Tarheel Consultancy Services

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Tarheel Consultancy Services

• Manipal, Karnataka

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Corporate Training and Consulting
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Course on Fixed Income Securities

• For
• XIM -Bhubaneshwar

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For

• PGP-II
• 2003-2005 Batch
• Term-V September-December 2004

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Module-I

• Part-III
• Basics of Debt Securities

6
Issuers

• Who issues debt?
• Governments and their agencies
• Corporations
• Commercial Banks
• States and municipalities
• Foreign institutions

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Issuers (Cont)

• Debt is important for public as well as private
  sector corporations.
• But it is indispensable for federal governments,
  and state and local governments for financing
  developmental activities.
• Such entities obviously cannot issue equity.

8
Nomenclature

• Debt securities are referred to by a variety of
  names.
• Bills
• Notes
• Bonds
• Debentures
• In the U.S. a debenture is an unsecured bond.
• In India the terms are used interchangeably.

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U.S. Treasury Securities

• They are fully backed by the federal government.
• Consequently they are devoid of credit risk or
  the risk of default.
• The interest rate on such securities is used as a
  benchmark for setting rates on other kinds of
  debt.

10
U.S. Treasury Securities (Cont)

• The Treasury issues three categories of
  marketable securities.
• T-bills are discount securities
• They are issued at a discount from their face
  values and do not pay interest.
• T-notes and T-bonds are sold at face value and
  pay interest periodically.

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U.S. Treasury Securities (Cont)

• T-bills are issued with a original time to
  maturity of one year or less.
• Consequently they are Money market instruments.
• T-notes and T-bonds have a time to maturity
  exceeding one year at the time of issue.
• They are therefore capital market instruments.

12
Why Invest in Bonds?

• Why do investors put money in bonds?
• They provide a steady and predictable income that
  can be used to meet monthly expenses.
• From this perspective they are very important for
  retirees and senior citizens.
• Most bonds pay interest on a semi-annual basis or
  once in six months.
• Thus a portfolio of six bonds with different
  maturity dates can be used to structure a monthly
  income plan.

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Why Bonds (Cont)

• They can be used to finance expenses that are
  likely to arise in the future.
• These include
• Expenses involved for the childrens college
  education.
• Marriage expenses of children
• Bonds are important for portfolio
  diversification.
• In general they tend to experience less price
  volatility than stocks.
• Because of milder price fluctuations they tend to
  pull the performance of the portfolio back from
  the extremes.
• They make steady contributions to portfolio
  returns.
• They react differently to economic news than
  stocks.

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Plain Vanilla Bells and Whistles

• The most basic form of a bond is called the Plain
  Vanilla version.
• This is true for all securities, not just for
  bonds.
• More complicated versions are said to have
• Bells and Whistles attached.

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Face Value

• It is the principal value underlying the bond.
• It is the amount payable by the borrower to the
  lender at maturity.
• It is the amount on which the periodic interest
  payments are calculated.

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Term to Maturity

• It is the time remaining in the life of the bond.
• It represents the length of time for which
  interest has to be paid as promised.
• It is represents the length of time after which
  the face value will be repaid.

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Coupon

• The coupon payment is the periodic interest
  payment that has to be made by the borrower.
• The coupon rate when multiplied by the face value
  gives the dollar value of the coupon.
• Most bonds pays coupons on a semi-annual basis.

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Example of Coupon Calculation

• Consider a bond with a face value of 1000.
• The coupon rate is 8 per annum paid
  semi-annually.
• So the bond holder will receive
• 1000 x 0.08
• ___ 40 every six months.
• 2

19
Yield to Maturity (YTM)

• Yield to maturity is the rate of return that an
  investor will get if he buys the bond at the
  prevailing market price and holds it till
  maturity.
• In order to get the YTM, two conditions must be
  satisfied.
• The bond must be held till maturity.
• All coupon payments received before maturity must
  be reinvested at the YTM.

20
Value of a Bond

• A bond holder gets a stream of contractually
  promised payments.
• The value of the bond is the value of this stream
  of cash flows.
• However you cannot simply add up cash flows which
  are arising at different points in time.
• Such cash flows have to be discounted before
  being added.

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Price versus Yield

• Price versus yield is a chicken and egg story,
  that is, we cannot say which comes first.
• If we know the yield that is required by us, we
  can quote a price accordingly.
• Similarly, once we acquire the asset at a certain
  price, we can work out the corresponding yield.

