9. Investing in Fixed Income Securities

Debt market and its need in financing structure of Corporates and Government

Debt markets are a vital part of the financial system and serve as a major source of financing for both corporates and governments. Debt markets provide access to funds to meet various financial requirements such as working capital, capital expenditure, debt refinancing, and project financing.

Corporates raise funds from the debt market through issuance of bonds or debentures, which are essentially fixed income securities. The terms and conditions of these securities are determined by the issuer and are based on the creditworthiness of the company. The bondholders receive periodic interest payments and the principal amount is repaid at maturity. Corporates also have the option to issue convertible bonds, which can be converted into equity shares at a pre-determined price.

Governments also issue debt securities to finance their budget deficits or for infrastructure projects. These securities are issued in the form of treasury bills, bonds, or notes. The interest rate on these securities is usually determined by the market and is based on the credit rating of the country. Government securities are considered to be low-risk investments and are often used as a benchmark for other debt instruments.

The need for debt markets arises due to the limitations of bank lending. Banks have limited capacity to lend, and the cost of borrowing from banks is often higher than the cost of borrowing from the debt market. Debt markets also provide diversification opportunities to investors and help to match the investment objectives of different market participants.

Debt markets play a crucial role in the overall health of the financial system. They help to allocate capital efficiently, provide liquidity, and facilitate risk transfer. The development of debt markets is therefore an important policy objective for governments and financial regulators.

Bond Market Ecosystem

The bond market ecosystem is a complex network of issuers, investors, traders, and other market participants involved in the buying, selling, and trading of debt securities. Bonds with options are a type of bond that gives the holder the right, but not the obligation, to buy or sell the underlying bond at a specific price and date in the future.

This type of bond is also known as a callable or puttable bond. Callable bonds give the issuer the right to call the bond back and repay the principal before the maturity date, while puttable bonds give the holder the right to sell the bond back to the issuer at a predetermined price and date.

Bonds with options are often issued by companies or governments that want to raise capital but also want to have flexibility in managing their debt. These bonds can be attractive to investors who want to limit their downside risk or take advantage of potential price movements in the bond market.

Risks associated with fixed-income securities

Here are some details about each of the risks associated with fixed income securities:

a. Interest Rate Risk: Interest rate risk is the risk of a decrease in the value of a fixed-income investment that is caused by an increase in interest rates. As interest rates increase, the value of fixed-income securities decreases. This happens because investors can earn a higher rate of return on new investments that have higher interest rates.

b. Call Risk: Call risk is the risk that a bond issuer will call back, or redeem, a bond before its maturity date. This can happen when interest rates decline, and the issuer can save money by issuing new bonds at a lower interest rate.

c. Reinvestment Risk: Reinvestment risk is the risk that the investor will be unable to reinvest cash flows from a fixed-income security at the same rate of return as the original investment. This risk is particularly relevant for bonds with long maturities, as the investor is exposed to fluctuations in interest rates over a longer period.

d. Credit Risk: Credit risk is the risk of a borrower defaulting on a loan or bond. The higher the credit risk of the borrower, the higher the yield required by investors to compensate for the risk.

e. Liquidity Risk: Liquidity risk is the risk that an investor may not be able to buy or sell a security quickly enough to prevent a loss or to realize a profit. This can happen if there is a lack of buyers or sellers in the market.

f. Exchange Rate Risk: Exchange rate risk is the risk that the value of an investment denominated in a foreign currency will decrease due to changes in the exchange rate. This risk is particularly relevant for international bonds and bond funds.

g. Inflation Risk: Inflation risk is the risk that the return on an investment will be eroded by inflation. This is a particular concern for fixed-income investments with long maturities, as inflation can reduce the purchasing power of the cash flows from the investment.

h. Volatility Risk: Volatility risk is the risk that the value of an investment will fluctuate significantly over a short period of time. This can happen due to changes in interest rates, credit ratings, or other market conditions.

i. Event Risk: Event risk is the risk that a significant event, such as a natural disaster or a geopolitical crisis, will impact the value of an investment. This type of risk is difficult to predict and can have a significant impact on the value of fixed-income securities.

