level that an appropriate credit spread is
offered.

-Interest Rate Risk. The level of Yields generally in a bond market, as

expressed by Government Bond Yields, may change and thus bring about
changes in the market value of Fixed-Coupon bonds so that their Yield to
Maturity adjusts to newly appropriate levels.

-Liquidity Risk. There may not be a continuous secondary market for a

bond, thus leaving an investor with difficulty in selling at, or even near to, a
fair price. This particular risk could become more severe in developing
market, where a large amount of junk bonds belong, such as China,
Vietnam, Indonesia, etc.

-Supply Risk. Heavy issuance of new bonds similar to the one held may
depress their prices.

-Inflation Risk. Inflation reduces the real value of future fixed cash flows. An
anticipation of inflation, or higher inflation, may depress prices
immediately.

-Tax Change Risk. Unanticipated changes in taxation may adversely impact

the value of a bond to investors and consequently its
immediate market value.
2. GOVERNMENT BONDS

A government bond is a bond issued by a national government, generally

promising to pay a certain amount (the face value) on a certain date, as
well as periodic interest payments. Bonds are debt investments whereby an
investor loans a certain amount of money, for a certain amount of time,
with a certain interest rate, to a company or country. Government bonds
are usually denominated in the country's own currency. Bonds issued by
national governments in foreign currencies are normally referred to as
sovereign bonds, although the term "sovereign bond" may also refer to
bonds issued in a country's own currency.

History

The first ever government bond was issued by the Bank of England in 1693
to raise money to fund a war against France. It was in the form of a tontine.
Later, governments in Europe started issuing perpetual bonds (bonds with
no maturity date) to fund wars and other government spending. The use of
perpetual bonds ceased in the 20th century, and currently governments
issue bonds of limited duration.

Risk

Credit risk
Government bonds are usually referred to as risk-free bonds, because the
government can raise taxes or create additional currency in order to
redeem the bond at maturity. Some counter examples do exist where a
government has defaulted on its domestic currency debt, such as Russia in
1998 (the "ruble crisis"), though this is very rare (see national bankruptcy).
Another example is Greece in 2011. Its bonds were considered very risky,
in part because Greece did not have its own currency.

Currency and inflation risk

As an example, in the US, Treasury securities are denominated in US

dollars. In this instance, the term "risk-free" means free of credit risk.
However, other risks still exist, such as currency risk for foreign investors
(for example non-US investors of US Treasury securities would have
received lower returns in 2004 because the value of the US dollar declined
against most other currencies). Secondly, there is inflation risk, in that the
principal repaid at maturity will have less purchasing power than
anticipated if the inflation rate is higher than expected. Many governments
issue inflation-indexed bonds, which protect investors against inflation risk
by increasing the interest rate given to the investor as the inflation rate of
the economy increases.

Terminology

In the UK, government bonds were called "government stock" or "treasury

stock" and the older issues are still called "treasury stock". Newer issues

are called "gilts". The name "bond" was reserved for fixed-value
investments, which were not tradeable on the stock market. Inflationindexed bonds are called Index-linked gilts in the UK.

Issuers

1.

Supranational Agencies
A supranational agency, such as the World Bank, levies assessments or fees against its member
governments. Ultimately, it is this support and the taxation power of the underlying national
governments that allow these organizations to make payments on their debts.

2.

National Governments
The "central" or national governments also have the power to print money to pay their debts,
as they control the money supply and currency of their countries. This is why most investors
consider the national governments of most modern industrial countries to be almost "risk-free"
from a default point of view.

3.

Provincial or State Governments

Provincial or state governments also issue debt, depending on their constitutional ability to do
this. Canadian provinces, notably Ontario, borrow more than many smaller countries. Most
investors consider provincial or state issuers to be very strong credits because they have the
power to levy income and sales taxes to support their debt payments. Since they can not
control monetary policy like national governments, they are considered lesser credits than
national governments.

4.

Municipal and Regional Governments

Cities, towns, counties and regional municipalities issue bonds supported by their property
taxes. School boards also issue bonds, supported by their ability to levy a portion of property
taxes for education.

5.

Quasi-Government Issuers
Many government related institutions issue bonds, some supported by the revenues of the
specific institution and some guaranteed by a government sponsor. In Canada, Federal
government agencies and Crown corporations issue bonds. For example, The Federal Business
Development Bank (FBDB) and the Canadian Mortgage and Housing Corporation (CMHC)
bonds are directly guaranteed by the Federal government. Provincial crown corporations such
as Ontario Hydro and Hydro Quebec are guaranteed by the Provinces of Ontario and Quebec
respectively.

3.

