1. Introduction 2. Types of Bonds by Issuer 3. Types of Bonds by Payout 4. Bond Pricing 5. REPO 6. Bond Futures & Options 7. The Development of Bond Market in India 8. Retail Debt Market of India 9. Wholesale Debt Market of India 10. ABC of investing in Fixed Income 11. Why invest in Fixed Income 12. Risk associated with Bonds
Project on Fixed Income _____________________________________________________________________ Fixed income refers to any type of investment that yields a regular (or fixed) return. For example, if you borrow money and have to pay interest once a month, you have issued a fixed-income security. When a company does this, it is often called a bond or corporate bank debt (although 'preferred stock' is also sometimes considered to be fixed income). Sometimes people misspeak when they talk about fixed income, bonds actually have higher risk, while notes and bills have less risk because these are issued by Government agencies. The term fixed income is also applied to a person's income that does not vary with each period. This can include income derived from fixed-income investments such as bonds and preferred stocks or pensions that guarantee a fixed income. When pensioners or retirees are dependent on their pension as their dominant source of income, the term "fixed income" can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large expenditures. Fixed-income securities can be contrasted with variable return securities such as stocks. To understand the difference between stocks and bonds, you have to understand a company's motivation. A company wants to raise money, and it doesn't want to wait until it has earned enough through ongoing operations (selling products or providing services). In order for a company to grow as a business, it often must raise money; to finance an acquisition, buy equipment or land or invest in new product development. Investors will only give money to the company if they believe that they will be given something in return commensurate with the risk profile of the company. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond) (bank loan) or (preferred stock). 2
Project on Fixed Income While a bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed-income industry:
The principal of a bond is the amount that is being lent. The coupon is the interest that will be paid. The maturity is the end of the bond, the date that the amount must be returned.
The issuer is the entity (company or govt.) who is borrowing the money (issuing the bond) and paying the interest (the coupon).
The issue is another term for the bond itself. The indenture is the contract that states all of the terms of the bond. People that invest in fixed-income securities are typically looking for a
constant and secure return on their investment. For example, a retired person might like to receive a regular dependable payment to live on, but not consume principal. This person can buy a bond with their money, and use the coupon payment (the interest) as that regular dependable payment. When the bond matures or is refinanced, the person will have their money returned to them. Interest rates change over time, based on a variety of factors, particularly rates set by the Federal Reserve. For example, if a company wants to raise $1 million and not a lot of people in the market have free cash to lend, the company will have to offer a high rate of interest (coupon) to get people to buy their bond. If there are a lot of people in the market trying to get a return on their money, the company can offer a lower coupon. To complicate matters further, fixed income securities are actually traded on the open market, just like stocks. To understand this, first realize that bonds are usually created in round face values, for example $100,000. If the current yield (interest rate) of newly issued similar bonds is 6% per year, and you are buying a bond with a coupon rate below 6%, then you can get the bond at a discount (below face value of $100,000), which brings your rate of return on that 3
Project on Fixed Income bond to 6%. Similarly, if the coupon rate of the bond you are buying is greater than 6% you will have to pay a premium for the bond to bring the rate of return down to 6%. There are also index-linked, fixed-income securities. The most common and an example of the highest rated variety of this kind could include Treasury Inflation Protected Securities (TIPS). This type of fixed income is adjusted to the Consumer Price Index for all urban consumers (CPI-U), and then a real yield is applied to the adjusted principal. This means that the US Treasury issues fixed income that is backed by the full faith and credit of the US Gov to outperform the CPI (e.g. to outperform the inflation rate). This allows investors of all sizes to not lose the purchasing power of their money due to inflation, which can be very uncertain at times. For example, assuming 3.88% inflation over the course of 1 year (just about the 56 year average inflation rate, through most of 2006), and a real yield of 2.61% (the fixed US Treasury real yield on October 19, 2006, for a 5 yr TIPS), the adjusted principal of the fixed income would rise from 100 to 103.88 and then the real yield would be applied to the adjusted principal, meaning 103.88 x 1.0261, which equals 106.5913; giving a total return of 6.5913%. TIPS moderately outperform conventional US Treasuries, which yield just 5.05% for a 1 yr bill on October 19, 2006. By investing in such fixed income, index linked fixed income securities, consumers can exceed the pace of inflation, and gain value in real terms. All fixed income securities from any entity have risks including but not limited to:
Inflationary risk Interest rate risk Currency risk Default risk Repayment of principal risk Reinvestment risk 4
Project on Fixed Income Liquidity risk
Types of bonds by issuer
Government Bond Sovereign Bond Agency Debt Municipal Bond Corporate bond Emerging market debt Government Bond
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds.
