Overview of Bond Market

Fixed Income Markets

Session -1&2

Bond Market: An Overview

2Basic Features of Bonds

Risks Associated with Bonds

Description of a Bond: ABC Co.

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Price: 91.97

Coupon (%): 10.0%

Maturity Date: 9-Sept-2035

Yield to Maturity (%): 11%

Face Value: 1000

Fitch Ratings: BB

Coupon Payment Frequency: Semi-Annual

First Coupon Date: 9-March-2016

Type: Corporate

Callable: No

The Bond Indenture The bond indenture is a three party contract between the bond

issuer, the bondholder, and the trustee The promises of the issuer and the rights of the bondholders

are set forth in detail in the bond indenture

Bond indenture describes: Basic terms of the bond issued Total amount of bonds issued Description of the security Repayment arrangements Details of Call/put provisions if any

Details of the affirmative and negative covenants Affirmative covenants set forth what the borrower has promised to do Negative (or restrictive covenants) set forth certain limitations and restrictions

on the borrowers activities

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Sectors of the U.S. Bond Market

Treasury sector securities issued by the U.S. government

Agency sector securities issued by federally related institutions and government-sponsored enterprises

Municipal sector securities issued by state and local governments bonds (Similar to State Development Loans in Indian context)

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Sectors of the U.S. Bond Market

Corporate sector securities issued in the U.S. by U.S. corporations and foreign corporations

Asset-backed sector securities backed by a pool of assets

Mortgage sector securities backed by mortgage loans

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Overview of Bond Features

Type of Issuer Term to Maturity Principal and Coupon Rate Amortization Feature Embedded Options

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Overview of Bond FeaturesContd

Type of Issuer there are three issuers of bonds The government and its agencies Municipal/State governments Corporations (domestic and foreign)

Term to Maturity refers to the date that the issuer will redeem the bond by paying the principal There may be provisions in the indenture that allow either

the issuer or bondholder to alter a bonds term to maturity (ex. Callable bonds).

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Principal and Coupon Rate Zero-Coupon Bond interest is paid at the maturity with

the exact amount being the difference between the principal value and the price paid for the bond

Floating-rate bonds issues where the coupon rate resets periodically (the coupon reset date) based on the coupon reset formula given by: reference rate + quoted margin

Linkers bonds whose interest rate is tied to the rate of inflation

Inverse-floating-rate bonds coupon interest rate moves in the opposite direction from the change in interest rates

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Amortization Feature the principal repayment of a bond issue can call for either (i) the total principal to be repaid at maturity or (ii) the principal repaid over the life of the bond

In the latter case, there is a schedule of principal repayments called an amortization schedule.

For amortizing securities, a measure called the weighted average life or simply average life of a security is computed.

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Embedded Options it is common for a bond issue to include a provision in the indenture that gives either the bondholder and/or the issuer an option Call provision - grants the issuer the right to retire the debt,

fully or partially, before the scheduled maturity date Put provision - gives the bondholder the right to sell the

issue back to the issuer at par value on designated dates Convertible bond - provides the bondholder the right to

exchange the bond for shares of common stock Exchangeable bond - allows the bondholder to exchange

the issue for a specified number of common stock shares of a corporation different from the issuer of the bond

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Coupon Rate Terminology

When describing a bond, it is typical to state the coupon rate and the maturity date For example, the expression 7s of 12/05/2018 means a

bond with a 7% coupon rate maturing on 12May 2018

Usually coupons are paid semiannually For 7% of 12/05/2018 security coupon payments will be

paid on 12-May and 12-Nov of every year till the redemption of the security i.e. till 12/05/2018

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Coupon Rate TerminologyContd

Zero-coupon bonds do not make periodic coupon payments

Mortgage- and asset-backed securities typically pay interest and principal monthly

Step-up bonds have a coupon rate that increases over time For example: a 5 year bond might have

A 6% coupon rate in year 1 A 6.5% rate in year 2 A 7% rate in year 3, and a 8% rate thereafter