ASSET-BACKED SECURITIES

Asset-backed securities are bonds that are based on underlying pools of assets.
A special purpose trust or instrument is set up which takes title to the assets and the cash flows
are "passed through" to the investors in the form of an asset-backed security.
The types of assets that can be "securitized" range from residential mortgages to credit card
receivables.
All asset-backed securities are securities which are based on pools of underlying assets. These
assets are usually illiquid and private in nature. A securitization occurs to make these assets
available for investment to a much broader range of investors.
The "pooling" of assets occurs to make the securitization large enough to be economical and
to diversify the qualities of the underlying assets.
Residential mortgages, for example, provide some insight into the development of the assetbacked securities market. Before the development of the mortgage-backed securities market in
the early 1980s, each residential mortgage underwritten was a unique transaction. Joe Q.
Public would walk into his bank or trust company and enter into a mortgage. By way of
example, Joe chooses Lack Trust Company. Joe enters into a mortgage on a specific real estate
property, 100 Easy Street in the Hills of Richmond, with the good people of Lack Trust.

Sounds easy. But think of what has to happen for this mortgage to be underwritten. Lack Trust
must check Joe's credit (salary, assets, etc.) and establish the worth of the property through an
appraisal. Joe and Lack Trust then negotiate and establish the terms. This includes the amount
and interest rate of the mortgage, the amortization of principal, as well as the prepayment
terms. Lack Trust then has to hire a lawyer to register the mortgage against the property with a
property registry office.

It can easily be seen that Joe's mortgage is an unique thing. There are no other mortgages on
100 Easy Street with Joe as the borrower on those terms and conditions. That is why most
mortgages were held by the financial company that originated them. Trading was awkward, as
the mortgages had to each be evaluated and administered differently. The originating
organization usually kept the servicing and were loath to part with their mortgages. Only very
large institutional investors participated in this market. Smaller investors did not have the
expertise to evaluate the mortgages, or a large enough portfolio to properly diversify. If a
single mortgage was in the $200,000 range, a maximum 10% position would require a total
portfolio of over $2,000,000 to be properly diversified. Therefore, for an individual investor, if
their portfolio was to be properly diversified, a mortgage was an awkward asset to own.

If we combine Joe and five hundred other borrowers in a mortgage "pool" we have something
that is bigger, which makes it more economical to issue, and better in credit quality, because of
the diversification from the large number of mortgages. In a total pool of $100 million, no one
mortgage of $200,000 is more 5% and not a large enough part of the pool to "skew" the pool's
characteristics in any one aspect. If, for example, Easy Street turns out to be the site of a
former radium factory, the fact Joe's house is worth less than we expected is not a fatal issue
for the pool of assets as a whole.

Administration of the pool of mortgages is more systematic as well. We can have the same
"servicing agent" collect all the monies from all the mortgages and "pass it through" to the
investors via a central trustee. We can have the payments made to the investors at the same
date each month. We can even supply aggregate data and statistics on the pool to investors,
such as the "Weighted Average Coupon" (WAC), or "Remaining Amortization" (RAM).

One can now see that this unruly mass of mortgages is starting to look pretty much like a
boring old bond to an investor. One payment from one source, once a month. Combined with a
"book-based" custody system, we have now made a source of cash flows that "walks and talks
like a bond". Not bad for something that used to be a lump of unique assets.

The wonder of securization is that it takes a wide variety of formerly illiquid and directly held
assets and makes them available to many investors in the form of asset-backed securities. This
simple process can be applied to all sorts of cash flow producing assets. If a retailer needs
cash, it securitizes part of its outstanding credit card balances from its customers into a "credit
card receivables trust". An auto leasing firm takes the outstanding automobile lease balances
and turns them into an "auto receivables trust". A bank takes a group of its higher quality
customers and creates an "evergreen revolving financing trust" which constantly takes high
quality receivables and finances them by issuing bonds from the trust.

4.

EUROBONDS

A Eurobond is an international bond that is denominated in a currency not native to the country
where it is issued. Also called external bond; "external bonds which, strictly, are neither
Eurobonds nor foreign bonds would also include: foreign currency denominated domestic
bonds. . ."[2] It can be categorised according to the currency in which it is issued. London is
one of the centers of the Eurobond market, but Eurobonds may be traded throughout the world
- for example in Singapore or Tokyo.

Eurobonds are named after the currency they are denominated in. For example, Euroyen and
Eurodollar bonds are denominated in Japanese yen and American dollars respectively. A
Eurobond is normally a bearer bond, payable to the bearer. It is also free of withholding tax.
The bank will pay the holder of the coupon the interest payment due. Usually, no official
records are kept. The word Eurobond was originally created by Julius Strauss.[citation needed]

The first European Eurobonds were issued in 1963 by Italian motorway network Autostrade.
[3] The $15 million six year loan was arranged by London bankers S. G. Warburg.[4][5]

The majority of Eurobonds are now owned in 'electronic' rather than physical form. The bonds
are held and traded within one of the clearing systems (Euroclear and Clearstream being the
most common). Coupons are paid electronically via the clearing systems to the holder of the
Eurobond (or their nominee account).

5.