Project on Fixed Income List of government bonds from the main issuers
Negotiable Government financial debt at Generic liabilities Rating mid-2005 Currency Country Name or as % of (S&P/Moody's) (US dollar Nickname GDP (end bn 2003 - source : equivalent) OECD)
Ministry of Finance (MoF)
US AAA/Aaa Treasuries
Bureau of the Public Debt
Dipartimento del Tesoro
Agence France Trésor
United Gilts Kingdom
UK Debt Management Office
A sovereign bond is a bond issued by a national government. Bonds issued by national governments in the country's own currency are also referred as government bonds.
Project on Fixed Income Nations with very high or unpredictable inflation or with unstable exchange rates often find it uneconomic to issue bonds in their own currencies and so are forced to issue bonds denominated in more stable foreign currencies. This raises the issue of default if the nation cannot afford to repurchase the necessary foreign currency at bond repayment time. Due to the risk of default, investors require the bonds to be issued with a higher yield. This makes the debt more expensive to service, increasing risk of default. In the event of default, unlike a corporation or even a municipal subdivision, a nation cannot file for bankruptcy. But on the rare occasions that a default occurs, just as in defaults on corporate bonds, recent practice has been that the defaulting borrower presents an exchange offer to its bond holders in an effort to restructure the sovereign debt, as has been the case in US dollar denominated bonds issued by Peru (1996) and Argentina (2001). However, getting the bond holders to accept an exchange offer has become very difficult, something caused by the holdout problem. During the early 1980s, the sovereign bonds of developing nations were a popular investment for Western banks. These created many problems when some nations found it difficult to repay those bonds.
Agency debt (sometimes referred to in plural as Agencies) is a type of bond issued by a corporation that is nominally independent of the government - though ownership may be public or private - but considered to be backed by the government, usually on a de facto basis. The most common issuers in the United States are the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), which are both heavily involved in the mortgage-backed securities market, and the Federal Home Loan Banks 7
Project on Fixed Income (FHLBanks), which issue significant amounts of debt [that are the joint and several liability of all 12 FHLBanks] to support the FHLBank mission of extending advances [secured loans] to it members [primarily the nations community banks].
In the United States, a municipal bond (or muni) is a bond issued by a state, city or other local government, or their agencies. Potential issuers of municipal bonds include cities, counties, redevelopment agencies, school districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) below the state level. Municipal bonds may be general obligations of the issuer or secured by specified revenues. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
A corporate bond is a bond issued by a corporation. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. (The term "commercial paper" is sometimes used for instruments with a shorter maturity.) Sometimes, the term "corporate bonds" is used to include all bonds except those issued by governments in their own currencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of local authorities and supranational organizations do not fit in either category.
Project on Fixed Income Corporate bonds are often listed on major exchanges (bonds there are called "listed" bonds) and ECNs like MarketAxess, and the coupon (i.e. interest payment) is usually taxable. Sometimes this coupon can be zero with a high redemption value. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based, over-thecounter markets. Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into equity. One can obtain an unfunded synthetic exposure to corporate bonds via credit default swaps.
Emerging market debt
Emerging market debt (EMD) is a term used to encompass bonds issued by less developed countries. It does not include borrowing from government, supranational organizations such as the IMF or private sources, though loans that are securitized and issued to the markets would be included. A broader discussion of all types of borrowing by developing countries exists at Developing countries' debt.
Types of bonds by payout
Fixed rate bond Floating rate note Zero coupon bond Inflation-indexed bond
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Commercial paper Accrual bond Auction rate security High-yield debt Convertible bond Mortgage-backed security Asset-backed security Fixed rate bond
In finance, a fixed rate bond is a bond with a fixed coupon (interest) rate, as opposed to a floating rate note. A fixed rate bond is a long term debt paper that carries a predetermined interest rate. The interest rate is known as coupon rate and interest is payable at specified dates before bond maturity.