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A floating-rate security is an issue whose coupon rate resets periodically Coupon rate = reference rate + quoted margin E.g., Coupon rate = LIBOR + 100bps

A floating-rate security may have a cap, which sets the maximum coupon rate that will be paid, and/or a floor, which sets the minimum coupon rate that will be paid

A cap is a disadvantage to the bondholder while a floor is an advantage to the bondholder

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Inverse Floaters Usually the coupon formula for a floating rate bond moves

in the same direction as the reference rate; however, inverse or reverse floaters move in the opposite direction

The coupon formula for an inverse floater is: Coupon rate = K - L * reference rate

K is set in the indenture and is a fixed interest rate (e.g., 10%) L is a multiplier (e.g., 2), it is also set in the indenture Reference rate could be the LIBOR, T-bill rate etc.

Suppose that on the reset date if the LIBOR is 4%, the coupon rate would be

=10% - (2 * 4%) or 2%.

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Inflation Protected Bonds Treasury Inflation Protected Securities (e.g., TIPS)

These bonds provide protection against inflation The coupon rate, also called the real rate, on a TIPS is set at a

fixed rate determined through auction The principal value, called inflation adjusted principal, is

adjusted semiannually and hence the coupon payments and the maturity value

At maturity, investors received the greater of the inflation-adjusted principal amount or the par value Investors are protected against the loss of principal amount

RBI issued inflation indexed bonds in 1997 , 2004 & 2013 These bonds are very popular in US, UK and other markets

In UK, inflation-indexed bonds account for more than 40% of outstanding government debt

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Inflation Indexed National Savings Securities - C

IINSS - Cumulative These bonds provide protection against inflation The coupon rate 1.5% per year above the rate of inflation

as measured by the consumer price index (CPI) Not attractive for the investors in higher income brackets Interest rate : reset every six months Principal is not fixed (issue price 5000) Redemption 10 years, Lock-in period 3 years, (1-year for senior citizens) with a

penalty of half of the interest earned in last six months

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Inflation Protected Bonds : Example An investor invested Rs. 10,000 in a inflation protected bond

with coupon rate 3% and two years maturity. During the first year the inflation rate observed was 6% and for the next year it was 7%. Estimate the payments receivable by the investor.

*Principal at the end of half year = Principal amount at the beginning*(1+semiannual inflation rate)

^Coupon payment =Principal*Coupon rate/2Note: Semiannual inflation rate may be taken as annual inflation rate/2

Period Years FromPrincipal

DueYears

ToPrincipal*

Due Coupon^Payments receivable

1 0.0 10000.00 0.5 10300.00 154.50 154.50

2 0.5 10300.00 1.0 10609.00 159.14 159.14

3 1.0 10609.00 1.5 10980.32 164.70 164.70

4 1.5 10980.32 2.0 11364.63 170.47 11535.10

Inflation Protected Bonds : Example 2 An investor invested Rs. 100,000 in a inflation protected bond

with coupon rate 5% and two year maturity. Annualized inflation rate observed was 6%. Estimate the payments receivable by the investor at the end of 3rd period.

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Principal amount at the end of half year = Principal amount at the beginning*(1+semiannual inflation rate)

Coupon=Principal*Coupon rate/2

Separate Trading of Registered Interest and Principal of Securities When a Treasury fixed-principal bond is stripped,

each interest payment and the principal payment becomes a separate zero-coupon security

Each component has its own identifying number and can be held or traded separately

Example: A bond with 5 years maturity, consists of a single principal

payment at the end of 5th year and 10 interest payments, one every six months for 5 years. When this bond is converted to STRIPS, each of the 10 interest payments

and the principal payment becomes a separate zero coupon security.