EXTENDIBLE/RETRACTABLE BONDS

Extendible and retractable bonds have more than one maturity date. An extendible bond gives
its holder the right to extend the initial maturity to a longer maturity date. A retractable bond
gives its holder the right to advance the return of principal to an earlier date than the original
maturity. Investors use extendible/retractable bonds to modify the term of their portfolio to
take advantage of movements in interest rates. The characteristics of these bonds are a
combination of their underlying terms. When interest rates are rising, extendible/retractable
bonds act like bonds with their shorter terms When interest rates fall, they act like bonds with
their longer terms.
Extendible/retractable bonds are created by issuers because they pay a lower interest rate on
these bonds than would otherwise be case or they "sweeten" the issue with this feature, making
the issue easier to sell. Buyers are attracted to these bonds because the extension or retraction
option is attractive to them.
Extendible Bonds

An extendible bond gives its holder the right to "extend" its initial maturity at a specific date or
dates. The investor initially purchases a shorter term bond combined with the right to extend its
term to a longer maturity date. An investor purchases an extendible bond to have the ability to
take advantage of potentially falling interest rates without assuming the risk of a long term
bond. As interest rates fall, the price of a shorter term bond rises less than the price of a longer
term bond. This means the extendible bond begins to behave or "trade" as a longer term bond.
On the other hand, if interest rates rose, the extendible bond would behave as a shorter term
bond.
Retractable Bonds

With a retractable bond, an investor owns a longer term bond with the right to "retract" it at a
specific date. Consider an investor that believes that interest rates will rise and bond prices will
fall, but is not willing or able to sell out of bonds completely. This investor can buy a longer
term retractable bond which behaves initially as a similar term long term bond. As interest
rates rise the bond falls in price. Once its price is low enough, it will begin to behave as a short
term bond and its price fall will be much less than a normal long term bond. At worst, the
investor can retract it at the retraction date and receive the par amount back to reinvest.
Pricing Extendible/Retractable Bonds

Usually, the extension or retraction feature means that the price of an extendible/retractable
bond is higher and the interest rate lower than other similar term bonds. The motivation of the
issuer is obvious, having to pay a lower interest rate than would otherwise be the case. The
investor's motivation comes from the "defensive" feature of these bonds. The investor gains the
potential upside of a longer term bond with the price risk of a shorter term bond. Looking at it
another way, the investor can lock in a longer term interest rate with the option to shorten at his
or her discretion.

Originally, these bonds were created as "sweeteners" as a way to sell bonds more easily. The
market conditions were not conducive to issuing longer term bonds or the issuer wanted a
lower interest rate than was available at that time. Adding the extension or retraction feature
made it easier to sell the issue or cheaper for the issuer. At that time, the "rule of thumb" was
that these bonds should be issued .2% less in yield than a normal bond of the same issuer.

More recently, with the development of options and swap markets, these bonds are priced
using option pricing techniques. These view extendible and retractable bonds as a combination
of a normal bond and a "call option" (extendible) or "put option" (retractable). "Option
Adjusted Spread" (OAS) analysis uses statistical "decision trees" to assess the worth of these
options given historical patterns of interest rate movements.
Are Extendible/Retractable Bonds Attractive?

As with anything, you get what you pay for with extendible/retractable bonds. If an investor
constantly invested in these bonds, the net result would be a lower return due to the lower yield
of these bonds compared to normal bonds of the same term. An investor unable to accept the
price risk of longer term bonds would be better off in extendible/retractable bonds than with
exclusively shorter term bonds, as this would generate a higher yield and reduce the income
risk of the portfolio. Investors with an interest rate view but not willing to accept the risk of
being "out of the market" should use these bonds to protect their portfolios.

6.

FOREIGN CURRENCY BONDS

A "foreign currency" bond is a bond that is issued by an issuer in a currency other than its
national currency. Issuers make bond issues in foreign currencies to make them more attractive
to buyers and to take advantage of international interest rate differentials. Foreign currency
bonds can "swapped" or converted in the swap market into the home currency of the issuer.
Bonds issued by foreign issuers in the United States market in U.S. dollars are known as
"Yankee" bonds. Bonds issued in British pounds in the British bond market are known as
"Bulldogs". Yen denominated bonds by foreign issuers are known as "Samurai" bonds.

The development of the world bond markets allowed bond issuers to bring issues in other than
their home markets. For example, since the 1970s, the Canadian provinces have used the U.S.
bond market as a major source of funding. The Canadian province of Ontario is one of the
world's largest and most sophisticated non-sovereign borrowers. It brings bond issues in many
different currencies and markets, seeking to fund at the lowest possible absolute rate. In the
U.S. bond market, Ontario and Ontario Hydro, its power corporation, have many "Yankee"
issues and is considered an alternative to domestic U.S. corporate issuers.

The "euromarket" is another major source of foreign currency bond issues. European investors
will buy the bonds of well known issuers like Ford, Toyota or General Electric or their
international subsidiaries, in many different currencies depending on their currency views. This
makes for a constant arbitrage between the foreign and domestic bond markets as investors
seek to gain the best possible yield employing currency hedges and swaps. A Canadian
institutional investor does not really care if the original Ford Motor Credit Canada bond was
issued in U.S. funds if he has swapped both the interest and principal payments into Canadian
dollars. The large international swap banks like Citibank make markets buying and selling
these swaps, which gives investors tremendous liquidity in these transactions. Dutch and
Danish banks often issue in Canadian dollars in the European markets despite eventually
requiring funding in their own currencies. They do this to take advantage of demands for
Canadian currency issues and to lower their funding costs.

