1.  Bonds-Basics  Bond Price Theorems Bond Price Theorems  Bonds-Duration & Immunization Bonds-Duration & Immunization  Bond Portfolio Mgt. Strategies Bond Portfolio Mgt. Strategies Dr. Irala 1 Bonds

2. Bonds-Basics Dr. Irala 2 Bonds

3. Bonds- Basics  What is a bond?  How does it differ from Equity  Do you like a bond or Equity?  How do you value a bond?  What determines the value of a bond?  How to measure returns from a bond? Dr. Irala 3 Bonds

4. The basic features of a Bond  Face Value  Issue Price  Interest/Coupon rate  Life of the Bond/ Term To Maturity(TTM)  Redemption Value(RV)  Market Price  Yield Dr. Irala 4 Dividends

5.  Bonds-Basics  Bond Price Theorems  Bonds-duration & Immunization  Bond Portfolio Mgt. Strategies Dr. Irala 5 Bonds

6. Bond Price Theorems Dr. Irala 6 Bonds

7. Theorem-01  sss Dr. Irala 7 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM A100065848.37 A10006511 A10006512 A10006513 A10006514

8. Theorem-01  sss Dr. Irala 8 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM A100065848.3710 A10006511 A10006512 A10006513 A10006514

9. Theorem-01  sss Dr. Irala 9 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM A100065848.3710 A100065815.2111 A10006512 A10006513 A10006514

10. Theorem-01  Plot a Scatter Diagram (YTM on X- Axis, Bond Price on Y –Axis). What do you think the relationship to be? Dr. Irala 10 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM A100065848.3710 A100065815.2111 A100065783.7112 A100065753.7913 A100065725.3514

11. Theorem-01 Dr. Irala 11 Bonds

12. Theorem-01  The market price and YTM of a bond are inversely related Dr. Irala 12 Bonds

13. Theorem-02A Dr. Irala 13 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM Size of the Discount / Premium A100065 848.3710151.63 A10006410 A10006310 A10006210 A10006110 A’1000653 A’1000643 A’1000633 A’1000623 A’1000613  Premium/ Discount is the difference between FV and CMP

14. Theorem-02A Dr. Irala 14 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM Size of the Discount / Premium A100065 848.3710151.63 A100064 873.21 10 126.79 A10006310 A10006210 A10006110 A’1000653 A’1000643 A’1000633 A’1000623 A’1000613  Premium/ Discount is the difference between FV and CMP

15. Theorem-02A Dr. Irala 15 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM Size of the Discount / Premium A100065 848.3710151.63 A100064 873.21 10 126.79 A100063 900.53 10 99.47 A100062 930.58 10 69.42 A100061 963.64 10 36.36 A’100065 1,137.39 3 137.39 A’100064 1,111.51 3 111.51 A’100063 1,084.86 3 84.86 A’100062 1,057.40 3 57.40 A’100061 1,029.13 3 29.13

16. Theorem-02A  If a bond’s yield doesn’t change over its life, then the size of the discount or premium will decrease, as its TTM gets shorter. Dr. Irala 16 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM Size of the Discount / Premium A100065 848.3710151.63 A100064 873.21 10 126.79 A100063 900.53 10 99.47 A100062 930.58 10 69.42 A100061 963.64 10 36.36 A’100065 1,137.39 3 137.39 A’100064 1,111.51 3 111.51 A’100063 1,084.86 3 84.86 A’100062 1,057.40 3 57.40 A’100061 1,029.13 3 29.13

17. Theorem-02A Dr. Irala 17 Bonds  If a bond’s yield doesn’t change over its life, then the size of the discount or premium will decrease, as its TTM gets shorter.