STRIPS are also called zero-coupon securities

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Pricing a Bond

Determining the price of any financial instrument requires an estimate of the expected cash flows the appropriate required yield the required yield reflects the yield for financial

instruments with comparable risk, or alternative investments

The cash flows for a bond that the issuer cannot retire prior to its stated maturity date consist of periodic coupon interest payments to the maturity date the par (or maturity) value at maturity

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Pricing a Bond

In general, the price of a bond (P) can be computed using the following formula:

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P = price (in dollars)n = number of periods (number of years times 2, if interest paid semiannually)t = time period when the payment is to be receivedC = semiannual coupon payment (in dollars)r = periodic interest rate (required annual yield divided by 2)M = maturity value

Pricing a Bond

Present Value of an Ordinary Annuity When the same amount of money is received (or paid) each

period, it is referred to as an annuity. When the first payment is received one period from now,

the annuity is called an ordinary annuity.

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Pricing of a bond

Consider a 20-year 10% coupon bond with a par value of $1,000 and a required yield of 11%.

Compute the price of the bond.

Zero-Coupon Bond Consider the price of a zero-coupon bond (P) that

matures 15 years from now, if the maturity value is $1,000 and the required yield is 9.4%.

Given M = $1,000, r = 0.094 / 2 = 0.047, and n = 2(15) = 30, what is P ?

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Price-Yield Relationship

A fundamental property of a bond is that its price changes in the opposite direction from the change in the required yield. The reason is that the price of the bond is the present value

of the cash flows. If we graph the price-yield relationship for any option-free

bond, we will find that it has the bowed shape.

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Bond Prices and Interest Rates

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Yield (r)

B

o

n

d

P

r

i

c

e

Non-linear inverse relationship between bond price and interest rateLonger term bonds are more sensitive to changes in interest rates than shorter term bonds

Relationship Between Coupon Rate, Required Yield, and Price When yields in the marketplace rise above the coupon

rate at a given point in time, the price of the bond falls so that an investor buying the bond can realizes capital appreciation. The appreciation represents a form of interest to a new

investor to compensate for a coupon rate that is lower than the required yield.

When a bond sells below its par value, it is said to be selling at a discount.

A bond whose price is above its par value is said to be selling at a premium.

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Relationship Between Coupon Rate, Required Yield, and Price For a bond selling at par value, the coupon rate equals

the required yield. As the bond moves closer to maturity, the bond continues

to sell at par. Its price will remain constant as the bond moves toward the

maturity date.

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Relationship Between Coupon Rate, Required Yield, and Price The price of a bond will not remain constant for a

bond selling at a premium or a discount. The discount bond increases in price as it approaches

maturity, assuming that the required yield does not change. For a premium bond, the opposite occurs. For both bonds, the price will equal par value at the

maturity date.

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Reasons for the Change in the Price of a Bond

The price of a bond can change for three reasons: there is a change in the required yield owing to changes in

the credit quality of the issuer there is a change in the price of the bond selling at a

premium or a discount, without any change in the required yield, simply because the bond is moving toward maturity

there is a change in the required yield owing to a change in the yield on comparable bonds (i.e., a change in the yield required by the market)

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Bond Prices and Interest Rates

Bond price = par value, If coupon rate is equal to the yield required by the market.

Bond price < par value (at a discount) If coupon rate is below the yield required by the market.

Bond price > par value (at a premium) If coupon rate is above the yield required by the market.

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Advantages of Bonds over Stocks

Bonds, while a more conservative investment than stocks, can offer certain investors some very attractive features: Safety Reliable income Potential for capital gains Diversification (especially for an otherwise all-equity

portfolio)

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Safety of Bonds

The safety of bonds derives mainly from two things:

Bondholders are in line ahead of both preferred and common stockholders for payment. Thus, if a firm falls on hard times, it must first pay its bondholders while stockholders may see dividends cut.

In the event that a company skips a payment or violates covenants of the indenture, the creditors may force it into bankruptcy to protect the value of their investment. Stockholders have no such right.

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Reliability of Income

The safety of bonds derives mainly from two things: Most bonds are fixed-income securities. As such, they

promise a fixed set of interest payments and the return of the principal at maturity.