22
Bond Valuation

• A bond is an instrument that will pay identical
  coupon payments every period, usually every six
  months, for a number of years, and will then
  repay the face value at maturity.
• The periodic cash flows obviously constitute an
  annuity.
• The terminal face value is a lump sum payment.

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Bond Valuation (Cont)

• Consider a bond that pays a semi-annual coupon of
  C/2, and which has a face value of M.
• Assume that there are N coupons left, and that we
  are standing on a coupon payment date.
• That is, we are assuming that the next coupon is
  exactly six months away.
• The required annual yield is y, which implies
  that the semi-annual yield is y/2.

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Bond Valuation (Cont)

• The present value of the coupon stream is

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Bond Valuation (Cont)

• The present value of the face value is

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Bond Valuation (Cont)

• So the price of the bond is

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Illustration

• IBM has issued a bond with a face value of
  1,000.
• The coupon is 8 per year to be paid on a
  semi-annual basis, on July 15 and January 15
  every year.
• Assume that today is 15 July 2002 and that the
  bond matures on 15 January 2022.
• The required yield is 10 per annum.

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Illustration (Cont)
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Par, Discount Premium Bonds

• In the above example, the price of the bond is
  less than the face value of 1,000.
• Such a bond is called a Discount Bond, since it
  is trading at a discount from the face value.
• The reason why it is trading for less than the
  face value is because the required yield of 10
  is greater than the rate of 8 that the bond is
  paying by way of interest.

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Par, Discount Premium Bonds

• If the required yield were to equal the coupon
  rate, the bond would sell for 1,000.
• Such bonds are said to be trading at Par.
• If the required yield were to be less than the
  coupon rate the price will exceed the face value.
• Such bonds are called Premium Bonds, since they
  are trading at a premium over the face value.

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Zero Coupon Bonds

• A Plain Vanilla bond pays coupon interest every
  period, typically every six months, and repays
  the face value at maturity.
• A Zero Coupon Bond on the other hand does not pay
  any coupon interest.
• It is issued at a discount from the face value
  and repays the principal at maturity.
• The difference between the price and the face
  value constitutes the interest for the buyer.

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Illustration

• Microsoft is issuing zero coupon bonds with 5
  years to maturity and a face value of 10,000.
• If you want a yield of 10 per annum, what price
  will you pay?
• The price of the bond is obviously the present
  value of a single cash flow of 10,000,
  discounted at 10.

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Illustration (Cont)

• In practice, we usually discount the face value
  using a semi-annual rate of y/2, where y in this
  case is 10.
• This is to facilitate comparisons with
  conventional bonds which pay coupon interest
  every six months.

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Zero Coupon Bonds

• Zero coupon bonds are called zeroes by traders.
• They are also referred to as Deep Discount Bonds.
• They should not be confused with Discount Bonds,
  which are Plain Vanilla bonds which are trading
  at a discount from the face value.

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Floating Rate Bonds

• In the case of a Plain Vanilla Bond, the coupon
  rate that is specified at the outset, is valid
  for the life of the bond.
• In the case of a Floating Rate bond, the coupon
  rate is reset at the beginning of every period,
  and is therefore valid for only the next six
  months.
• Thus when you buy such a bond, the coupon will be
  known only for the first six months. Subsequent
  coupons will be unknown.

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Floaters

• For instance the rate on a floating rate bond,
  also called a Floater, may be specified as LIBOR
  50b.p. in which case the spread is positive.
• Or it may be specified as LIBOR 30b.p., in
  which case the spread is negative.
• The rate of interest on a floater will move
  directly with changes in the benchmark.
• Thus if LIBOR rises, the rate will increase,
  whereas if LIBOR falls, the rate will decrease.

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Inverse Floaters

• In the case of an inverse floater the coupon
  varies inversely with the benchmark.
• For instance the rate on an inverse floater may
  be specified as 10 - LIBOR.
• In this case as LIBOR rises, the coupon will
  decrease, whereas as LIBOR falls, the coupon will
  increase.
• In this case a floor has to be specified for the
  coupon.

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Inverse Floaters (Cont)

• In the absence of a floor the coupon can become
  negative in principle.
• In the above case, if LIBOR were to exceed 10,
  then we would be confronted with the spectre of a
  negative coupon.