Floating rate notes
Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months, though counter examples do exist. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%. 10
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Zero coupon bonds
Zero coupon bonds are bonds that pay no periodic interest payments, or so-called "coupons". Zero coupon bonds are purchased at a discount from their value at maturity. The holder of a zero coupon bond is entitled to receive a single payment, usually of a specified sum of money at a specified time in the future. Investors earn interest via the difference between the discounted price of the bond and its par (or redemption) value. Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value of the bond. In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures. Zero coupon bonds may be long or short term investments. Longterm zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets. Short term zero coupon bonds generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world.
Inflation-indexed bonds (also known as linkers) are bonds whose principal are indexed to inflation, cutting out inflation risk. The first known inflation-indexed bond was issued by the Massachusetts Bay 11
Project on Fixed Income Company in 1780. The market has grown dramatically since the British government began issuing inflation-linked Gilts in 1981. Today, the asset class comprises over $500 Billion of the international debt market. The market primarily consists of sovereign debt, with privately issued inflation-linked bonds constituting a small portion of the market.
Commercial paper is a money market security issued by large banks and corporations. It is generally not used to finance long-term investments but rather to purchase inventory or to manage working capital. It is commonly bought by money funds (the issuing amounts are often too high for individual investors), and is generally regarded as a very safe investment. As a relatively low risk option, commercial paper returns are not large. There are four basic kinds of commercial paper: promissory notes, drafts, checks, and certificates of deposit. Because commercial paper maturities do not exceed nine months and proceeds typically are used only for current transactions, the notes are exempt from registration as securities with the United States Securities and Exchange Commission. Commercial paper is defined in Canada as having a maturity of not more than one year and is exempt from dealer registration and prospectus requirements. Commercial paper essentially can be compared as an alternative to lines of credit with a bank. Once a business becomes large enough, and maintains a high enough credit rating, then using commercial paper is always cheaper than using a bank line of credit. Nevertheless, many companies still maintain bank lines of credit to act as a "backup" to the commercial paper. In this situation, banks often charge fees for the amount of the line of the credit that does not have a balance. While these 12
Project on Fixed Income fees may seem like pure profit for banks, if the company ever actually needs to use the line of credit it would likely be in serious trouble and have difficulty repaying its liabilities.
An accrual bond is a fixed-interest bond that is issued at its face value and repaid at the end of the maturity period together with the accrued interest. In Germany, the accrued interest is compounded.
Auction rate security
An auction rate security (ARS) typically refers to a debt instrument (corporate or municipal bonds) with a long-term nominal maturity for which the interest rate is reset through a dutch auction. It could also refer to a preferred stock for which the dividend is reset through the same process. In a dutch auction, a broker-dealer submits bids, on behalf of current and prospective investors, to the auction agent. Based on the submitted bids, the auction agent will set the next interest rate by determining the lowest rate to clear the total outstanding amount of ARS. ARS holders do not have the right to put their securities back to the issuer; as a result no bank liquidity facility is required. Auctions are typically held every 7, 28, or 35 days; interest on these securities is paid at the end of each auction period. Certain types of ARS auction daily, with coupon being paid on the first of every month. There are also other, more unusual, reset periods, including 14 day, 49 days, 91 days, semi-annual and annual. Non-daily ARS settle on the next business day, daily ARS settle the same day. As bank liquidity has become more expensive, the auction market has become increasingly attractive to issuers seeking the low cost and flexibility of variable rate debt. 13
Project on Fixed Income The first auction rate security for the tax-exempt market was introduced by Goldman Sachs in 1988. Today the market for ARS has grown to over $200 billion, with roughly half of it being composed of corporate issues. Because of their complexity and the minimum denomination of $25,000 or more, most holders of auction rate securities are institutional investors and high net worth individuals. Some negative aspects of ARS include lower liquidity and potential drops in the coupon rate.
In finance, a high yield bond (non-investment grade bond, speculative grade bond or junk bond) is a bond that is rated below investment grade at the time of purchase. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors.