Investors can count on receiving their interest payments in full and on time, except in the event of severe financial distress. Common stockholders can never be sure of the exact amount (and sometimes the exact timing) of dividends.

Bonds that are callable do not offer as much reliability, though it has less risk than stocks.

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Risk Associated with investing in Bonds

Investment risk is the uncertainty that the actual rate of return realized from an investment will differ from the expected rate

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Risk Associated with investing in Bonds

Interest-rate Risk/Market Risk Reinvestment Risk Call Risk Credit Risk Inflation Risk Exchange Rate Risk Liquidity Risk Volatility Risk Risk Risk

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Interest Rate/Market Risk Market Risk is the uncertainty that the realized return

will deviate from the expected return because of interest rate changes

The return on a bond comes from: Coupons Interest earned from reinvesting coupons: interest on interest Capital gains or losses

A change in rates has two-effects on a bond returns: price effect and interest on interest effect which leads to the price risk and reinvestment risk

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Risk Associated with investing in BondsContd

Interest-rate Risk Interest-rate risk or market risk arises when

investment horizon differs from the maturity date. An increase in interest rates will mean the realization

of a capital loss because the bond sells below the purchase price.

Interest-rate risk is by far the major risk faced by an investor in the bond market.

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Market Risk : Example -1 Consider the following case:

An investor with an investment horizon of 12 years buys a GS 9.85 16th Oct, 2015, (issued in Oct 2001) bond on 31stOct, 2003 @ 140.25 with current yield 5.27%.

If the interest rates remains fixed @ 5.27%, then the investor would realize a rate of return of 5.27%

Suppose investor have an investment horizon of five years. Calculate the expected price of the bond after five years.

Have you made any assumption? Download the historical price of the bond and comment on the realized

returns.

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Market Risk : Example -1 Consider the following case:

An investor with an investment horizon of 12 years buys a GS 9.85 16th Oct, 2015, (issued in Oct 2001) bond on 31stOct, 2003 @ 140.25 with current yield 5.27%.

If the interest rates remains fixed @ 5.27%, then the investor would realize a rate of return of 5.27%

Suppose investor have an investment horizon of five years. Calculate the expected price of the bond after five years.

Have you made any assumption? Download the historical price of the bond and comment on the realized

returns.

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Spread 10Year 2Year bond (USA)

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Spread 10Year 2Year bond (USA)

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Key-features Impacting Interest Rate Risk

The features of a bond that affect interest rate risk: Maturity

All else the same: longer the bonds maturity, the greater the bonds price sensitivity to changes in market interest rates

The reason: the time value of money

Coupon rate For a given maturity: lower the coupon, the greater the price change Zero-coupon bond: all else the same, has a greater price change

than a coupon-bearing bond

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Interest Rate Risk The impact of yield level

Sometimes credit considerations cause different bonds to trade at different yields even if they have the same coupon and maturity

The higher a bonds yield, the lower the bonds price sensitivity, all else the same

Floating rate securities For floating rate bonds, the coupon rate is reset periodically based

on market interest rates (reference rates plus a quoted margin) Note: the quoted margin is set for the life of the bond in the

indenture. Therefore, the price of a floating-rate bond depends on: The length of time between the coupon resetting dates The investors required margin Whether the bond has a cap/floor rate

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Interest Rate Risk

Consider a 20-year 10% coupon bond with a par value of $1,000 and a required yield of 11%.

Suppose your investment horizon is 2 years, what is your expected rate of return?

Further suppose that yield rate increases to 12% immediately after purchasing the bond, what will be your realized return?