Foreign currency bonds have a vocabulary all their own. Bonds issued in foreign currencies are
given the names listed beside the currencies below:

"Yankee Bonds" for U.S. dollars;

"Samurai Bonds" for Japanese Yen;
"Bulldog Bonds" for British pounds; and
"Kiwi Bonds" for New Zealand dollars.
A more recent innovation are bonds that are hybrids in currency terms, with their coupon and
principal payments in different currencies. For example, some recent bonds have had their
coupon payments in Yen with their principal amounts in Canadian dollars. This satisfies the
needs of Japanese institutional investors for yen income while keeping the eventual return of
principal in the national currency of the issuer.
Foreign currency bonds have a much different risk and return profile than domestic bonds. Not
only is their price affected by movements in a foreign country's interest rate, they also change
in value depending on the foreign exchange rates. In Canada, for example, the Canadian dollar
has moved upwards to 4% in U.S. dollar terms in very short periods of time. This exchange
rate movement would result in price changes of 4% in Canadian dollars which completely
overwhelms the coupon income of a bond. Studies have shown that the longer term risk and
return characteristics of foreign bonds in domestic currencies are closer to domestic equity
returns than domestic fixed income returns.

7.

CONVERTIBLE BONDS

A convertible bond is a bond that gives the holder the right to "convert" or exchange the par
amount of the bond for common shares of the issuer at some fixed ratio during a particular
period. As bonds, they have some characteristics of fixed income securities. Their conversion
feature also gives them features of equity securities.

Convertible bonds are bonds. They have a coupon payment and are legally debt securities,
which rank prior to all equity securities in a default situation. Their value, like all bonds,
depends on the level of prevailing interest rates and the credit quality of the issuer.

The exchange feature of a convertible bond gives the right for the holder to convert the par
amount of the bond for common shares a specified price or "conversion ratio". For example, a
conversion ratio might give the holder the right to convert $100 par amount of the convertible
bonds of Ensolvint Corporation into its common shares at $25 per share. This conversion ratio
would be said to be " 4:1" or "four to one".

The share price affects the value of a convertible substantially. Taking our example, if the
shares of the Ensolvint were trading at $10, and the convertible was at a market price of $100,
there would be no economic reason for an investor to convert the convertible bonds. For $100
par amount of the bond the investor would only get 4 shares of Ensolvint with a market value
of $40. You might ask why the convertible was trading at $100 in this case. The answer would
be that the yield of the bond justified this price. If the normal bonds of Ensolvint were trading
at 10% yields and the yield of the convertible was 10%, bond investors would buy the bond
and keep it at $100. A convertible bond with an "exercise price" far higher than the market
price of the stock is called a "busted convertible" and generally trades at its bond value,
although the yield is usually a little higher due to its lower or "subordinate" credit status.

Think of the opposite. When the share price attached to the bond is sufficiently high or "in the
money", the convertible begins to trade more like an equity. If the exercise price is much lower
than the market price of the common shares, the holder of the convertible can convert into the
stock attractively. If the exercise price is $25 and the stock is trading at $50, the holder can get
4 shares for $100 par amount that have a market value of $200. This would force the price of
the convertible above the bond value and its market price should be above $200 since it would
have a higher yield than the common shares.

Issuers sell convertible bonds to provide a higher current yield to investors and equity capital
upon conversion. Investors buy convertible bonds to gain a higher current yield and less

downside, since the convertible should trade to it bond value in the case of a steep drop in the
common share price.

Investors traditionally use "breakeven" analysis to compare the coupon payment of the
convertible to the dividend yield of the common shares. Modern techniques of option analysis
examine the convertible as a bond with an equity option attached and value it in this manner.

8.

HIGH YIELD OR "JUNK" BONDS

A high yield, or "junk", bond is a bond issued by a company that is considered to be a higher
credit risk. The credit rating of a high yield bond is considered "speculative" grade or below
"investment grade". This means that the chance of default with high yield bonds is higher than
for other bonds. Their higher credit risk means that "junk" bond yields are higher than bonds of
better credit quality. Studies have demonstrated that portfolios of high yield bonds have higher
returns than other bond portfolios, suggesting that the higher yields more than compensate for
their additional default risk.
High yield or "junk" bonds get their name from their characteristics. As credit ratings were
developed for bonds, the credit rating agencies created a grading system to reflect the relative
credit quality of bond issuers. The highest quality bonds are "AAA" and the credit scale
descends to "C", and finally to the "D" or default category. Bonds considered to have an
acceptable risk of default are "investment grade" and encompass "BBB" bonds and higher.
Bonds "BB" and lower are called "speculative grade" and have a higher risk of default.

Rule makers soon began to use this demarcation to establish investment policies for financial
institutions, and government regulation has adopted these standards. Since most investors were
restricted to investment grade bonds, speculative grade bonds soon developed negative
connotations and were not widely held in investment portfolios. Mainstream investors and
investment dealers did not deal in these bonds. They soon became known as "junk" since few
people would accept the risk of owning them.

