VALUATION OF FIXED INCOME SECURITIES

Security Analysis Semester 3

Valuation of Fixed Income Securities

Strategic Role of Bonds Bond Terminology Types of Bonds Valuation of Bonds Bond Yield Measures Bond Price Analysis Risk Associated with Bonds Forecasting Interest Rates and Determinants of Interest Rates

Valuation of Fixed Income Securities

Theories of Interest Rates Analysis of Deep Discount Bonds Analysis of Convertible Bonds Analysis of Tax-Sheltered Fixed Income Securities

Valuation of Fixed Income Securities

Dual Currency Bonds Equity Index-linked Bonds Commodity Linked Bull and Bear Bonds Swap-linked Notes

Strategic Role of Bonds

Bond returns have very low positive corelation with returns of stocks, hence adding bond to a portfolio reduces risk significantly. Investment avenue for risk-averse investors. Different tax treatment of bond. Certainty of return of bond. Preferential right of a bond-holder over a shareholder in case of liquidation of company.

Fixed Income Securities Market

Instruments
-Bonds -Debentures -Preference Shares -Other Convertible Securities
Issuers
-Government -Quasi Government Bodies -Corporate (PSUs also) -Municipal Corporation

Investors
-Retail Investors -Mutual Funds -PE Funds -Recognized PFs -Trusts

Regulator RBI and SEBI

Bond Classification
Secured versus Unsecured Bonds Senior versus Subordinate Bonds Registered and Unregistered Bonds Convertible and non-convertible bonds Floating rate bonds Debentures Indexed linked bonds Deep Discount (Original Issue Discount) Bond

Bond Terminology
Face value Coupon and frequency of interest payment Maturity date, maturity and residual maturity Redemption premium Call and put option Bond Price Basis point

Bond Terminology
Indenture Covenants/Provisions
Lengthy and complex legal documents Spells out the legal rights of holders, obligations of issuing company and restrictions on its operations as well as rights of holders and obligation of borrower in case of liquidation Maintains desirable risk profile throughout the life of security/investment Controls total amount of debt financing

Bond Terminology
Indenture Covenants/Provisions
Protects holders priority on interest and principal payment in case of default and liquidation Negative pledge Limitation on additional indebtedness Limitation on asset sales Limitation on restricted payments

Bond Market Quotations

NSE Whole Debt Market RBI Negotiated Dealing System Accrued Interest and Settlement Value for bond deals

Bond Returns and Prices

Current Yield
Calculation formula Relationship with price Merits and demerits

Time Adjusted Value of Bond Valuation of Zero Coupon Bond Yield to Maturity IRR Method of Approximation for YTM Assumptions Underlying YTM

Bond Returns and Prices

Extensions of YTM Yield to Call and Yield to Put Realized Yield
Its the actual yield earned by the investor Equates the future value of purchase price to the total cash flow realized on bond Depends upon reinvestment rate and holding period

Bond Returns and Prices

Calculation of Expected Realized Yield Properties of The Realized Yield
RI = RY = YTM RI > RY > YTM RI < RY < YTM For longer maturity bonds, RY will be closer to RI For shorter maturity bonds, RY will be closer to YTM.

Bond Returns and Prices

Bond Price-Yield Relationship
Price and yield inversely related

Bond Price-Maturity Relationship

Directly related

Bond Coupon-YTM-Price Relationship

If coupon > YTM, then market price > face value If coupon < YTM, then market price < face value If coupon = YTM, then market price = face value

Principles of Bond Price Movement

The YTM is inversely related to the price of the bond. For a difference between the coupon and the YTM, the extent of change in the price of a bond depends on the remaining term to maturity. Longer the maturity, greater will be the price change. The increase in price of a bond due to changes interest rate will be at a diminishing rate as the term to maturity increases.

Principles of Bond Price Movement

Given the maturity, the increase in bond prices will be greater with decrease in YTM than the decrease in bond price with an equal increase in YTM. For any given change in YTM, the percentage price change will be higher for low coupon bonds than for high coupon bonds. A change in YTM affects the prices of bonds with higher YTM more than prices of bonds with lower YTM.

Bond Returns and Prices

Valuation of Preferred Shares/equity Valuation of Warrants
Warrants are long term call option Valuation depends upon market price of shares and exercise price of warrant Graphical representation of relationship of warrant price and price of underlying shares

Bond Returns and Prices

Valuation of Convertible Securities
Depends upon conversion characteristics Generally, it is summation of PV of interest and principal and PV of equity shares receivable on conversion Terminology conversion rate, conversion value, investment value, conversion premium, investment premium, conversion parity price of share, current yields on share and bond, breakeven period

Bond Returns and Prices

Attractiveness of Convertibles
Consideration for default risk Profitable in stable or declining interest rate scenario Reasonable break even period Investment premium < 15% Conversion premium <20%

Bond Returns and Prices

Valuation of Tax Sheltered Fixed Income Securities/Investment
Tax saving at the time of investment and/or at the time of redemption Examples ELSS, NSC