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Measuring Interest Rate Risk

Approximate Percentage Price Change Duration (crude measure)

Change in percentage price for a change of 100 bps in yield

Duration = [Price (if yields decline) Price (if yields rise)] / [2 X Initial Price X Change in Yield (in %)]

If the estimated duration is 10.44 basis, then this means that for a +/- 1% (or 100bps) change in market rates, this

bond would change in price by -/+ 0.1044% A 50 basis point change would be 0.1044%/2 or

0.0522%

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Measuring Interest Rate Risk

Approximate Dollar Price Change Dollar duration

The approximate dollar price change for a 100 bps in yield

Dollar duration = market value of bond * duration

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Reinvestment Risk Reinvestment risk is the risk that the interest rate at

which interim cash flows can be reinvested will fall. Reinvestment risk is greater for longer holding

periods, as well as for bonds with large, early, cash flows, such as high coupon bonds.

It should be noted that interest-rate risk and reinvestment risk have offsetting effects.

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Call Risk Call risk is the risk that the issuer may retire full or a

part of the bond when interest rates fall. For investors, there are three disadvantages to call

provisions: cash flow pattern cannot be known with certainty investor is exposed to reinvestment risk bonds capital appreciation potential will be reduced

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Call Risk When a bond is called the holder receives the call price

(CP). Since the CP usually exceeds the principal, the return the investor receives over the call period is often greater than the initial YTM

The investor, though, usually has to reinvest in a market with lower rates (as per investment horizon) that often causes his return for the investment period to be less than the initial YTM

Because of the call risk, investors demand a risk premium called call risk premium

Call risk premium is greater in higher interest rate periods

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Call Risk: Example Suppose, a bond with maturity 5 years and coupon rate 10% is

trading at par, the bond can be called at the end of second/third/fourth year at

call price 110/108/106.

An investor with an investment horizon of five years invest in the above bond and expecting yield of 10%.

But interest decreases to 6% at the end of second year and bond is called. Estimate the loss to the investor. Coupons are paid annually.

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Call Risk: ExampleContd If interest rate remains at 10% and the bond is not called

the expected return for the investor would be 10% (Scenario I) If the bond called and the interest rate decline to 6% (Scen II)

As the call price> the buy price, there will be capital gain of (110-100) 10

But, investor will loss some amount because of the reinvestment risk, i.e. now, he has to invest the principal and coupon payments received @ 6% instead of 10% from 3rd year to 5th year

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Call Risk: ExampleContd Suppose, a bond with maturity 5 years and coupon rate 10% is

trading at par, the bond can be called at the end of second year at call price 110. If the rate of interest decreases to 6% at the end of second year and bond is called. Estimate the expected loss expected by the investor. Coupons are paid annually.

Period 0 1 2 3 4 5

Cash Flow

Scenario I -1000 100 100 100 100 1100

Scenario II -1000 100 1200

Amount expected to be received at the end of 5th year

Scenario I =100*(1.1)^4+100*(1.1)^3+100*(1.1)^2+100*(1.1)+1100 =1610.51

Scenario II =100*(1.1)*(1.06)^3+1200*(1.06)^3 =1560.23


Credit Risk/Default Risk Credit risk is the default risk that the bond issuer will

fail to satisfy the terms of the obligation with respect to the timely payment of interest and principal.

Credit spread is the part of the risk premium or spread attributable to default risk.

Credit spread risk is the risk that a bond price will decline due to an increase in the credit spread.

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56Source:Soloman YieldBook,CreditRiskofGMBond

Risk Associated with investing in BondsContd Graph presents the GM yield spread over Benchmark T-

yield Spread shows the extra compensation required by the

investors while investing in GM bond instead of T-bond In 2001, Moddy Rating A3 In 2003 to 2005 GM rating fell down from A3 to lower and

lower, resulted increase in credit spread In 2005, spread reduces better market sentiments and

falling risk premium Because of financial distress credit spread increases after

2007

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Reducing Credit Risk A sinking fund provision requires that the issuer retire a

specified portion of an issue each year The purpose of the provision is to reduce credit risk

To lower the credit risk, bonds may be backed by collateral (secured) may be preferred or protective covenants may be added

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Inflation Risk Inflation risk arises because of the variation in the

value of cash flows from a security due to rises in purchasing power.