In finance, a convertible bond (or convertible debenture) is a type of bond that can be converted into shares of stock in the issuing company, usually at some pre-announced ratio. It is a hybrid security with debt- and equity-like features. Although it typically has a low coupon rate, the holder is compensated with the ability to convert the bond to common stock, usually at a substantial premium to the stock's market value. From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.
Project on Fixed Income The convertible bond markets in the United States and Japan are of primary global importance. These two domestic markets are the largest in terms of market capitalisation. Other domestic convertible bond markets are often illiquid, and pricing is frequently non-standardised. USA: It is a highly liquid market compared to other domestic markets. Domestic investors have tended to be most active within US convertibles Japan: In Japan, the convertible bond market is relatively more regulated than other markets. It consists of a large number of small issuers. Europe: Convertible bonds have become an increasingly important source of finance for firms in Europe. Compared to other global markets, European convertible bonds tend to be of high credit quality. Asia (ex Japan): The Asia region provides a wide range of choice for an investor. Each domestic market within the Asian convertible bond market is at a various level of development. Domestics versus Euroconvertible bonds A further important classification is between the domestic and euroconvertibles markets. Euroconvertibles pay their interest gross and are free of transfer duty when bought, and are delivered into Euroclear or CEDEL for 7 day settlement. Domestics may have different settlement dates, they may pay their interest net of tax and be subject to transaction taxes. European euroconvertibles are generally highly liquid and have a pan-European investor base, dominated by hedge funds and proprietary desks. European domestic convertibles (such as in the UK and Italy) are dominated more by local investment institutions. Since the early nineteeneighties, foreigners have been able to receive interest on U.S. domestic convertible bonds gross, and this has broadened the global investor base to embrace global hedge funds and other global investors. Likewise, 15
Project on Fixed Income foreigners have been able to receive interest gross on French convertibles (obligations convertibles or OCs), further blurring the differentiation between the domestic and euro CB markets. The pan-European CB market has substantially replaced the various domestic CB markets, and the driver behind this has been the ability of cross-border investors to receive interest payments gross.
Types of convertible bonds :
There are many variations of the basic structure of a convertible bond. Vanilla convertible bonds are bonds which may be converted at the option of the owner into the shares of the issuer, usually at a pre-determined rate. They may or may not be redeemable by the issuer prior to the final maturity date, subject to certain share price performance conditions. Exchangeables are bonds which may be exchanged into shares other than those of the issuer. Strictly speaking, they are not convertibles, but they share certain common evaluation characteristics. Mandatory convertibles are short duration securities—generally with yields higher than found on the underlying common shares — that are mandatorily convertible upon maturity into a fixed number of common shares. If it is intended to provide a minimum value for the convertible at maturity, convertibility may be into a sufficient number of shares based on the stock price at maturity to provide that minimum redemption value. Mandatory exchangeables are short duration securities—generally with yields higher than found on the underlying common shares — that are mandatorily exchangeable upon maturity into a fixed number of common shares. Likewise, if it is intended to provide a minimum value for the convertible at maturity, exchange may be 16
Project on Fixed Income into a sufficient number of shares (based on the stock price at maturity) to provide that minimum redemption value. Such exchangeables may be said to be "redeemed into equity", and care should be taken when reading the offering documentation, lest "redemption" and "conversion" are confused. Contingent convertibles (co-co) only allow the investor to convert into stock if the price of the stock is a certain percentage above the conversion price. For example, a contingent convertible with a $10 stock price at issue, 30% conversion premium and a contingent conversion trigger of 120%, can be converted (at $13) only if the stock trades above $15.60 ($13 x 120%) over a specified period, often 20 out of 30 days before the end of the quarter. The co-co feature was often favored by issuers because the shares of underlying common stock were only required to be included in diluted EPS calculation if the issuer's stock traded above the contingent conversion price. In contrast, non-co-co convertible bonds result in an immediate increase in diluted shares outstanding, thereby reducing the EPS. The impact to diluted shares outstanding is calculated using the "as-if-converted" method, which requires the most conservative EPS value be used. Recent changes to GAAP have eliminated the favorable treatment of co-co's, and as a result their popularity with issuers has waned. OCEANEs (or Obligation Convertible En Actions Nouvelles ou Existantes) are bonds which may be converted into the equity of the issuer, but the issuer has the right to deliver new shares or old shares held in Treasury (possibly with different dividend rights). They are a common structure for French issues. These bonds are technically not convertibles, as defined by the law of 25 February 1953. Consequently, there is no three-month conversion period for investors following the date that bonds called are due for 17
