Bond Portfolio

Issuers, Investors & important features Issuers – Central Govt., State Govt., PSUS, Corporate Bodies, Banks. Issuers – Central Govt., State Govt., PSUS, Corporate Bodies, Banks. Investors – Banks, Insurance Companies, PFs, Individuals, Trusts, corporate bodies Investors – Banks, Insurance Companies, PFs, Individuals, Trusts, corporate bodies Law requires that certain categories must invest in debt securities. Like Banks must invest at least 25% of demand and time deposits in the T-Bills, Central Govt. Bonds and state Govt. development loans and other approved securities (SLR requirement) Law requires that certain categories must invest in debt securities. Like Banks must invest at least 25% of demand and time deposits in the T-Bills, Central Govt. Bonds and state Govt. development loans and other approved securities (SLR requirement) Corporate bonds require ratings Corporate bonds require ratings Maturity of Central Govt. bonds extend up to 30 years. Maturity of Central Govt. bonds extend up to 30 years. Debt securities issued by the Central Govt. (G-Sec) are considered risk-free. In the jargon of credit rating agencies they are supposed to be AAA+, the plus (+) comes from right to print currency notes. Debt securities issued by the Central Govt. (G-Sec) are considered risk-free. In the jargon of credit rating agencies they are supposed to be AAA+, the plus (+) comes from right to print currency notes. All bonds other than G-sec bonds carry credit risk. Even Industrial Finance Corporation of India Ltd defaulted. All bonds other than G-sec bonds carry credit risk. Even Industrial Finance Corporation of India Ltd defaulted. In most bond markets clearing and settlement are done by specialized clearing companies. In India the function is discharged by the Clearing Corporation of India Ltd. (CCIL) In most bond markets clearing and settlement are done by specialized clearing companies. In India the function is discharged by the Clearing Corporation of India Ltd. (CCIL)

Determinants of Bond Safety Almost similar credit analysis carried out by the banks and Financial Institutions. Coverage Ratio ( Interest Coverage Ratio = EBIT/ I, Cash Flow Coverage Ratio =EBIDTA / Interest on debt + Loan Repayment Installment/ (1- tax rate) etc. Coverage Ratio ( Interest Coverage Ratio = EBIT/ I, Cash Flow Coverage Ratio =EBIDTA / Interest on debt + Loan Repayment Installment/ (1- tax rate) etc. Leverage Ratio Leverage Ratio Profitability Ratios Profitability Ratios Liquidity Ratios Liquidity Ratios

Bond - Basics Bond (option free) Bond (option free) Callable Bond Callable Bond Puttable Bond Puttable Bond Yield (Current) [coupon interest/current Price] ( T-bills are zero coupon bonds. A 91 day T-bill priced, at say Rs will thus yield -1.50/98.50 X 365/91=6.108% p.a.) Yield (Current) [coupon interest/current Price] ( T-bills are zero coupon bonds. A 91 day T-bill priced, at say Rs will thus yield -1.50/98.50 X 365/91=6.108% p.a.) Yield to Maturity (YTM) [ =IRR, Different from current yield] Yield to Maturity (YTM) [ =IRR, Different from current yield] Floating Rate Bond Floating Rate Bond Junk Bond (Low-rated bonds. In India mostly junk bonds are ‘fallen angels’) Junk Bond (Low-rated bonds. In India mostly junk bonds are ‘fallen angels’) Zero coupon Bond (Deep Discounts Bond) Zero coupon Bond (Deep Discounts Bond) Premium bond ( selling over par value, coupon > current yield) Premium bond ( selling over par value, coupon > current yield) Discount Bond ( selling below par value, coupon < current yield) Discount Bond ( selling below par value, coupon < current yield) Clean Price / Dirty Price. Clean Price / Dirty Price. Commercial Papers (issued by corporate houses for raising short term fund – requires rating, may be issued at a discount to face value) Commercial Papers (issued by corporate houses for raising short term fund – requires rating, may be issued at a discount to face value) Certificate of Deposits (Like CP issued except that issuer is bank) Certificate of Deposits (Like CP issued except that issuer is bank)

Reasons for Change in the Price of a Bond Change in the credit quality of the issuer Change in the credit quality of the issuer Change in the required yield of a comparable bond. Change in the required yield of a comparable bond. Movement towards maturity of a discount / premium bond. Movement towards maturity of a discount / premium bond. Note: Bond prices approach par value as maturity approaches.

Dynamic Price-Yield Relationship for Option – Free Bond Bond Prices and Yields are inversely related, as yields increase bond prices fall and vice versa Bond Prices and Yields are inversely related, as yields increase bond prices fall and vice versa An increase in a bond’s yield to maturity results in a smaller price change than a decrease in yield of equal magnitude. An increase in a bond’s yield to maturity results in a smaller price change than a decrease in yield of equal magnitude. putting differently - putting differently - The shape of the price-yield relationship is referred to as convex – meaning decrease in yield have bigger impact on prices than increases in yields of equal magnitude The shape of the price-yield relationship is referred to as convex – meaning decrease in yield have bigger impact on prices than increases in yields of equal magnitude Prices of long term bonds tend to be more sensitive to interest rate changes than the prices of short tem bond. Prices of long term bonds tend to be more sensitive to interest rate changes than the prices of short tem bond. The sensitivity of a bond’s price to a change in yield increases at a decreasing rate as maturity increases. Thus, interest rate sensitivity increases with maturity but it does so less than proportionally as bond maturity increases. The sensitivity of a bond’s price to a change in yield increases at a decreasing rate as maturity increases. Thus, interest rate sensitivity increases with maturity but it does so less than proportionally as bond maturity increases. Interest rate risk is inversely related to the bond’s coupon rate. Prices of high coupon bonds are less sensitive to changes in the interest rate than the prices of low- coupon bond Interest rate risk is inversely related to the bond’s coupon rate. Prices of high coupon bonds are less sensitive to changes in the interest rate than the prices of low- coupon bond The sensitivity of a bond’s price to a change in its yield is inversely related to yield to maturity at which the bond is currently trading. The sensitivity of a bond’s price to a change in its yield is inversely related to yield to maturity at which the bond is currently trading.

Change in bond price as a function of change in YTM Bond Face Value Coupon Maturity YTM Price % Change in Price Bond Face Value Coupon Maturity YTM Price % Change in Price A % 1 year 6% % A % 1 year 6% % B % 1 year 4% % B % 1 year 4% % C % 2 years 6% % C % 2 years 6% % D % 3 years 6% % D % 3 years 6% % E % 1 year 5% % E % 1 year 5% %