Before the 1980s, most junk bonds resulted from a decline in credit quality of former
investment grade issuers. This was a result of a major change in business conditions, or the
assumption of too much financial risk by the issuer. These issues were known as "fallen
angels".

The advent of modern portfolio theory meant that financial researchers soon began to observe
that the "risk-adjusted" returns for portfolios of junk bonds were quite high. This meant that
the credit risk of these bonds was more than compensated for by their higher yields, suggesting
that the actual credit losses were exceeded by the higher interest payments

Underwriters being creative and profit-oriented, soon began to issue new bonds for issuers that
were less than investment grade. This led to the Drexel-Burnham saga, where Michael Millken
led a major investment charge into junk bonds in the late 1980s, which ended with a scandal
and the collapse of many lower rated issuers. Despite this, the variety and number of high yield
issues recovered in the 1990s and is currently thriving. Many mutual funds have been
established that invest exclusively in high yield bonds, which have continued to have high riskadjusted returns.

High yield bond investment relies on credit analysis. Credit analysis is very similar to equity
analysis in that it concentrates on issuer fundamentals, and a "bottom-up" process. It is
concentrated on the "downside" risk of default and the individual characteristics of issuers.
Portfolios of high yield bonds are diversified by industry group, and issue type. Due to the

high minimum size of bond trades and the specialist credit knowledge required, most
individual investors are best advised to invest through high yield mutual funds.

9.

INFLATION-LINKED BONDS

An inflation-linked bond is a bond that provides protection against inflation. Most inflationlinked bonds, the Canadian "Real Return Bond "(RRB), the British "Inflation-linked Gilt"
(ILG) and the new U.S. Treasury "inflation-protected security" (IPS) are principal indexed.
This means their principal is increased by the change in inflation over a period. In most
countries, the Consumer Price Index (CPI) or its equivalent is used as an inflation proxy. As
the principal amount increases with inflation, the interest rate is applied to this increased
amount. This causes the interest payment to increase over time. At maturity, the principal is
repaid at the inflated amount. In this fashion, an investor has complete inflation protection, as
long as the investor's inflation rate equals the CPI.

We must compare an inflation-linked bond to a conventional or "nominal" bond to understand

it properly. A normal bond pays its coupon on a fixed principal amount. Using the Government
of Canada 8% bond maturing in 2023 as an example, we are due 8%, or $8 on every $100 of
principal, each year until we are finally repaid our principal of $100 at maturity. Contrast this
with the Canadian RRB, the 4.25% maturing in 2021. It pays a 4.25% "real" interest rate or
$4.25 on its principal each year. But the principal increases with inflation, which is based on
the Canadian CPI. For example, when Canadian inflation, the CPI, was 1.8% in 1995, the
principal amount was increased by 1.8%. Since its issue in November 1991, the RRB has seen
its principal amount increase by 8% to $108. The 4.25% coupon now generates a payment of

$4.60 versus its original payment of $4.25. At maturity, when the principal will be repaid by
the Canadian government, the principal amount will have increased to well over $200.

By applying a "real" interest rate or coupon to the principal amount, an inflation-linked bond
protects the investor from unexpected changes in the consumer price index. Normally, bond
investors demand an extra "yield premium" or compensation for inflation risk. Since inflationlinked bonds are not exposed to inflation, their yield is lower than normal or nominal bonds.
As of December 1996, a thirty year Canada bond has a yield of about 7%. The Canadian RRB
has a yield of 4.2%. The 2.8% difference between these two bonds reflects the "break-even
inflation rate". This means that inflation would have to average more than 2.8% per year until
the maturity of the bond for the inflation-linked bond to do better than another bond of similar
term. Investors do not necessarily expect inflation to be as high as 2.8%, since they do not
know what the future will bring they are willing to sacrifice some current yield for inflation
protection on the principal.

10.

U.S. TREASURY INFLATION PROTECTED SECURITIES (TIPS)

A new age dawned in the U.S. capital markets on Wednesday, January 29, 1997. The United
States Treasury made its first issue of an inflation-linked bond, the 3.375% of 2007. This bond
increases its principal by the changes in the Consumer Price Index (CPI). Its interest payment
is calculated on the inflated principal, which is eventually repaid at maturity. This gives an
investor the ability to protect against inflation while providing a certain "real" return over an
investment horizon. Despite critics and uncertainty over the "great inflation debate", the
auction went extremely well with interest five times the size of the $7.0 billion issue. The "real
yield" of the TIP reached more than 3.5% in the "when issue" trading before the auction but
fell dramatically to 3.3% in the aftermarket trading.

It's the "Real" Thing

The issue of the TIP is a major development in the U.S. capital markets. For the first time,
investors will be able to achieve a certain "real return" above inflation over their investment
period. A normal or "nominal" bond pays its interest on a fixed principal amount, which is
repaid at maturity. Inflation is a major risk to a nominal bond holder, since increasing inflation
means reduced "purchasing power" is in the face of increasing prices.

