Fixed Income Security

Analysis
Prof. Akhil Shetty
Introduction to Fixed Income
► Fixed Income security is an investment that provides a return in the form of periodic
interest payment along with the principal amount till maturity
► Judged by total market value, fixed- income securities constitute the most prevalent
means of raising capital globally (Approx. over 70 % of total capital is raised with the help
of debt)
► A fixed- income security is an instrument that allows governments, companies, and
other types of issuers to borrow money from investors
► Payments of interest and repayment of principal (amount borrowed) are a prior claim on
the company’s earnings and assets compared with the claim of common shareholders
► The promised payments on fixed- income securities are, in general, contractual (legal)
obligations of the issuer to the investor
► A bond is a contractual agreement between the issuer and the bondholders.
► There are three important elements that an investor needs to know about when
investing in a bond: The bond’s features; The legal, regulatory, and tax considerations
& The contingency provisions
Basic Features of Fixed Income Securities
► Issuer
► Supranational Organisation
► Sovereign (National) Government
► Non Sovereign (Local) Government
► Quasi – Government Entities
► Corporate
► Special Legal Entities
► Credit Rating
► Maturity
► Par Value
► Coupon Rate & Frequency
► Currency Denomination
► Source of Repayment
► Collaterals
► Legal & Tax Consideration
Characteristics of Investment
► Return
► The principal component of return is the periodic income on the investment, either
in the form of interest or dividends
► The second component is the change in the price of the asset— commonly called the
capital gain or loss
► Historical rate of Return is calculated using Arithmetic Mean or Geometric Mean
► Expected Rate of Return = (Expected Selling Price – Purchase Price + Periodic
Income)/Purchase Price
► Risk
► Risk is generally associated with the possibility that realized returns of securities will
be less than the returns that were expected
► Total Risk can calculated using variance and standard deviation
► Safety
► Liquidity
Factors Affecting Risk
► Systematic risk (External Factors)
► Market Risks
► Interest-rate risk
► Purchasing-power risk
► Political Risks
► Exchange rate risk
► Unsystematic risk (Internal Factors)
► Business risk
► Financial Risk
► Default or insolvency risk
► Liquidity Risks
► Management Risks
Fixed Income Securities
► Money Market Instrument
► Treasury Bill (T-Bill)
► Commercial Paper
► Certificate of Deposit
► Repurchase agreements (repos)
► Capital Market Instrument
► G sec Bond
► Secured Bond
► Unsecured Bond
► Debentures
► Zero – Coupon Bond
► Convertible / Callable / Puttable Bond
► Mortgage Backed Securities & Asset Based Securities
► Fixed Deposits
Relationships between the Bond Price
and Bond Characteristics
 Relationships between the Bond Price
and Bond Characteristics
► The price of a fixed- rate bond will change whenever the market discount rate changes
► Four relationships about the change in the bond price given the market discount rate are:
► The bond price is inversely related to the market discount rate. When the market
discount rate increases, the bond price decreases (the inverse effect)
► For the same coupon rate and time- to- maturity, the percentage price change is
greater (in absolute value, meaning without regard to the sign of the change) when
the market discount rate goes down than when it goes up (the convexity effect)
► For the same time- to- maturity, a lower- coupon bond has a greater percentage
price change than a higher- coupon bond when their market discount rates change
by the same amount (the coupon effect)
► Generally, for the same coupon rate, a longer- term bond has a greater percentage
price change than a shorter- term bond when their market discount rates change by
the same amount (the maturity effect)
Bond Pricing with a Market Discount Rate
► Price of a fixed- rate bond, relative to par value, depends on the relationship of
the coupon rate to the market discount rate
► When the coupon rate is equal to the market discount rate, the bond is priced
at par value
► When the coupon rate is less than the market discount rate, the bond is
priced at a discount below par value
► When the coupon rate is greater than the market discount rate, the bond is
priced at a premium above par value
► The yield to maturity is the internal rate of return on a bond’s expected cash
flows—that is, the discount rate that equates the present value of the bond’s
expected cash flows until maturity with the bond’s price
► The yield to maturity can be considered an estimate of the bond’s expected
return; it reflects the expected annual return that an investor will earn on a
bond if this investor purchases the bond today and holds it until maturity
Bond Pricing with a Market Discount Rate
► The market discount rate is used in the time- value- of- money calculation to obtain
the present value
► The market discount rate is the rate of return required by investors given the
risk of the investment in the bond. It is also called the required yield, or the
required rate of return or Yield to Maturity (YTM)
► General formula for calculating a bond price given the market discount rate:
Calculation of Bond Pricing
► An investor who owns a bond with a 9% coupon rate that pays interest
semiannually and matures in three years is considering its sale. If the required
rate of return on the bond is 11%, the price of the bond per 100 of par value is
closest to
► Identify whether each of the following bonds is trading at a discount, at par
value, or at a premium. Calculate the prices of the bonds per 100 in par value
using Equation 1. If the coupon rate is deficient or excessive compared with
the market discount rate, calculate the amount of the deficiency or excess per
100 of par value.
Bond Coupon Payment Number of Periods Market Discount Rate
per Period to Maturity per Period
A 2 6 3%
B 6 4 4%
C 5 5 5%
D 0 10 2%
YIELD SPREADS
► The building blocks of the yield- to- maturity include benchmark and the spread
► The benchmark is often called the risk- free rate of return. Also, the benchmark can
be broken down into the expected real rate and the expected inflation rate in the
economy.
► The yield spread is called the risk premium over the “risk- free” rate of return. The
risk premium provides the investor with compensation for the credit and liquidity
risks, and possibly the tax impact of holding a specific bond
► The benchmark captures the macroeconomic factors: the expected rate of inflation in
the currency in which the bond is denominated, general economic growth and the
business cycle, foreign exchange rates, and the impact of monetary and fiscal policy
► The spread captures the microeconomic factors specific to the bond issuer and the
bond itself: credit risk of the issuer and changes in the quality rating on the bond,
liquidity and trading in comparable securities, and the tax status of the bond. It should
be noted, however, that general yield spreads across issuers can widen and narrow with
changes in macroeconomic factors
YIELD SPREADS
Bonds with Contingency Provisions
► Callable Bonds (Embedded option)
► A callable bond gives the issuer the right to redeem all or part of the bond
before the specified maturity date
► Putable Bonds (Embedded option)
► A put provision gives the bondholders the right to sell the bond back to the
issuer at a pre- determined price on specified dates
► Convertible Bonds (Embedded option)
► The convertible bond is a hybrid security with both debt and equity features.
It gives the bondholder the right to exchange the bond for a specified number
of common shares in the issuing company
► Warrant (Attached option)
► Warrant entitles the holder to buy the underlying stock of the issuing
company at a fixed exercise price until the expiration date
Risk and Return Characteristics
► An investor in a fixed- rate bond has three sources of return:
► receipt of the promised coupon and principal payments on the scheduled
dates,
► reinvestment of coupon payments, and
► potential capital gains or losses on the sale of the bond prior to maturity
► Two commonly used measures of interest rate risk: duration and convexity.
► It distinguishes between risk measures based on changes in a bond’s own yield to
maturity (Yield Duration and Convexity)
► The Duration of a bond measures the sensitivity of the bond’s full price
(including accrued interest) to changes in the bond’s yield- to- maturity
► Convexity is a measure of the curvature, or the degree of the curve, in the
relationship between bond prices and bond yields
Risk and Return Characteristics
Modified Duration
► Modified duration expresses the change in the value of a security due to the change in
interest rate
► If Modified duration is 4.22 then 1% increase in YTM will reduce the price of the
bond by 4.22%
► Modified Duration = Macaulay Duration / (1+YTM/n) where n = number of coupon
period per year
► Approximate Duration can be calculated using following formula:

Where PV0 = Original Price

ΔYield = % change in YTM (Up & Down)
PV+ = price when the yield is increased by ΔYield
PV- = price when the yield is reduced by ΔYield
► %ΔPVFull ≈ –AnnModDur × ΔYield
Modified Duration
► An investor buys a three- year bond with a 5% coupon rate paid annually.
The bond, with a yield- to- maturity of 3%, is purchased at a price of
105.6572 per 100 of par value. Calculate Approximate modified duration?

► An investor buys a five year bond with a 5% coupon rate paid Semi -
annually. The bond, with a yield- to- maturity of 5%, is purchased at a price
of 100 per 100 of par value. Calculate Approximate modified duration?

► An investor buys a five- year bond with a 5% coupon rate paid Semi -
annually. The bond, with a yield- to- maturity of 7%, is purchased at a price
of 91.6834 per 100 of par value. Calculate Approximate modified duration?
Macaulay Duration
► Macaulay duration is named after Frederick Macaulay, the Canadian
economist who first wrote about the statistic in a book published in 1938

The Macaulay duration of the 10- year, 8% annual payment bond is calculated by
entering r = 0.1040, c = 0.0800, N = 10, and t/T = 0
Macaulay Duration
Interest Rate Risk, Macaulay Duration, and the Investment Horizon
Macaulay Duration
► The earlier numerical example and Prior exhibit allow for a
statement of the general relationships among interest rate risk, the
Macaulay duration, and the investment horizon
► When the investment horizon is greater than the Macaulay
duration of a bond, coupon reinvestment risk dominates market
price risk. The investor’s risk is to lower interest rates
► When the investment horizon is less than the Macaulay duration
of the bond, market price risk dominates coupon reinvestment
risk. The investor’s risk is to higher interest rates
► When the investment horizon is equal to the Macaulay duration
of a bond, coupon reinvestment risk offsets market price risk
Convexity
► The true relationship between the bond price and the yield- to- maturity is the curved
(convex) line
► The convexity statistic for the bond is used to improve the estimate of the percentage
price change provided by modified duration alone

► The first bracketed expression, the “first- order” effect i.e The (annual) modified
duration, AnnModDur, is multiplied by the change in the (annual) yield- to- maturity,
Δyield. The second bracketed expression, the “second-order” effect, is the convexity
adjustment
► Approximate Convexity is calculated using below mentioned formula
Convexity & Duration
► A bond is currently trading for 98.722 per 100 of par value. If the bond’s
yield-to- maturity (YTM) rises by 10 basis points, the bond’s full price is
expected to fall to 98.669. If the bond’s YTM decreases by 10 basis points,
the bond’s full price is expected to increase to 98.782. The bond’s
approximate convexity is closest to?

► A bond has an annual modified duration of 7.020 and annual convexity of

65.180. If the bond’s yield- to- maturity decreases by 25 basis points, the
expected percentage price change is closest to?

► A bond has an annual modified duration of 7.020 and annual convexity of

65.180. If the bond’s yield- to- maturity decreases by 25 basis points, the
expected percentage price change is closest to?
Yield Curve