Investment opportunities

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Investment opportunities

• Debt market

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Debt instrument What is it?

• Unlike an equity share, when you subscribe to
  debt, the company/bank/FI promises to return the
  principal on a future date
• In addition, they usually pay periodic interest
  on the principal
• In some debt instruments such as zero coupon
  bonds, no interest is paid. The maturity amount
  will be much larger than the amount of
  subscription.

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Types of debt instruments

• Issued by the government for short term
  (treasury)
• Issued by the government for long term (dated
  paper)
• Issued by financial institutions public sector
  companies (bond)
• Issued by the private sector companies (debenture)

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Products and participants
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Interest

• The face value is the value printed on the
  certificate.
• Annual interest is calculated as (coupon rate
  multiplied by face value divided by 100).
• If the face value is Rs.1000, coupon is 8 p.a.,
  then interest is (10008/100)Rs.80.

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Interest paid half-yearly

• If the face value is Rs.1000, coupon is 8 p.a.,
  then half-years interest is (10008/100/2)Rs.40.

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Fixed rate and floating rate

• Fixed rate means the coupon rate is fixed till
  maturity. If the interest rate in the economy
  goes up, the lender stands to lose if the
  interest rate goes down, the borrower loses
• Floating rate means the coupon changes as the
  reference rate changes.

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Market price of a debt instrument

• Like equity, debt instruments can also be listed
  on a stock exchange. A number of corporate
  debentures are listed and are traded. The price
  at which the trade takes place is called market
  price of the debt instrument.

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Market price

• Market price of the debt can be higher or lower
  than the face value
• When the market price is higher, the paper is
  selling at a premium
• When the market price is lower, the paper is
  selling at a discount

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Current yield

• Let the face value be Rs. 1000
• Let the coupon rate be 8 p.a.
• Let the market price be Rs. 1050
• The current yield is
• 81000/1050 7.62 p.a.
• When the paper sells at a premium, current yield
  is lower than coupon rate.

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Change in yield

• Yield may change due to
• Changes in the financial health of the company
• Changes in the interest rate in the economy

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Premium and discount

• We know that risk and return go hand-in-hand
• If the yield reduces, then it means risk of the
  debt paper is decreasing
• Clearly, papers selling at premium are becoming
  less risky (better quality) or are paying higher
  coupon in comparison to other papers of the same
  quality.
• Conversely, papers selling at discount are
  becoming more risky or are paying coupon lower
  that what they should be paying

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Credit rating

• Debt instruments are classified according to
  their quality through credit rating.
• There are four credit rating agencies CRISIL,
  ICRA, CARE, Fitch
• AAA is the highest rating and indicates good
  quality
• D is the lowest quality and means default

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Credit rating and yield

• Better rating means better quality
• Better quality means lower risk
• Lower risk means lower return
• Lower return means lower yield
• High quality debt paper will give low yield
• Conversely, papers that promise high yield are
  poor quality debt papers

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Credit rating and yield-A hypothetical example
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Current yield and yield to maturity

• Current yield is based on the interest received
  now
• Yield to maturity (YTM) takes into account all
  interest payments in the remaining periods and
  the principal repayment.
• An investor should look at YTM.

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Yield and maturity

• As maturity increase YTM increases.

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Debt investment does not always mean safety

• Safety of a debt paper depends on the yield or
  credit rating
• Poor quality debt papers have inferior ratings
  and high yield.
• Poor quality debt is quite risky.

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Secondary market for debt

• There is secondary market for debt it is
  dominated by government securities
• It is not as active as that for equity
• Retail participation in the secondary market for
  dent is almost absent
• This creates liquidity problems for persons
  purchasing debt in primary issues
• Usually there is no choice for small investors
  but to hold debt papers till maturity

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Debt mutual funds

• Though it is difficult for small investors to
  directly participate in the secondary debt
  market, they can buy debt-oriented mutual funds
• These funds are quite active in the secondary
  debt market

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