A good example of a TIPS investor would be an individual setting aside retirement funds in an
IRA. Purchasing a $100,000 TIPS would lock in this amount in real terms. Whatever the

inflation rate until the eventual retirement, the $100,000 would be completely "indexed" or
have its value increased to offset any increases in inflation.

The Naked Bond?

The TIPS issue used the structure of the Canadian inflation-linked program, which allows for
"stripping" or the creation of "zero coupon" bonds. This separates the coupon payments or
"coupons" from the principal amount or "residual". While this has been done for years with
nominal bonds, it promises a new capability for investors. Using the "real zeroes", an investor
could place an amount in a specific term and ensure an inflation proof" result. For example, an
insurance company wishing to set funds aside to pay claims which are linked to inflation could
purchase the exact amount of "real zeroes" to cover the claim in today's dollars. No matter
what the intervening inflation, the amount invested would grow to exactly equal the amount
required to settle the claim.

How Good is a "Real" Thing

The value of the inflation protection of the TIPS is being hotly debated in investment circles.
To simplify the arguments, we can compare the yield available on a normal or "nominal" 10
year Treasury Bond to the TIP. At current yields, a nominal 10 year Treasury yields 6.4%. If
we subtract inflation, currently 3.3% for the CPI, we get a "real yield" of 3.1% (6.4 - 3.3 =
3.1). The current yield of the TIPS is 3.3% "real". This means that the real yield of the TIPS is .
2% higher than the same term nominal Treasury. We can think of it another way. Add 3.3%
inflation to the TIPS yield of 3.3% and we have a total yield of 6.6% which exceeds the
nominal treasury yield of 6.4%. Given that the TIPS is inflation-risk free, this doesn't make a
lot of sense. We receive more interest for a an inflation-protected bond than a normal risk
bond!

The reasons for this are threefold:

First, with any new investment, especially in the conservative bond market, the first issues
come "cheap", or inexpensive relative to standard "plain vanilla" issues, which attracts
investors and compensates for the new nature of the security.
The second reason is the smaller size of the TIPS market which makes it "illiquid" or harder to
trade than the huge existing Treasury market. Given the $7.0 billion size of the initial TIPS
issue, this might come as a surprise, but this is small change compared to the hundreds of
billions of existing Treasury bonds.
The third and perhaps the most important reason is the uncertainty over the status of the
current CPI index. Many politicians, government officials and even Alan Greenspan, the
Federal Reserve Chairman, are of the belief that the current CPI, as calculated by the Bureau of
Labour Statistics (BLS), is overstated.

The Great Inflation Debate

Conveniently, a lowering of the CPI would help to balance the budget and this is the political
incentive. The widespread and vocal discussion has created much uncertainty in the
marketplace about TIPS, since its principal is increased by the published CPI. The thesis that
the CPI is overstated by .5% to 1.5% has led to a much higher yield on the TIPS than would
probably otherwise be the case. Not a smart move by the government and those involved, but
whoever said that politicians were smart? The arguments for and against the CPI's accuracy are
being mustered but in any event, the eventual resolution will be well into the future. So far
we've only heard one side of the story and the other will soon come out. Any restatement will
take time and research. This could provide some shorter term value to prescient investors.

Other Countries Have Been Doing It

The United Kingdom has issued "Inflation-linked Gilts" (ILGs) since 1981 and has a variety of
different terms of issues. Canada issued the 4.25% of 2021 "Real Return Bond" (RRBs) in

1991 and has reopened this issue many times since. Canada added a second issue, the 4.25% of
2026 last year. Sweden, Australia and New Zealand also issue inflation-linked bonds.

The Time to Buy Insurance is When You Don't Need It!

As the old saying goes: "the time to buy insurance is when you don't need it". This holds true
for the TIPS as well. Inflation, remarkably under control for the past five years at 3% plus or
minus a bit, is the biggest anger a fixed income investor faces. The fact that most bond
managers, and investors, can't conceive of generally higher inflation means that it is not
factored into the price of current bonds. Compared to the savaged bond investors of the 1970s,
who called bonds "certificates of confiscation", the current crop of bond managers is diving
into 100 year securities and fretting about upcoming bond shortages. Almost twenty years of
declining interest rates and inflation has made wary bond managers an extinct species.

The "trend is your friend", low-inflation, camp has made the inflation protection of the TIPS
very cheap. It wasn't so long ago that Saddam Hussein's army was in Kuwait and oil prices
were going through the roof. Don't wait until inflation springs, do it now!

11.

MORTGAGE-BACKED SECURITIES

A mortgage-backed security (MBS) is a security that is based on a pool of underlying

mortgages. MBS are usually based on mortgages that are guaranteed by a government agency
for payment of principal and a guarantee of timely payment. The analysis of MBS concentrates
on the nature of the underlying payment stream, particularly the prepayments of principal prior
to maturity.