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Callable Bonds

• In the case of such a bond, the issuer has the
  right to call back the bond prematurely.
• That is he can buy it back from the holder before
  maturity by paying him the face value.
• In this case the option is with the issuer, and
  so he has to pay a price for it.
• This compensation will manifest itself as a lower
  price for the bond as compared to a Plain Vanilla
  Bond.

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Callable Bond (Cont)

• Since prices and yields are inversely related a
  lower price means a higher yield.
• Thus buyers of callable bonds demand a higher
  yield from them as compared to buyers of
  otherwise similar plain vanilla bonds.
• This is because a buyer of a callable bond is
  exposed to cash flow uncertainty. That is, he can
  never be sure as to when a bond will be recalled.

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Callable Bonds (Cont)

• When will a callable bond be recalled?
• Obviously when interest rates or required yields
  are falling.
• Under such conditions, the issuer can call back
  the bonds and issue fresh bonds with a lower
  coupon.
• However this is precisely the scenario when a
  holder would like to hold on to his bonds, since
  they are yielding a higher rate of interest.

42
Callable Bond (Cont)

• Thus the call provision works in favour of the
  borrower and against the lender.
• Hence it is not surprising that callable bonds
  command a lower price.
• Freely callable bonds can be called at any time.
• Thus they offer the lender no protection.

43
Callable Bonds (Cont)

• Deferred Callable Bonds on the other hand do
  offer some protection.
• This is because they have a Call Protection
  Period during which they cannot be recalled.
• For instance if a bond with 20 years to maturity
  has a call protection period of 10 years, then it
  cannot be recalled for the first 10 years. After
  that, it will of course become freely callable.

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Callable Bond (Cont)

• In practice when a bond is recalled, the issuer
  will pay the lender not just the face value, but
  usually also one years coupon.
• This additional amount is called the Call
  Premium.
• The call premium acts as a sweetener, that is it
  makes such bonds more attractive to potential
  investors.

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Callable Bond (Cont)

• The call price, which is the face value plus the
  premium, acts as a ceiling on the price of the
  bond once the call protection period is over.
• That is, once a bond becomes callable, no one
  will pay more than this, even if the required
  yield is very low.
• This is because, in such a scenario the bond can
  be recalled any time at the Call Price.

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Puttable Bonds

• Such bonds give the lender or the bondholder, the
  right to return the bond prematurely, and take
  back the face value.
• The option in such cases is with the bondholders
  or the lenders, and consequently they have to pay
  an option premium.
• This will manifest itself as a higher bond price,
  as compared to that of an otherwise similar plain
  vanilla bond.

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Puttable Bonds (Cont)

• A higher bond price obviously means a lower
  yield.
• When will such a put option be exercised?
• Obviously when interest rates are rising.
• Under such conditions holders can return the
  bonds and buy fresh bonds with a higher coupon
  rate.
• This is precisely the scenario when the issuers
  would prefer that the holders hold on to the
  bonds.

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Puttable Bonds (Cont)

• Since the put option works in favour of the
  holder and against the issuer, it is but natural
  that such bonds are characterized by higher
  prices or lower yields.
• The price at which a bond can be sold back by the
  holder acts as a floor price for the bond when
  interest rates rise.
• Since the holders can always return the bonds to
  the issuer at this price, they will never sell
  them to anyone else at a lower price.

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Convertible Bonds

• Such bonds give the holders the right to convert
  the debt into shares of equity.
• Obviously the conversion option will be exercised
  only if the price at which conversion is allowed,
  is lower than the prevailing market price of the
  shares at the time of conversion.

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Exchangeable Bonds

• These are a category of convertible bonds where
  the holder gets the shares of a different company
  when he converts the bonds.
• For instance if IBM were to issue convertible
  bonds, the holders would get shares of IBM if
  they were to convert.
• On the other hand, if IBM were to issue
  exchangeable bonds, the holders would get shares
  of another company, say Hewlett Packard.

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Exchangeable Bonds (Cont)

• Exchangeable bonds may be issued by firms which
  own blocks of shares of another company and
  intend to sell them eventually.
• They may like to defer the sale and issue such
  bonds, because they may perceive a rise in the
  value of the shares.
• It may also be the case that they desire to defer
  their capital gains tax liability.