If investors purchase a bond on which they can realize a coupon rate of 7% but the rate of inflation is 8%, the purchasing power of the cash flow falls.

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Inflation Risk For all but floating-rate bonds, an investor is exposed

to inflation risk because the interest rate the issuer promises to make is fixed for the life of the issue.

Nominal debt security only compensates for the expected inflation rate at the time it was issued.

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Exchange-Rate Risk Exchange-rate risk refers to the unexpected change in

one currency compared to another currency. From the perspective of a U.S. investor, a nondollar-

denominated bond (i.e., a bond whose payments occur in a foreign currency) has unknown U.S. dollar cash flows.

The dollar cash flows are dependent on the exchange rate at the time the payments are received.

The risk of the exchange rate causing smaller cash flows is the exchange rate risk or currency risk.

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Liquidity Risk Liquidity risk or marketability risk depends on the

ease with which an issue can be sold at or near its value.

The primary measure of liquidity is the size of the spread between the bid price and the ask price quoted by a dealer.

The wider the dealer spread, the more the liquidity risk.

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Features of a Developed Bond Market Liquidity

Liquidity is the ease with which an investor can buy or sell immediately at a price close to the mid quote. A liquid market should have following characteristics:

Tightness: indicates the cost of turning around a position during a short period which should be low. A tight market has very low bid-ask spread

Depth: A market is said to be deep if only the large trades can affect the price

Resiliency: Market prices should reflect fundamental value of the asset and should return to the fundamental value quickly after the shock

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Measuring liquidity: Impact cost

Impact cost Impact cost represents the cost of executing a transaction in

a given stock/bond, for a specific predefined order size, at any given point of time

Buyer/seller pays the cost for immediacy Therefore the price of the Secs. deviates from the fair price

depending upon the availability of the trade or market depth

This transaction cost is reflected in the impact cost Impact cost = (Actual buy price Ideal buy price)*100 / Ideal Price

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Measuring liquidity: Impact cost..Contd

Limitations Impact cost is separately computed for buy and sell Impact cost may vary for different transaction sizes

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Measuring liquidity: Impact cost..Contd

Sol: Actual buy price =(100*90.75+500*90.80+400*91.00)/(100+500+400)

= 90.875 Ideal Price = (90.25+90.75)/2

=90.50Impact cost = (90.875-90.50)*100/90.50

=0.4144%

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Buy Sell

Quantity Price Price Quantity

100 90.25 90.75 100

100 90.20 90.80 500

200 90.10 91.00 400

500 90.00 91.20 300

600 89.80 91.30 500

Example: From the available order

book for a security 8% GS 2014, compute the impact cost for a buyer who want to buy 1000 qty. of the security

Off the run vs On the run issue

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Source:Barclay,MichaelJ.,TerrenceHendershott,andKennethKotz."Automationversusintermediation:EvidencefromTreasuriesgoingofftherun." TheJournalofFinance 61.5(2006):23952414.


Risk Risk Risk risk refers to not knowing the risk of a security. Two ways to mitigate or eliminate risk risk are:

Keep up with the literature on the state-of-the-art methodologies for analyzing securities

Avoid securities that are not clearly understood

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Volatility Risk Volatility risk is the risk that a change in volatility

will adversely affect the price of a bond. The value of an option rises when expected interest-

rate volatility increases. For example, consider the case of a callable bond

where the borrower has an embedded option, the price of the bond falls when interest rates fall due to increased downward volatility in interest rates.

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Other Risk Event Risk: Occasionally an issuer is unable to make

either interest or principal payments because of unexpected events A natural catastrophe or disaster, such as a hurricane or

industrial accident A corporate takeover (LBOs) or restructuring that prevents

the issuer from making timely payment

Sovereign risk: As the result of the actions of a foreign government, such as: Currency revaluations, political change, or war, there may be either a default or an adverse price change in the bond price

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Thank You!

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Documents

Overview of Bond Market