Before the development of the mortgage-backed securities market in the early 1980s, each
residential mortgage underwritten was a unique transaction. Joe Q. Public would walk into his
bank or trust company and enter into a mortgage. Say Joe chooses Lack Trust Company. Joe
enters into a mortgage on a specific real estate property, 100 Easy Street in the Hills of
Richmond, with the good people of Lack Trust. Sounds easy. But think of what has to happen
for this mortgage to be underwritten. Lack Trust must check Joe's credit (salary, assets etc.)
and establish the worth of the property through an appraisal. Joe and Lack Trust then negotiate
and establish the terms. This includes the amount and interest rate of the mortgage, the
amortization of principal as well prepayment terms. Lack Trust then has to hire a lawyer to
register the mortgage against the property with a property registry office.

It can easily be seen that Joe's mortgage is an unique thing. There are no other mortgages on
100 Easy Street with Joe as the borrower on those terms and conditions. That is why most
mortgages were held by the financial company that originated them. Trading was awkward, as
the mortgages had to each be evaluated and administered differently. The originating
organization usually kept the servicing and were loath to part with their mortgages. Only very
large institutional investors participated in the market. Smaller investors didn't have the
expertise to evaluate the mortgages or a large enough portfolio to properly diversify. If a single
mortgage was in the $200,000 range, a maximum 10% position would require a total portfolio
of over $2,000,000 to be properly diversified. Therefore, for an individual investor, if their
portfolio was to be properly diversified, a mortgage was an awkward asset to own.

By grouping a large number of mortgages together in a "pool", the uniqueness of each

mortgage is submerged in the whole. Let's take 500 mortgages at $200,000. This gives us a
pool of $100 million of mortgages. We can take the aggregated statistics such the "weighted
average maturity" (WAM) or the "remaining amortization" (RAM) and use these to describe

the pool. We can then make sure no mortgage is too large a portion of the pool. Arrangements
are made such that the "servicing agent" collects the mortgage payments and gives them to
"central paying agent" which, in turn, "passes through" the payments to the final investor. We
now have something that looks very much like a bond. However, we do have a problem: how
do we assess each of the mortgages for their creditworthiness?

Enter mortgage insurance. Mortgage insurance guarantees the principal of a mortgage against
default by the borrower. This process provides investors with a "commoditized" credit risk.
The large mortgage insurers in the United States and Canada are government or quasigovernment agencies. These agencies use the credit standing of their respective national
governments to guarantee mortgage loans. In Canada, the Central Housing and Mortgage
Corporation (CHMC) guarantees mortgages for different programs backed by its borrowing
power under federal government legislation, the National Housing Act (NHA). Investors could
then view the credit risk on the principal amount as equivalent to the credit risk of Canadian
government bond.

Investors were still wary of the "timely payment" issue, since the process of collecting on a
defaulted loan was a lengthy affair. In the 1980s, some investors in NHA mortgages in Canada
were unable to collect on their defaulted mortgages from the CHMC for several years. This
meant they lost the use of their money and the interest it could earn for a lengthy period,
although they eventually collected their principal and accrued interest. The Canadian MBS
program remedied this by adding a "guarantee of timely payment" in 1987. This guarantee of
principal and timely payment meant that the credit risk was removed from the equation. With a
defaulted mortgage, the payments would be kept up until the principal amount was repaid by
the guarantor, CMHC.

The removal of credit risk does not mean that MBS are without risk. There is a major risk
inherent in the cash flows called "prepayment risk". Let's say that Joe was unusually frugal and
decided to pay off his mortgage early. All his neighbours, who also were in the same pool (we
did not obviously diversify geographically) decide to follow suit. We, the investors, are sitting
pretty. We know we're safe credit wise for the next five years. But when Joe and his neighbours
walk in the door of Lack Trust, our portfolio starts to shudder. Their combined frugality means

that we get our principal back early. Not bad, but to the investors it also depends on what
interest rates have done since the pool was issued.

Let's say we bought the pool when interest rates were high in early 1994. We have a pool with
a coupon of almost 9%. Two years later, we have interest rates for the remaining three year
term at somewhere around 5%. Oh, oh. We thought we would get 9% for five years, yet two
years into the term we are forced to reinvest at 5%. That means we lose 4% for three years.
OUCH! Even if there are a few stalwarts who decide not to pay their mortgage off, nobody is
going to want to buy something at $112 that could be paid off at any time. Therefore, the price
falls to the point where the market thinks its being compensated for the prepayment risk
(which is going to be not too far above par). Whether we are paid out early or not, we are
going to take a bath on this one. We would have done much better to put our money in a
normal bond that did not prepay.

Now consider whether or not we should buy the pool in the current low interest rate
environment. By religiously reading the bond articles on our favourite internet site we have
learned about reinvestment risk, prepayment risk and the effect of interest rate changes on
bond values. We have stayed fully invested in long-term bonds until now (December 1996) but
have now decided to become defensive as we think rates will rise. Now assume, going forward
a year, we are right (this only happens on the Internet). The economy surges. Inflation and
interest rates surge. Central bankers fling themselves into Jacuzzis in fits of despair. How have
our MBS done considering Joe and his neighbors have decided to pay off their mortgages after
two years (their houses have doubled in price and they're trading up)?