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Risks Inherent in Bonds

• What is risk?
• Risk is the possibility of loss arising due to
  the uncertainty regarding the outcome of a
  transaction.
• All bonds are exposed to one or more sources of
  risk.

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Credit Risk

• This risk refers to the possibility of default by
  the borrower.
• That is, it refers to the risk that coupon
  payments and/or principal payments may not be
  forthcoming as promised.
• Except for Treasury securities, which are backed
  by the full faith and credit of the Federal
  government, all debt securities are exposed to
  credit risk of varying magnitudes.

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Credit Evaluation

• At the time of issue, it is the issuers
  responsibility to provide accurate information
  about his financial soundness and
  creditworthiness.
• This is provided in the Offer Document or the
  Prospectus.
• But every potential investor cannot be expected
  to be able to properly evaluate the
  creditworthiness of a borrower.
• Thus in practice we have credit rating agencies.

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Credit Rating Agencies

• Such agencies specialize in evaluating the credit
  quality of a bond at the time of issue.
• They also monitor the issuing company, throughout
  the life of the bond, and modify their
  recommendations if required.
• The main rating agencies in the U.S. are Moodys
  Investors Service, Standard and Poors
  Corporation and Fitch Ratings.

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Rating Criteria

• Ratings are based on an in-depth analysis of the
  issuers financial condition and management, and
  the specific source of revenue that has been
  specified as collateral for the bond.

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Investment Grade Ratings
Credit Risk Moodys Ratings SPs Ratings Fitchs Ratings
Highest Quality Aaa AAA AAA
High Quality Aa AA AA
Upper Medium A A A
Medium Baa BBB BBB
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Non Investment Grade Ratings
Credit Risk Moodys SP Fitch
Somewhat Speculative Ba BB BB
Speculative B B B
Highly Speculative Caa CCC CCC
Most Speculative Ca CC CC
Imminent Default C C C
Default C D D
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Changes in Ratings

• Ratings can change over the course of time.
• If a rating change is being contemplated, the
  agency will signal its intentions.
• SP will place the security on Credit Watch.
• Moodys on Under Review.
• Fitch on Rating Watch.

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Bond Insurance

• A company can have its issue insured in order to
  enhance its credit quality.
• An insurance premium will have to be paid, but
  the coupon rate will come down.
• The insurance company will then guarantee the
  timely payment of the principal and interest.

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List of Specialist Insurance Companies
American Municipal Bond Assurance Corporation (AMBAC)
ACA Financial Guaranty
Asset Guaranty Insurance Company
AXA Re Finance
Capital Guaranty Insurance Company
Capital Reinsurance Company
Enhance Reinsurance Company
Financial Guaranty Insurance Company
Financial Security Assurance
Municipal Bond Insurance Association
62
Insured Bonds

• Insured bonds receive the same rating as the
  insurance company, which is based on the
  insurers capital and claims-paying ability.
• In the U.S., the buyer of an uninsured bond can
  separately buy insurance for it on his own.

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Liquidity Risk

• This risk refers to the possibility that the
  market may be illiquid or thin at a time when the
  asset holder wants to buy or sell the security.
• A liquid market is characterized by the presence
  of a sizeable number of buyers and sellers at any
  point in time.

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Illiquid Markets

• In illiquid markets, potential buyers will have
  to offer a large premium over the fair value of
  an asset in order to acquire it, whereas
  potential sellers will have to accept large
  discounts at the time of sale.
• Illiquid markets are characterized by large
  bid-ask spreads, because trades will be few and
  far between.

65
Interest Rate Risk

• The interest rate or yield is the key variable of
  interest in debt markets.
• The yield is the fundamental variable that drives
  the market.
• Interest rate risk refers to the fact that rates
  may move in an adverse fashion from the
  standpoint of the holder of the debt instrument.

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Interest Rate Risk

• Interest rate risk impacts fixed income
  securities in two ways.
• Firstly, all bonds with the exception of zeroes
  pay coupons, which have to be reinvested.
• Reinvestment risk is the risk that market rates
  of interest may decline by the time a coupon is
  received.

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Interest Rate Risk (Cont)

• If so, the coupon will have to be reinvested at a
  lower than anticipated rate of interest.
• Secondly a bond may not be held to maturity.
• If it is sold prior to maturity, it will have to
  be at the prevailing market price, which will be
  inversely related to the prevailing yield.