Pricing of Bond

1. The Concept of Par Value:

The par value of a bond refers to the face value or nominal value of the bond. It is the amount that will be paid to the bondholder upon maturity. The par value is usually set at $1,000 per bond, but it can vary based on the issuing company or government. The par value is an essential concept as it is used to calculate the coupon payment on the bond and is also the basis for calculating the yield to maturity.

For example, suppose you buy a bond with a par value of $1,000 and a coupon rate of 5%. In that case, you will receive $50 in interest payments each year until the bond matures, at which point you will receive the $1,000 principal. The par value of the bond is $1,000, which is the amount you will receive when the bond reaches maturity.

2. Determining Cash Flow, Yield, and Price of Bonds:

To determine the cash flow, yield, and price of bonds, one must consider the bond’s coupon rate, maturity date, and par value. The coupon rate is the interest rate paid by the bond issuer to the bondholder, typically paid semi-annually. The maturity date is the date when the bond will be fully repaid, and the par value is the amount that will be paid at maturity.

The cash flow of a bond is the sum of all coupon payments and the par value payment received at maturity. Yield is the expected return an investor will receive from holding a bond, which can be calculated as the internal rate of return. The price of a bond is determined by discounting its cash flows at the appropriate discount rate, which is based on the bond’s yield to maturity.

For example, consider a bond with a face value of $1,000, a coupon rate of 4%, and a maturity of 10 years. If the prevailing interest rate in the market is 3%, then the bond’s price will be higher than its face value. The bond’s cash flow will be $40 per year in coupon payments, and the principal amount of $1,000 will be received at maturity. The yield to maturity can be calculated using a financial calculator or Excel, and the bond’s price can be calculated using the discounted cash flow formula.

3. Valuation and Pricing of Bonds:

Bond valuation involves determining the fair value of a bond, based on its cash flows, risk, and market conditions. Pricing a bond involves determining the market value of the bond, based on supply and demand in the bond market. Bond valuation can be done using various methods, such as discounted cash flow analysis, relative valuation, or option pricing models.

For example, consider a bond with a face value of $1,000, a coupon rate of 6%, and a maturity of 5 years. If the prevailing interest rate in the market is 8%, then the bond’s price will be lower than its face value. The bond’s valuation can be done using the discounted cash flow method. The cash flow of the bond will be $60 per year in coupon payments, and the principal amount of $1,000 will be received at maturity. The present value of each cash flow can be calculated using the appropriate discount rate, which is the yield to maturity. The sum of the present values will give the fair value of the bond.

4. Price-Yield Relationship and the Pricing Matrix:

The price-yield relationship is an inverse relationship, which means that as yields increase, bond prices decrease, and vice versa. The pricing matrix is a tool used to determine the price of a bond based on its yield to maturity and time to maturity. The pricing matrix includes the coupon rate, maturity date, yield to maturity, and bond price for different combinations

Traditional Yield Measures

1. Current Yield:
   Current yield is a basic measure of a bond’s return that calculates the annual interest payment divided by the bond’s current market price. The formula for current yield is:

Current Yield = Annual Interest Payment / Current Market Price of the Bond

For example, let’s consider a bond with a face value of INR 1,000, a coupon rate of 5%, and a current market price of INR 900. The annual interest payment would be INR 50 (5% of INR 1,000), and the current yield would be:

Current Yield = 50 / 900 = 0.0555 or 5.55%

2. Yield to Maturity:
   Yield to maturity (YTM) is a more comprehensive measure of a bond’s return, as it takes into account the bond’s price, coupon rate, and time to maturity. It represents the total return an investor can expect if they hold the bond until maturity. The formula for YTM is:

YTM = [(Face Value / Price)^(1/n)] – 1 + (Annual Interest Payment / ((Face Value + Price) / 2)) / (1/n)

Where:
n = Number of years to maturity

For example, let’s consider a bond with a face value of INR 1,000, a coupon rate of 5%, a current market price of INR 900, and a maturity date of 5 years. Using the above formula, the YTM would be:

YTM = [(1,000 / 900)^(1/5)] – 1 + (50 / ((1,000 + 900) / 2)) / (1/5) = 0.0705 or 7.05%

3. Effective Yield:
   Effective yield is a measure of the total return an investor can expect from a bond when taking into account any changes in its market price. It is also known as the yield to maturity when considering reinvestment of coupon payments. The formula for effective yield is:

Effective Yield = [(1 + (Annual Interest Payment / Price))^n] – 1

For example, let’s consider the same bond as above, but with a market price of INR 950 instead of INR 900. Using the formula for effective yield, the effective yield would be:

Effective Yield = [(1 + (50 / 950))^5] – 1 = 0.0684 or 6.84%

4. Yield to Call:
   Yield to call is a measure of the return an investor can expect if the issuer decides to call the bond before its maturity date. It is calculated using the same formula as yield to maturity, but assumes that the bond will be called at the next call date, if any. The formula for yield to call is:

Yield to Call = [(Face Value + (Call Premium / Years to Call)) / Call Price]^(1/Years to Call) – 1

For example, let’s consider a bond with a face value of INR 1,000, a coupon rate of 5%, a current market price of INR 1,050, and a call price of INR 1,100 in 3 years. Using the above formula, the yield to call would be:

Yield to Call = [(1,000 + (100 / 3)) / 1,050]^(1/3) – 1 = 0.0382 or 3.82%

5. Yield to Put:
   Yield to put is a measure of the return an investor can expect if they decide to put the bond back to the issuer before its maturity date. It is calculated using the same formula as yield to maturity , but assumes that the bond will be put back to the issuer at the next put date, if any. The formula for yield to put is:
   
   Yield to Put = [(Face Value – (Put Premium / Years to Put)) / Put Price]^(1/Years to Put) – 1
   
   For example, let’s consider a bond with a face value of INR 1,000, a coupon rate of 5%, a current market price of INR 950, and a put price of INR 900 in 2 years. Using the above formula, the yield to put would be:
   Yield to Put = [(1,000 – (50 / 2)) / 900]^(1/2) – 1 = 0.0877 or 8.77%
   
   These traditional yield measures are important for bond investors to evaluate the potential return on their investments and make informed investment decisions. However, they should be used in conjunction with other factors, such as credit risk, market conditions, and interest rate changes, to make a comprehensive analysis of a bond’s overall value.

Concept of Yield Curve

The yield curve is a graphical representation of the relationship between the yields (interest rates) of bonds with different maturities. The yield curve plots the yield on the vertical axis and the time to maturity on the horizontal axis.

The most commonly used yield curve is the government bond yield curve. In this case, the yields of government bonds of various maturities are plotted against their respective maturities. A yield curve is said to be normal when longer-term bonds have higher yields than shorter-term bonds. This is because longer-term bonds expose investors to greater interest rate risk, and therefore, investors demand higher yields to compensate for the additional risk.

There are three main types of yield curves: normal, flat, and inverted. A normal yield curve slopes upwards, indicating that long-term bonds have higher yields than short-term bonds. A flat yield curve indicates that yields across all maturities are similar, suggesting that investors have a neutral view on the direction of interest rates. An inverted yield curve slopes downwards, indicating that short-term bonds have higher yields than long-term bonds. This is typically interpreted as a signal of an impending economic recession or slowdown, as investors are seeking the safety of long-term bonds and pushing their prices up and yields down.

The yield curve is an important tool for investors, as it can provide information on the market’s view on the economy’s direction, interest rate expectations, and inflation expectations. For example, if the yield curve is steep, with long-term bonds yielding significantly higher than short-term bonds, it may indicate that the market is expecting interest rates to rise in the future. Conversely, if the yield curve is flat, it may indicate that the market is expecting interest rates to remain relatively stable in the near future.

Concept of Duration

Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. It is an important concept in fixed-income investing and helps investors understand how much the price of a bond may change in response to fluctuations in interest rates.