18. Theorem-02B  If two bonds have the same coupon rate, Par value and yield then the one with the shorter life will sell at a smaller discount / premium Dr. Irala 18 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM Size of the Discount / Premium A100065883.31 B1000629

19. Theorem-02B Dr. Irala 19 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM Size of the Discount / Premium A100065883.31 9116.69 B100062 947.23 9 52.77

20. Theorem-03 Dr. Irala 20 Bonds Bo nd Face Value (Rs.) Cou pon (%) TTM (Years) Current Market Price (Rs.) YTM (%) Size of the Discount / Premium (Rs.) % Change in Discount / Premium A100065848.37xxxx A10006410 A10006310 A10006210 A10006110  % Change in Discount / Premium w.r.t the previous year

21. Theorem-03 Dr. Irala 21 Bonds Bo nd Face Value (Rs.) Cou pon (%) TTM (Years) Current Market Price (Rs.) YTM (%) Size of the Discount / Premium (Rs.) % Change in Discount / Premium A100065848.37 10151.63 xxxx A100064 873.21 10 126.7916.38% A100063 900.53 10 99.4721.55% A100062 930.58 10 69.4230.21% A100061 963.64 10 36.3647.62%

22. Theorem-03  If a bond’s yield doesn’t change over its life, then the size of the discount or premium will decrease at an increasing rate, as its TTM gets shorter Dr. Irala 22 Bonds Bo nd Face Value (Rs.) Cou pon (%) TTM (Years) Current Market Price (Rs.) YTM (%) Size of the Discount / Premium (Rs.) % Change in Discount / Premium A100065848.37 10151.63 xxxx A100064 873.21 10 126.7916.38% A100063 900.53 10 99.4721.55% A100062 930.58 10 69.4230.21% A100061 963.64 10 36.3647.62%

23. Theorem-04 Dr. Irala 23 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM (%) Fall / Rise in Market Price A10006512xxxx A100065848.37 A10006512xxxx A10006514

24. Theorem-04  How does the rise in bond’s price(….64.66…) owing to decrease in the bond’s yield compare with the fall in bond’s price (….58.36…) owing to increase in the bond’s yield (from 12 to 14%)? Dr. Irala 24 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM (%) Fall / Rise in Market Price A100065 783.71 12xxxx A100065848.37 1064.66 A100065 783.71 12xxxx A100065 725.35 14 58.36

25. Theorem-04  How does the rise in bond’s price(….64.66…) owing to decrease in the bond’s yield compare with the fall in bond’s price (….58.36…) owing to increase in the bond’s yield (from 12 to 14%)?  Do you have any thing to say about your assumption (in Table -01) of the relationship between YTM and Bond Price? Dr. Irala 25 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM (%) Fall / Rise in Market Price A100065 783.71 12xxxx A100065848.37 1064.66 A100065 783.71 12xxxx A100065 725.35 14 58.36

26. Theorem-04  A decrease in bond’s yield will raise the bond’s price by an amount that is greater in size than the corresponding fall in the bond’s price that would occur if there were an equal sized increase in the bond’s yield Dr. Irala 26 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM (%) Fall / Rise in Market Price A100065 783.71 12xxxx A100065848.37 1064.66 A100065 783.71 12xxxx A100065 725.35 14 58.36

27. Theorem-04B  Plot the results on a graph sheet (YTM on X- Axis, Bond Price on Y –Axis).  How are the YTM and bond price related? Re visit your observations in Table -01 and Table -04 A Dr. Irala 27 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM A100065848.37 10 A100065 581.31 20 A100065 415.46 30 A100065 308.04 40 A100065 235.88 50

28. Theorem-04B Dr. Irala 28 Bonds  The relation between YTM and Bond Price is Convex

29. Theorem-05 Dr. Irala 29 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM % Change in Bond Price A100065 848.37 XXXX A10006520 D10009510 XXXX D10009520

30. Theorem-05 Dr. Irala 30 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM % Change in Bond Price A100065 848.37 10 XXXX A100065 581.31 20 31.48% D100095 962.09 10 XXXX D100095 671.03 20 30.25%

31. Theorem-05  The percentage change in a bond’s price owing to a change in its yield will be smaller if the coupon rate is higher Dr. Irala 31 Bonds Bond Face Value (Rs.) Coupon (%) TTM (Years) Current Market Price (Rs.) YTM % Change in Bond Price A100065 848.37 10 XXXX A100065 581.31 20 31.48% D100095 962.09 10 XXXX D100095 671.03 20 30.25%