68
Interest Rate Risk (Cont)

• Market Risk or Price Risk, is the risk that
  interest rates may be higher than anticipated at
  the time of sale, in which case the bond will
  have to be sold at a lower than anticipated
  price.
• The two risks work in opposite directions.
• Reinvestment risk arises because rates may fall
  subsequently, whereas market risk arises because
  rates may rise subsequently.

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Inflation Risk

• Inflation refers to the erosion in the purchasing
  power of money.
• Most bonds promise fixed cash flows in dollar
  terms.
• Inflation risk is the risk that the purchasing
  power of money may have eroded by more than what
  was anticipated, by the time the cash flow from
  the bond is received.

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Inflation Risk (Cont)

• High inflation will reduce the effective or Real
  rate of interest.
• The interest rate in monetary terms is called the
  Nominal Rate of interest.
• The Real Rate, on the other hand, is the nominal
  rate adjusted for changes in the purchasing power.

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Indexed Bonds

• These are bonds whose coupons are linked to a
  price index.
• Price indices are used as barometers of changes
  in the purchasing power of a currency.
• If inflation is high, so will be the index level
  and vice versa.

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Indexed Bonds (Cont)

• Thus indexed bonds will offer higher cash flows
  during times of high inflation, and relatively
  lower cash flows during periods of lower
  inflation, which will ensure that the cash flow
  in real terms is kept at a virtually constant
  level.

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Timing Risk

• In the case of Plain Vanilla bonds, there is no
  uncertainty regarding the times to receipt of the
  cash flows.
• However, callable bonds can be recalled at any
  time.
• For a callable bond holder there is cash flow
  uncertainty, since he is unsure as to how many
  periods he is going to get coupons for, and also
  as to when the face value will be repaid.

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Timing Risk (Cont)

• Thus holders of callable bonds will demand a
  premium for bearing this risk.
• That is why callable bonds trade at a lower price
  than otherwise comparable plain vanilla bonds.

75
Foreign Exchange Risk

• This risk arises when the cash flows from a bond
  are denominated in a foreign currency.
• If the foreign currency depreciates in value with
  respect to the home currency of the bondholder,
  then when the cash flows from the bond are
  converted into the home currency, the returns
  will be lower than anticipated.

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Illustration

• A bond promises to pay a coupon of 10 every six
  months.
• Assume that the rate of exchange is Rs 50 per
  dollar.
• So an Indian bondholder will expect to receive
  Rs 500 every six months.
• However, what if the exchange rate at the time of
  the coupon payment is Rs 45.
• If so, he will receive only Rs 450.

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Traded Government Securities

• We have already had a brief look at T-bills,
  notes and bonds.
• They are backed by the full faith and credit of
  the U.S. government.
• Unlike savings bonds they are actively traded in
  the market.
• Since 1986 all such securities have been issued
  in book-entry form.

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Traded(Cont)

• These securities are fixed principal securities.
• The investor knows the amount that he will be
  paid on maturity.
• It also issues inflation indexed bonds.
• In this case all that is certain is that whatever
  may be the amount received at maturity, it will
  have the same purchasing power.
• The actual dollar amount is a function of future
  inflation/deflation.

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Traded(Cont)

• T-bills are issued with 3-month, 6-month and
  1-year maturities.
• T-notes are issued with 2-year, 5-year and
  10-year maturities.
• Of late to trim borrowing and reduce the
  governments debt burden the Treasury has stopped
  issuing securities with a maturity exceeding 10
  years.
• Earlier 20 and 30 year securities have been
  issued.

80
Zero Coupon Treasury Securities

• The Treasury per se does not issue zero coupon
  securities.
• But there exist two types of treasury based zero
  coupon securities.
• The principle behind both forms is the same.
• Take a large quantity of a T-note or bond and
  separate al the coupons from each other and from
  the principal.
• Sell the entitlement to each cash flow separately.

81
Zero(Cont)

• Take the case of a two-year T-note.
• It can be separated into four zero coupon
  securities maturing after
• 6 months
• 12 months
• 18 months
• 24 months

82
Zero(Cont)

• Earlier investment banks used to buy regular
  coupon bonds from the Treasury and then separate
  the cash flows themselves.
• Each cash flow was then sold separately as a zero
  coupon bond.
• Such issues are called trademarks.