The duration of a bond is expressed in years and is calculated as the weighted average of the time until each of the bond’s cash flows is received, with the weights being the present value of each cash flow divided by the total present value of all cash flows. The formula for duration is:

Duration = [(Present Value of Cash Flow * Time to Cash Flow) / Present Value of All Cash Flows]

For example, let’s consider a bond with a face value of INR 1,000, a coupon rate of 5%, and a maturity of 10 years. The bond pays semi-annual coupons, and the current yield to maturity is 6%. The bond’s cash flows and present values are as follows:

The present value of all cash flows is INR 867.77, and the duration of the bond is calculated as follows:

Duration = [(23.58 * 1) + (22.20 * 2) + (20.90 * 3) + (19.66 * 4) + (18.49 * 5) + (17.38 * 6) + (16.32 * 7) + (15.33 * 8) + (14.39 * 9) + (719.12 * 10)] / 867.77

Duration = 7.88 years

This means that if interest rates were to rise by 1%, the bond’s price would be expected to fall by approximately 7.88%. Conversely, if interest rates were to fall by 1%, the bond’s price would be expected to rise by approximately 7.88%.

Duration is a useful measure for investors who are trying to manage their interest rate risk. It helps them to identify bonds that are more or less sensitive to changes in interest rates and to construct portfolios that reflect their risk tolerance and investment objectives.

Introduction to Money Market

The money market is a sub-section of the financial market where short-term financial instruments are traded. It is used for borrowing and lending in the short term, usually up to one year. The money market plays a crucial role in the overall financial system by providing liquidity to financial institutions, governments, and businesses.

a. Key players in the money market:
The key players in the money market are:

1. Banks: Commercial banks, regional rural banks, and foreign banks are active participants in the money market. They lend and borrow money in the money market to maintain their reserve requirements.
2. Non-banking financial companies (NBFCs): NBFCs also participate in the money market by lending and borrowing funds.
3. Corporates: Corporates with surplus funds can invest their excess cash in the money market. They can also borrow money in the money market to meet their short-term requirements.
4. Mutual funds: Mutual funds invest a significant portion of their corpus in money market instruments to generate returns.

b. Types of Instruments:
The following are the various types of instruments that are traded in the money market:

1. Call Money: Call money is a short-term loan that is availed for one day. Banks borrow or lend money in the call money market to maintain their reserve requirements or to meet their short-term liquidity needs.
2. Notice Money: Notice money is a short-term loan that is availed for two to fourteen days. The interest rate on notice money is usually higher than call money rates.
3. Term Money: Term money is a short-term loan that is availed for a period of fifteen days to one year. It is generally used by corporates to meet their short-term funding requirements.
4. Market Repo: Market repo is a money market instrument used for borrowing or lending funds for a short period, usually one day. It is a collateralized instrument where the borrower has to pledge securities as collateral.
5. Triparty Repo: Triparty repo is a variation of the repo market where a third-party custodian manages the collateral. The borrower and the lender agree on the terms of the repo, and the third-party custodian ensures the timely transfer of the securities and funds.
6. Treasury Bills (T-Bills): T-Bills are short-term instruments issued by the government to meet its short-term funding requirements. They are issued at a discount to the face value and mature at par.
7. Cash Management Bills (CMBs): CMBs are short-term instruments issued by the government to manage its short-term cash needs. They are issued for a period of less than 91 days and are similar to T-Bills.

Introduction to Government Debt Market

1. Key Players in the Government Debt Market:
   The Government debt market, also known as the sovereign debt market, is a market where government bonds or securities are traded. The key players in the government debt market are:

a. Central Bank: The central bank plays a vital role in the government debt market as it manages the issuance and redemption of government securities.

b. Commercial Banks: Commercial banks act as intermediaries between the government and investors by participating in the primary market as underwriters and in the secondary market as dealers.

c. Primary Dealers: Primary dealers are a set of institutions that have been authorized by the central bank to participate in the auction process for the issuance of government securities.

d. Pension Funds and Insurance Companies: Pension funds and insurance companies invest heavily in government securities as they are considered to be safe and secure investments.

e. Foreign Institutional Investors (FIIs): FIIs also participate in the government debt market as they see it as a low-risk investment option.