Duration of Bonds
Actual life/tenor of bond Maturity of a bond and duration of a bond Duration WA measure of a bonds life. Various time periods at which the bond generates cash flows are weighted according to the relative size of the present values of the cash flow. The idea of duration was first propounded by Fredrick Macaulay in 1938

Duration of Bonds
Calculation of duration of a bond Formula of calculating duration as suggested by Fredrick Macaulay A simplified formula to calculate duration Formula suggested by Prof. G. Hawawini Relationship between coupon, YTM, maturity and duration Duration - a fulcrum that balances present values of cash flows of a bond on a time scale

Bond Duration Properties

For all bonds paying periodic coupons, duration < term to maturity For zero coupon or single period bonds, duration = term to maturity For perpetual bonds, duration = (1 + YTM)/YTM Maturity and duration are directly related Duration and YTM are inversely related

Bond Duration Properties

Duration and market price of the bond are directly related. Coupon/frequency of coupon payment and duration of a bond are inversely related. Duration of a bond declines as the bond approaches maturity.

Bond Duration
Interest rate risk and interest rate elasticity Interest rate elasticity and duration Modified Duration Modified Duration as a Measure of Bond Volatility Rupee Duration Price Value of a Basis Point(PV01) a variant of rupee duration

Duration of Bond Portfolio

Consider the portfolio as a single bond Map portfolio cash flows into various buckets. Find present value of cash flows using portfolio YTM as discount rate. Apply regular formula to calculate portfolio duration. Weighted duration of the portfolio can be calculated using individual duration of bonds and applying weight according to the market price of the bond.

Limitations of Macaulay and Modified Duration

Duration is not static. Bond investment strategies based on duration values needs to be regularly fine tuned. Estimation of price change for small change in yield only. For large yield changes, price change for two bonds having equal duration will be unequal because of different convexity. All the limitations of YTM is applicable to duration also.

Limitations of Macaulay and Modified Duration

Not applicable for option embedded and floating rate bonds because of basic assumption that intermittent cash flows are not affected by changes in yield. ( the answer is Effective Duration) Not applicable for large yield changes. Not applicable for non-parallel shift in yield curve. ( answer is Key Rate Duration)

Effective Duration of Bonds

Addresses limitations of Macaulay and Modified Duration Considers changes in cash flow due to changes in yield and also due to embedded options Formula for calculating Effective Duration Uses interest rate model and related bond price model For option free bonds, Macaulays Duration = Effective Duration

Key Rate Duration

Addresses the problem of non-parallel shift in yield curve Introduced by Thomas Ho Not a single duration measure, but a vector of numbers defining price sensitivity of a security over the entire domain of possible movement of yield curve. Possible to construct a portfolio of bonds with embedded options using zero coupon bonds.

Duration and convexity

Effective Duration > maturity Negative Effective Duration Empirical duration Regression model of bond pricing

Application of the Concept of Duration

Immunization of the portfolio against interest rate risk. Estimation of price change for a bond/portfolio due to interest rate change. Extended application
Duration of equity dividend discount model and dividend yield model

Convexity of Bonds
Convexity the shape of the curve representing relationship of bond price and yield One of the bond theorem - Given the maturity, the increase in bond prices will be greater with decrease in YTM than the decrease in bond price with an equal increase in YTM. Convexity an important tool to study bond characteristics

Convexity of Bonds
Prices of bonds with high convexity will increase more with decrease in YTM and will fall less with increase in YTM Duration is the first and convexity is the second approximation of price changes for bonds Duration good for small changes in YTM Convexity good for both small and large changes in YTM

Convexity of Bonds
Convexity also indicates changes in yield Convexity is second derivative of price with respect to yield Relationship of convexity, coupon, maturity and yield of a bond
Coupon and convexity inversely related Maturity and convexity directly related Yield and convexity inversely related Duration and convexity directly related

Convexity of bonds
Convexity effect on price change of bonds due to changes in yield Computation of convexity for a bond Price change for a bond due to convexity Effective Convexity Convexity of Option Embedded Bonds

Risk Associated with Bonds

Systematic Risk
Purchasing power risk/inflation risk/interest rate risk Reinvestment risk Indicated through sovereign rating of a country Also, non-diversifiable

Unsystematic Risk
Business and financial risk Approximated through the process of credit rating

Term Structure of Interest Rates

Yield curve definition and various shapes Significance of Zero Coupon Yield Curve Shift in the shape of yield curve from rising, to flat to declining as economic condition changes Explanation of term structure of interest rates

Term Structure of Interest Rates

Shape of Yield Curve
Term Structure Hypothesis Flat Rising Declining Humped

Pure Expectation

short term interest short term interest short term interest short term interest rates are expected rates are not rates are expected rates are expected to increase initially expected to change to increase. to decrease and then decrease. there is no liquidity premium on long positive liquidity term rates over premium over short term rates increasing term. demand and supply excess supply of are matched over short maturity all maturities. instruments. negative liquidity premium over increasing term. excess supply of long maturity instruments. liquidity premium positive upto certain term, then negative. excess supply of mid-term instruments.

Liquidity Preference

Segmentation

Thank you
Mayank Patel