83
Zero(Cont)

• The issue of trademarks has now ceased.
• This is because investment banks can now create
  such instruments in concert with the Treasury
  itself.
• These zero coupon bonds are known as STRIPS
  Separate Trading of Registered Interest and
  Principal of Securities.
• These are not issued or sold by the Treasury
• The market is made by investment banks.
• But such issues are considered to be an
  obligation of the Treasury.

84
Trademark Products

• Some of the older trademark products which have
  not yet matured continue to trade.
• The process of issuing trademarks was begun by
  Merrill Lynch and Salomon Brothers in 1982.
• These securities are synthetic zero coupon
  Treasury receipts.

85
Trademarks (Cont)

• The procedure for issuing them is as follows
• The bank concerned would purchase a Treasury
  coupon bearing security and deposit it in a bank
  custody account.
• It would then issue receipts representing an
  ownership interest in each coupon payment on the
  underlying asset, as well as a receipt for
  ownership of the maturity value.

86
Trademarks (Cont)

• The process of separating each coupon payment as
  well as the principal and selling securities
  backed by them is referred to as Coupon
  Stripping.
• The receipts issued in the process are not
  created by the Treasury.
• But the underlying asset in the bank custody
  account is an obligation of the Treasury.
• Thus the cash flows from the underlying asset are
  guaranteed.

87
Example

• Assume that a bank purchases 100 MM worth of a
  Treasury note with a 10 year maturity and a
  coupon of 10.
• This note will yield 20 coupon payments of 5
  million each and a final principal repayment of
  100 million.
• This note will be deposited in a custody account.

88
Example (Cont)

• 21 zero coupon securities will then be issued.
• Each will represent a claim on one cash flow from
  the underlying security.
• The first 20 such securities will have a face
  value of 5 million.
• The last will have a face value of 100 MM.
• The maturity dates for the receipts will coincide
  with the coupon payment dates on the underlying.

89
Trademarks (Cont)

• Merrill Lynch marketed its Treasury receipts as
  Treasury Income Growth Receipts TIGRS for
  short.
• Salomon Brothers called its receipts as
  Certificates of Accrual on Treasury Securities
  CATS for short.
• Lehman Brothers offered Lehman Investment
  Opportunities Notes or LIONS for short.

90
Trademarks (Cont)

• These securities are called trademarks because
  each is associated with a particular investment
  banking firm.
• They are called Animal Products for obvious
  reasons.
• This segment of the financial market was also
  referred to as the Zoo.

91
Trademarks (Cont)

• Receipts created by one firm were rarely traded
  by others.
• So the secondary market was illiquid.
• What is the motivation for investment banks to
  create such products?
• In practice arbitrage is possible when a Treasury
  coupon security is purchased at a price that is
  lower than what could be obtained by selling each
  cash flow separately.

92
STRIPS

• The Treasury launched this programme in 1985 to
  facilitate the stripping of designated Treasury
  securities.
• All new T-bonds and notes with a maturity of 10
  years or more are eligible.
• The zeroes created in the process are direct
  obligations of the U.S. government.
• They are cleared through the Federal Reserves
  book-entry system.

93
STRIPS (Cont)

• On dealer quote sheets and vendor screens, STRIPS
  are identified as follows.

Cash Flow Source Symbol
Coupon ci
Principal from T-bond bp
Principal from T-note np
94
TIPS

• The acronym stands for Treasury Inflation
  Protection Securities.
• These are marketable inflation indexed
  securities.
• The coupon rate is fixed at the outset.
• But the principal is adjusted semi-annually to
  account for inflation.

95
Illustration

• Assume that a bond with a face value of 10,000
  and a 5 coupon has been issued.
• Assume that the inflation rate during the first
  six months is 3.
• For the first six months interest will be paid on
  a principal amount of 10,000.
• It will amount to 250.

96
Illustration (Cont)

• At the end of six months the principal will be
  increased by 1.5 to account for inflation.
• The interest for the next six months will be paid
  on the adjusted principal of 10,150.
• It will amount to
• 10,150 x 0.05 x ½ 253.75

97
TIPS (Cont)

• As per IRS rules taxes have to be paid not only
  on the interest earned but also on any inflation
  adjustment that is made to the principal.
• In the event of deflation if the principal at
  maturity is less than the face value at issuance,
  the government will still pay back the original
  face value.