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Fixed Income Securities: July 2011

Fixed income securities include bonds and debentures. Bonds are issued by companies and governments to borrow money and must be repaid on a specified date, along with periodic interest payments. Debentures are issued by companies as unsecured debt. Bonds carry less risk than debentures since they are backed by governments. The value of bonds and debentures faces risks such as default, interest rate changes, inflation, and reinvestment risks. The yield curve plots bond yields of different maturities and indicates expectations of future interest rates.

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Vivek Sharma
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415 views

Fixed Income Securities: July 2011

Fixed income securities include bonds and debentures. Bonds are issued by companies and governments to borrow money and must be repaid on a specified date, along with periodic interest payments. Debentures are issued by companies as unsecured debt. Bonds carry less risk than debentures since they are backed by governments. The value of bonds and debentures faces risks such as default, interest rate changes, inflation, and reinvestment risks. The yield curve plots bond yields of different maturities and indicates expectations of future interest rates.

Uploaded by

Vivek Sharma
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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FIXED INCOME SECURITIES

S.Y.B.A.F.

July 2011

BONDS
A debt security is generally issued by a company, municipality or government. A bond investor lends money to the issuer and in exchange, the issuer promises to repay the loan amount on a specified maturity date. The issuer usually pays the bond holder periodic interest payments over the life of the bond.
A written and signed promise to pay a certain sum of money on a certain date, or on fulfillment of a specified condition. All documented contracts and loan agreements are bonds. Bonds are actual contract notes issued by the borrower to pay interest at regular intervals and return the principal on the maturity of the bond. These bonds are issued by the companies for their expenses and future expansions. The bonds are also issued by the government for its expenses. A bond is seen as loan taken by a borrower from the investor so unlike equity share it does not give stake in the company but he is seen as a lender. These bonds are redeemed at a definite time.

Debentures
Meaning A debenture is defined as a certificate of agreement of loans which is given under the company's stamp and carries an undertaking that the debenture holder will get a fixed return (fixed on the basis of interest rates) and the principal amount whenever the debenture matures.

Bonds v/s Debentures


Debentures are issued by companies where as Bonds are issued by public sector companies which are backed and supported by government. Risk in bonds is less as compared to Debentures. Bonds are more secure than debentures. As a debenture holder, you provide unsecured loan to the company. It carries a higher rate of interest as the company does not give any collateral to you for your money. For this reason bond holders receive a lower rate of interest but are more secure.

Risk in Debt Instruments


Like all other investments, certain risks are associated with investments made in bonds and debentures. Some of such risks are :(i) Default Risk / Credit Risk : This risk refers to the risk of default in payment of interest and / or principal on due dates. There can be various reasons for such default e.g. poor performance of the company. To manage such risks, the investor has to be careful while taking decisions for investments in such bonds / debentures. He should use various techniques of analysis of the financial statements of the company. This risk can be minimised by an investor on the street, if he / she merely opts to invest only in bonds / debentures which carry good ratings by known rating agencies like CARE, CRISIL, ICRA and FITCH. 5

Risk in Debt Instruments


(ii) Interest Rate Change Risk : Most of the bonds / debentures carry fixed coupon. This means the return on such bonds / debentures is fixed during the tenure of the instrument. However, in the financial market the rate of interests keep on changing on day to day basis. Once an investor has made investments in fixed income bonds / debentures, he is sure to get the returns (barring the default by the issuer), but if the interests rate go up during the tenure of the instrument, he will be loser as he has lost the opportunity of investing at a higher rate of returns.

Risk in Debt Instruments


(iii) Purchasing Power Risk : This is another risk associated with almost all kinds of investments. The money received from the fixed income bonds / debentures when redeemed on maturity may not have the same purchasing power as at the time of investment. This happens due to inflation. Sometimes the rate of inflation may be even more than the coupon rate on such bonds. In such a situation it is considered as a negative actual returns on the bonds / debentures (iv) Reinvestment risk: It means that if market interest rates change during the tenure of the instrument then intermediate cash flows get reinvested at lower rates of interest 7

Yield Curve
What is the Yield Curve? The yield curve is a line graph that plots the relationship between yields to maturity and time to maturity for bonds. Yield curve show the curve based on the expectation of the investor about the interest rate in future. Yield relation to bond price Inverse: As the yield increases the bond price reduces

The Why- Why are yield curves important?


Investors use the yield curve as a reference point for forecasting interest rates, pricing bonds and creating strategies for boosting total returns.

The yield curve is a important policy instrument for the monetary authorities to stimulate or check economic growth
The yield curve has also become a reliable leading indicator of economic activity especially in the light of international capital flows as we have seen in the earlier slides
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Bond Valuation
1.

Face Value: is the principal amount on which interest is paid by issurer. It remains the same throughout the life of Bond. Redemption:: Bonds are normally redeemed at premium to face value.

2.

3.

Coupon Rate : is annual rate at which interest is paid.


Maturity Date: is the date on which bond is repaid.

4.

5.

Call Option: Many bond contains call option which entitles the issuer to call the bonds and redeem them before maturity.
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Bond Valuation
6. Put Option: Many bond contain put option which entitles the bond holder to put the bond back to the issuer for redemption before maturity. 7. Bond Price: This is market price of the bond and its expressed as a percentage of Face Value.

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Bond Valuation
The Value of Bond is Present value of all future cash flows which is determined as follows: Value of Bonds = interest(PVAF) + Future value (DF)

PVAF= Present value of annuity factor. DF= Discounting factor

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Bond YTM
Yield to Maturity is same as Internal rate of Return of bond. Yield to maturity: reflects the total return an investor receives by holding the bond until it matures. A bonds yield to maturity reflects all of the interest payments from the time of purchase until maturity. YTM= Interest amount + Future value present value Year to maturity . Future value + present value 2 13

Preference shares valuation


(a)

Value of Preference shares = Net assets available to preference shareholders No of preference shares

(b) When preference shares are NON- PARTICIPATING Value of Preference shares =Paid up Preference share capital + Arrears of dividend No of preference shares (c) When preference shares are PARTICIPATING Value of Preference shares =Paid up Preference share capital + Arrears of dividend +Surplus
No of preference shares

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The What contd..

The yield curve is a measure of the markets expectations of future interest rates given the current market conditions.
A graphic representation that shows the relationship at a given point in time between yields and maturity for bonds that are identical in every way except maturity. This relationship between yields and maturities is known as the term structure of interest rates. When investors purchase bonds they are taking a view that the interest rates will either remain steady or will fall in the future
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Glossary
Yield: Annual return earned on an investment
Current yield: Annual return earned on the price paid for a bond. It is calculated by dividing the bond's annual coupon interest payments by its purchase price. Yield to maturity: reflects the total return an investor receives by holding the bond until it matures. A bonds yield to maturity reflects all of the interest payments from the time of purchase until maturity, including interest on interest.

When we talk about yield we are talking about yield to maturity

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