32.  Bonds-Basics  Bond Price Theorems  Bonds-duration & Immunization  Bond Portfolio Mgt. Strategies Dr. Irala 32 Bonds

33. Duration & Immunization Dr. Irala 33 Bonds

34. Apply Your Knowledge  Of A & B which do you choose? And why? BOND FV COUPON (%) TTMRVCMP A 10000.0651000883.31 B 10000.0751000883.31  Other things being same, the one with the higher coupon is more attractive Dr. Irala 34 Bonds

35. Applying Knowledge  Of C & D which do you choose? And why? BOND FV COUPON (%) TTMRVCMP C 10000.0651000883.31 D 10000.0631000924.06  If two bonds have the same coupon rate, Par value and yield then the one with the shorter life will sell at a smaller discount / premium Dr. Irala 35 Bonds

36. Apply your Knowledge!!!  Of E & F which do you choose? And why? BOND FV COUPON (%) TTMRVCMP E 10000.0661000843.32 F 10000.0751000883.31  Find the Yield Dr. Irala 36 Bonds

37. Apply your Knowledge!!!  Of E & F which do you choose? And why? BOND FV COUPON (%) TTMRVCMPYTM E 10000.0661000843.32 9.55% F 10000.0751000883.31 10.08%  Prefer F to E Dr. Irala 37 Bonds

38. Apply your Knowledge!!!  Of G & H which do you choose? And why? BONDCMPFV COUPO N TTMRV G1,034.6510000.0741000 H1,034.4610000.0441131 Dr. Irala 38 Bonds

39. Apply your Knowledge!!!  Of G & H which do you choose? And why? BONDCMPFV COUPO N TTMRVYTM G1,034.6510000.07410000.06 H1,034.4610000.04411310.06  Both have the same return  What about Risk?  The percentage change in a bond’s price owing to a change in its yield will be smaller if the coupon rate is higher Dr. Irala 39 Bonds

40. Apply your Knowledge!!!  Of I & J which do you choose? And why? BONDFV COUPO NTTMRVYTMCMP I10000.07410000.061,034 J10000.04311050.061,034 Dr. Irala 40 Bonds

41. Apply your Knowledge!!!  Of I & J which do you choose? And why? BONDFV COUPO NTTMRVYTMCMP DURAT ION I10000.07410000.061,0343.6 J10000.04311050.061,0342.8 Dr. Irala 41 Bonds

42. Computing Duration  CMP EOYCFPVIF@YTMPVCF? 1700.943366.031*(66.03/1034)=0.0638 2700.889962.292*(62.29/1034)=0.1204 3700.839658.773*(58.77/1034)=0.1704 410700.7920847.544*(847.54/1034)=3.2766 1034.65 3.63 CMP Duration BONDFVCOUPONTTMRVYTMCMPDUR I10000.07410000.061,0343.6 Dr. Irala 42 Bonds

43. Duration Defined  Weighted average number of years necessary to recover the initial cost of the bond, where the weights reflect the time value of money

44. Understanding Duration  Of two bonds K & L which do you choose? And why? 0 12345 K (5,597)300020001000500200 L (5,597)2025506600 Dr. Irala 44 Bonds

45. Dr. Irala 45 Bonds

46. Dr. Irala 46 Bonds

47. Dr. Irala 47 Bonds

48.  Bonds-Basics  Bond Price Theorems  Bonds-duration & Immunization  Bond Portfolio Mgt. Strategies Dr. Irala 48 Bonds

49. Bond Portfolio Mgt. Strategies Dr. Irala 49 Bonds

50. Bond Portfolio Mgt. Strategies  Passive Management Steady Income  Semi Active Management Apart from steady income, meeting a future liability  Active Management Maximize the total return in each period Dr. Irala 50 Bonds

51. Bond Portfolio Mgt. Strategies  Passive Management Buy-and-hold Indexing  Semi Active Management Dedication Immunization  Active Management Interest Rate Anticipation Bond Swaps Dr. Irala 51 Bonds