2. Types of Instruments:

a. T-Bills: Treasury Bills or T-Bills are short-term government securities with a maturity period of up to 364 days. They are issued at a discount to the face value and are redeemed at face value upon maturity.

b. CMBs: Cash Management Bills or CMBs are short-term government securities issued to meet the temporary cash requirements of the government. They have a maturity period of up to 90 days.

c. Dated G-Sec: Dated Government Securities or Dated G-Sec are long-term government securities with a maturity period ranging from 5 years to 40 years. They pay a fixed coupon rate and are issued at par.

d. Fixed Rate Bonds: Fixed Rate Bonds are long-term government securities that pay a fixed coupon rate throughout the life of the bond.

e. ZCBs: Zero Coupon Bonds or ZCBs are long-term government securities that do not pay any coupon. They are issued at a discount to the face value and are redeemed at face value upon maturity.

f. CIBs: Capital Index Bonds or CIBs are long-term government securities whose principal amount is adjusted for inflation.

g. IIBs: Inflation Indexed Bonds or IIBs are long-term government securities whose coupon rate is adjusted for inflation.

h. Bonds with Call/Put Options: Some government securities come with call/put options that allow the issuer or the investor to redeem the security before its maturity date.

i. Special Securities: Special Securities are government securities that are issued to specific entities such as the Oil Marketing Companies (OMCs) or the Food Corporation of India (FCI).

j. STRIPS: Separate Trading of Registered Interest and Principal of Securities or STRIPS are government securities that have been stripped of their coupon payments and principal amounts. They are traded separately as individual securities.

k. SGBs: Sovereign Gold Bonds or SGBs are government securities that are denominated in grams of gold. They offer investors the opportunity to invest in gold without having to physically store it.

l. Savings Bonds: Savings Bonds are government securities that are issued to small investors. They have a lower minimum investment amount and are designed to promote household savings.

m. SDLs: State Development Loans or SDLs are government securities issued by state governments to fund their development projects. They have a maturity period of up to 30 years and pay a fixed coupon rate.

Introduction to Corporate Debt Market:

The Corporate Debt Market is an integral part of the financial system that helps companies raise funds for their business operations. In India, the Corporate Debt Market comprises various players and instruments that facilitate the issuance, trading, and investment in corporate debt securities.

1. Key Players in the Corporate Bond Ecosystem in India:

a. Issuer – A company or a corporate entity that issues debt securities to raise funds for their business operations.

b. Debenture Trustee – A trustee appointed by the issuer to protect the interests of bondholders by ensuring that the issuer complies with the terms and conditions of the bond issue.

c. Qualified Institutional Buyers (QIB) – Large investors such as mutual funds, insurance companies, and pension funds that have the expertise and financial resources to invest in corporate bonds.

d. Retail Individual Investors – Small investors who invest in corporate bonds through mutual funds or directly purchase the securities.

e. Designated Stock Exchange – A stock exchange that facilitates the listing and trading of corporate debt securities.

2. Corporate Debt Instruments:

a. Company Deposits – A type of corporate debt instrument that allows companies to raise funds from retail investors by offering a fixed rate of interest for a specific period. Company deposits are unsecured debt instruments and carry a higher risk than bank fixed deposits.

b. Bonds and Debentures – A bond is a debt security issued by a company that pays a fixed or variable rate of interest for a specified period. Debentures are similar to bonds but are not secured by any collateral. They are backed only by the creditworthiness of the issuer.

c. Infrastructure Bonds – These are debt securities issued by companies engaged in infrastructure-related activities such as power, roads, and telecom. Infrastructure bonds offer tax benefits to investors under section 80C of the Income Tax Act.

d. Inflation Indexed Bonds – These are debt securities that offer a return linked to the inflation rate. The interest rate on inflation-indexed bonds is adjusted periodically to reflect changes in the inflation rate, thereby protecting the investor from inflationary risks.

Small Saving Instruments