Think of it. Dream of it. Interest rates are back to 9%. Our pool carries an average mortgage
rate of 5% and coupon nearly the same. When Joe and his frugality bunch pay us out, we sign
up for Club Med, despite the impending recession of 1998. We get $100 of principal invested
at 5% returned to us to invest at 9%. Even if some of the pool doesn't prepay, the rise in
interest rates has knocked the value of the MBS down as interest rates have risen. Our $100
invested is now worth less than $90. Except that everyone recognizes that any prepayments
will be at $100 and all pools tend to prepay something. People move, default and even are

frugal and prepay their mortgage even though it does not make economic sense. The MBS will
do much better than a normal bond that doesn't prepay.

IT'S THE PREPAYMENT RISK, STUPID, to badly paraphrase an American Presidential

candidate. You won't hear much about prepayments from your favourite salesperson, but its the
only thing that counts with MBS. A good trick is to watch out for the words "after analysis".
This means that a certain prepayment experience has been assumed in calculating the yield. A
smart analyst takes this with a "chunk of rock salt" and concentrates on the pool characteristics
and prepayment experience of similar pools and issuers. She then tries out a few scenarios to
see how things will go with varying interest rates and prepayment conditions. The trick is
establishing the future payment stream and pricing it.

If you think interest rates are going to fall, avoid prepayable MBS. If you think they are going
to rise, MBS might not be a bad investment. If you don't think you have an insight into interest
rates, don't buy prepayable or "open" MBS. Try closed MBS or normal bonds. And remember
your mantra: "it's the prepayment risk, stupid".

12. ZERO COUPON OR "STRIP" BONDS

Zero coupon or strip bonds are fixed income securities that are created from the cash flows that
make up a normal bond.
The cash flows of a normal bond consist of the regular interest or "coupon" payments, that take
place over the term of the bond, and the principal repayment that occurs at maturity of the
bond. For example, the cash flows of the Government of Canada 8% bond with a maturity date
of June 1, 2023 are:
$4 every December and June 1st up to and including June 1, 2023, representing 4% of the
$100 par value; and
$100 on June 1, 2023, representing the repayment of the principal or par amount of the bond.

Taken individually, each of these payments is an obligation of the issuer, in this case, the
Government of Canada. The process of "stripping" a bond involves deppositing bonds with a
trustee and having the trustee separate the bond into its individual payment components. This
allows the components to be registered and traded as individual securities. The interest
payments are known as "coupons" after their source of cash flow, and the final payment at
maturity is known as the "residual" since it is what is left over after the coupons are stripped
off. Both coupons and residuals are known as "zero coupon" bonds or "zeros".

Initially, when this process first took place in the early 1980s, the individual coupons were
"physical", which meant that an actual paper certificate existed for each coupon and the
residual. Now these securities are "book based" which means that they are entries on a
centralized financial registry system known as the Central Depository System (CDS).

Once a bond has been stripped, a trustee directs the appropriate amount of the interest or
maturity payment to the security holders. The holder of a zero coupon receives the par amount
of the particular term of the zero that she holds. For example, an investor holding $100,000 par
amount of the December 1, 2001 coupon would receive $100,000 on that date.

Conceptually, a zero coupon security is just like a Treasury Bill or "T-Bill". The investor pays
something up front in exchange for a promise to receive $100 on the maturity date. Take our
example of the coupons and residual generated by stripping the Canada 8% of 2023. If we start
on December 1, 1996 the first two payments are identical to a 6 month and 1 year T-Bill. An
investor would receive $100 on June 1st and December 1st for each $100 par amount she
purchased of these terms of coupons.

The basic mathematics are easy. What should an investor pay for the 1 year coupon? If the
investor demands a 4% return over a one year period, she should pay something around $96
for the $100 maturity value (actually $96.154 since we're starting at less than $100).

The longer coupons get a bit more complicated. Take the coupon due on December 1, 2001,
five years from December 1, 1996. What do we pay for this $100? First of all, we need to
consider what interest rate would be appropriate. Reflecting on the term structure of interest
rates, we know that we should use the yield on a similar term Government of Canada bond.
Being bond market fans, we just happen to know that there is a Government of Canada issue
the 9.75% of December 1, 2001. We also know that it currently yields 5.6% semiannually.

As a rough cut, forgetting the compounding of interest (interest-on-interest) and the conversion
to semiannual yields, we know that 5.6% for 5 years is 28%. This means if we pay something
around $72 (100-28) on December 1, 1996 for the $100 coupon due on December 1, 2001, we
will earn something around 30% over the period or 6% a year.

Pulling out our trusty bond calculator, we can actually do the calculation. At a semiannual
yield of 5.6%, the price works out to be $75.91. At a semiannual yield of 6%, the price works
out to be $74.44.

Of course, nothing is as easy as it seems. The yield of a zero coupon bond is different than the
yield of a normal bond of the same issuer. This difference of "spread" reflects the economics or
profits available to investment dealers from "stripping" activities and the supply and demand
for zero coupon bonds. There is also a difference in yield between coupons and residuals
which reflects the larger size of residuals and the economies of trading compared to many
smaller coupon positions or "lines".