52. Passive Mgt. -Buy-and-hold  Select a portfolio of bonds based on the desires characteristics(e.g., credit quality, coupon, maturity) and holding to maturity  Do not trade actively  Suitable to income maximizing Investors  Low level of risk  Easy and better management of portfolio performance Dr. Irala 52 Bonds

53. Passive Mgt. -Indexing  Design a portfolio of bonds that mimics a certain index (e.g., Sensex).  Selecting in Index Matching investor's risk profile  Approaches to indexing: (1) full replication  All of the securities represented in the index are held in their exact proportions (2) stratified sampling or cellular approach  divides the index into cells based upon parameters such as coupon, maturity, country, etc. and each cell is represented in the portfolio. Dr. Irala 53 Bonds

54. Passive Mgt. -Indexing  Approaches to indexing: (3) Optimization  An extension of cellular approach  Includes few more constraints and an objective function  Optimization though LP or QP (4) Variance Minimization  Maximize the expected return of indexed portfolio while minimizing the variance of the tracking error Dr. Irala 54 Bonds

55. Passive Mgt. -Indexing  Tracking error Deviation of performance of the portfolio from that of the underlying Index  Transaction costs  Replication discrepancy Dr. Irala 55 Bonds

56. Bond Portfolio Mgt. Strategies  Passive Management Steady Income  Semi Active Management Apart from steady income, meeting a future liability  Active Management Maximize the total return in each period Dr. Irala 56 Bonds

57. Bond Portfolio Mgt. Strategies  Passive Management Buy-and-hold Indexing  Semi Active Management Dedication Immunization  Active Management Interest Rate Anticipation Bond Swaps Dr. Irala 57 Bonds

58. Semi Active Mgt. -Dedication  To create and maintain a portfolio that has a cash flow structure that exactly or closely matches the liability structure  Approaches to Dedication Pure Cash matching Cash matching with reinvestment Dr. Irala 58 Bonds

59. Semi Active Mgt. -Dedication  Pure Cash matching Cash flows (coupons & principal payments) exactly match the liabilities Dedication with Zeros  Purchasing zero coupon bonds with maturities and proceeds exactly matching the liability structure  Cash matching with Reinvestment To create a portfolio whose expected re investment proceeds and principal payments match the liability structure Dr. Irala 59 Bonds

60. Semi Active Mgt. -Immunization  Matching the duration of a portfolio with that of the investment horizon Dr. Irala 60 Bonds

61. Bond Portfolio Mgt. Strategies  Passive Management Steady Income  Semi Active Management Apart from steady income, meeting a future liability  Active Management Maximize the total return in each period Dr. Irala 61 Bonds

62. Bond Portfolio Mgt. Strategies  Passive Management Buy-and-hold Indexing  Semi Active Management Dedication Immunization  Active Management Interest Rate Anticipation Bond Swaps Dr. Irala 62 Bonds

63. Active Mgt. Rate Anticipation  Choosing Maturity Interest rates are expected to decline  Invest in long duration( More TTM, less coupon) bonds  Logic: when int. rates fall –Price rises & yield falls –Benefit form capital appreciation Interest rates are expected to increase  Invest in short duration( less TTM, more coupon) bonds  Logic: when int. rates rise –Prices fall & yield rises –Preserve & transfer capital Dr. Irala 63 Bonds

64. Active Mgt. Rate Anticipation  Choosing Maturity  Choosing the sector  Mapping returns Dr. Irala 64 Bonds

65. Active Mgt. –Bond Swaps  liquidating a current position and simultaneously buying a different issue in its place with similar attributes, but a chance of improved returns. Dr. Irala 65 Bonds

66. Active Mgt. –Bond Swaps  Pure Yield Pickup Swaps: Swapping out a low-coupon bond into a comparable higher-coupon bond to realize an automatic and instantaneous increase in current yield and yield to maturity.  Substitution Swaps Swapping comparable bonds that are trading at different yields; based on the premise that the credit market is temporarily out of balance.  Tax Swaps Trades motivated by prevailing tax codes and accumulated capital gains in a portfolio (e.g., selling a bond with a capital loss to offset one with a capital gain). Dr. Irala 66 Bonds