Project on Fixed Income redemption, (as is otherwise required, under French law, for French convertibles). Convertible preferred stock, (convertible preference shares in the UK), is similar in valuation to a bond, but with lower seniority in the capital structure. Non-payment of income is generally not regarded as an act of default by the issuer. The terms of each issue will define whether or not entitlement to unpaid preference income is cumulative. SPV structures Many convertibles, particularly Euroconvertibles, are issued though special purpose vehicles (SPVs), (typically a subsidiary based offshore in British Virgin Islands, the Cayman Islands or Jersey). The SPV debt is convertible (exchangeable to be more precise) into the equity of the parent company, which is often a holding company. Although the parent may guarantee the SPV debt on an unsubordinated basis, the assets of a parent company could just be shares of various subsidiaries. This means that nominally unsubordinated guarantee on the debt could in fact be structurally subordinated. More significantly, the basis of seniority upon which money raised by the issuing entity has been onwardly applied is rarely revealed at issue; if on-lent on a subordinated basis, the asset quality of the issuing entity and its debt is impaired. This creates a fundamental weakness in the credit analysis of any convertible and non-convertible SPV debt. Reverse convertible securities are short-term coupon-bearing notes, structured to provide enhanced yield while participating in certain equity-like risks. Reverse convertibles securities are most commonly targeted towards the US market. Their investment value is derived from underlying equity exposure, which is paid in the form of fixed coupons. Generally speaking, the higher the coupon payment, the more likely it is that the investor is delivered shares on maturity. Investors receive full principal back at maturity (plus 18
Project on Fixed Income accrued interest) in cash (but no more) if the Knock-in Level is not breached at any time during the life of the security. The Knock-in level is typically 70-80% of the initial reference price. The underlying stock, index or basket of equities is defined as Reference Shares. In most cases, Reverse convertibles are linked to a single stock. Going-public bonds are fixed interest securities which convert or exchange into shares of a company when it later achieves a stock market listing. Distribution is initially syndicated to subunderwriters, this distribution typically being helped by a shortterm redemption feature, possibly in equity, at or near the subsequently prevailing share price. This reduces the downside risks to sub-underwriters taking bonds at issue. Some time subsequent to their issue, the bonds become convertible or exchangeable into shares, the conversion price reflecting in some measure the share price (or expected share price) at the time of conversion – and may be fixed at a discount, to encourage conversion. The key element of going-public bonds is that the primary distribution date is de-coupled from the date when the conversion or exchange price is fixed. In France a series of such bonds were known as Balladur bonds. Hybrid bonds typically are issued as loan capital, but the issuer retains the right to exchange or convert the bonds into convertible preference shares with similar conversion rights and income. The purpose is generally to ensure that the bonds (as loan capital) have the tax offset-ability (against taxable profits) of loan interest, and perhaps pay gross to qualifying investors. At the same time, the ability to change the bonds into cumulative or non-cumulative preference capital should mean that they pose less balance sheet risk. The issuer only achieves the best of both worlds if the hybrid
Project on Fixed Income bond is structured so that non-payment of interest does not constitute an event of default.
In finance, a mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans. Residential mortgagors in the United States have the option to pay more than the required monthly payment (curtailment) or pay off the loan in its entirety (prepayment). Because curtailment and prepayment affect the remaining loan principal, the monthly cash flow of a MBS is not known in advance, and therefore presents an additional risk to MBS investors. Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, industrial properties and other commercial sites). The properties of these loans vary, with longer-term loans (5 years or longer) often being at fixed interest rates and having restrictions on prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely prepayable.
Types of MBS
Any bond ultimately backed by mortgages is classified as a MBS. This can be confusing, because securities derived from MBS are also called MBS(s). To distinguish the basic MBS bond from other mortgage-backed instruments the qualifier pass-through is used, in the same way that 'vanilla' designates an option with no special features. Mortgage-backed security sub-types include:
Project on Fixed Income Pass-through mortgage-backed security is the simplest MBS, as described in the sections above. Essentially, a securitization of the mortgage payments to the mortgage originators. These can be subdivided into:
Residential mortgage-backed security (RMBS) - a passthrough MBS backed by mortgages on residential property
Commercial mortgage-backed security (CMBS) - a passthrough MBS backed by mortgages on commercial property
Collateralized mortgage obligation (CMO) - a more complex MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as a separate security.
Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:
Interest-only stripped mortgage-backed securities (IO) - a bond with cash flows backed by the interest component of property owner's mortgage payments.
Principal-only stripped mortgage-backed securities (PO) a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.
Varieties of underlying mortgages in the pool:
Prime: conforming mortgages: prime borrowers, full documentation (such as verification of income and assests), strong credit scores, etc.
Alt-A: an ill-defined category, generally prime borrowers but nonconforming in some way, often lower documentation (or in some other way: vacation home, etc.) (Article on Alt-A)
Subprime: weaker credit scores, no verification of income or assets, etc. There are also jumbo mortgages, when the size is bigger than the "conforming loan amount" as set by FannieMae. 21
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In finance, an asset-backed security is a type of bond or note that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. Assets are pooled to make otherwise minor and uneconomical investments worthwhile, while also reducing risk by diversifying the underlying assets. Securitization makes these assets available for investment to a broader set of investors. These asset pools can be made of any type of receivable from the common, like credit card payments, auto loans, and mortgages, or esoteric cash flows such as aircraft leases, royalty payments and movie revenues. Typically, the securitized assets might be highly illiquid and private in nature. In some cases it can be used as credit enhancement by creating a security that has a higher rating than the issuing company which monetizes its assets. This allows it to pay a lower rate of interest than would be possible via a secured bank loan or debt issuance.
Types of ABS :
Home equity loans
Securities collateralized by home equity loans (HELs) are currently the largest asset class within the ABS market. Investors typically refer to HELs as any nonagency loans that do not fit into either the jumbo or alt-A loan categories. While early HELs were mostly second lien subprime mortgages, first-lien loans now make up the majority of issuance. Subprime mortgage borrowers have a less than perfect credit history and are required to pay interest rates higher than what would be available to a typical agency borrower. In addition to first and second-lien loans, other HEL loans can consist of high loan to value (LTV) loans, re-performing
Project on Fixed Income loans, scratch and dent loans, or open-ended home equity lines of credit (HELOC),which homeowners use as a method to consolidate debt.
The second largest subsector in the ABS market is auto loans. Auto finance companies issue securities backed by underlying pools of autorelated loans. Auto ABS are classified into three categories: prime, nonprime, and subprime:
Prime auto ABS are collaterlized by loans made to borrowers with strong credit histories.
Nonprime auto ABS consist of loans made to lesser credit quality consumers, which may have higher cumulative losses.
Subprime borrowers will typically have lower incomes, tainted credited histories, or both. Owner trusts are the most common structure used when issuing auto loans and allow investors to receive interest and principal on sequential basis. Deals can also be structured to pay on a pro-rata or combination of the two.
Credit card receivables
Securities backed by credit card receivables have been benchmark for the ABS market since they were first introduced in 1987. Credit card
holders may borrow funds on a revolving basis up to an assigned credit limit. The borrowers then pay principal and interest as desired, along with the required minimum monthly payments. Because principal repayment is not scheduled, credit card debt does not have an actual maturity date and is considered a nonamortizing loan.
Project on Fixed Income ABS backed by credit card receivables are issued out of trusts that have evolved over time from discrete trusts to various types of master trusts of which the most common is the de-linked master trust. Discrete trusts consist of a fixed or static pool of receivables that are tranched into senior/subordinated bonds. A master trust has the advantage of offering multiple deals out of the same trust as the number of receivables grows, each of which is entitled to a pro-rata share of all of the receivables. The delinked structures allow the issuer to separate the senior and subordinate series within a trust and issue them at different points in time. The latter two structures allow investors to benefit from a larger pool of loans made over time rather than one static pool.
ABS collateralized by student loans (“SLABS”) comprise one of the four (along with home equity loans, auto loans and credit card receivables) core asset classes financed through asset-backed securitizations and are a benchmark subsector for most floating rate indices. Federal Family Education Loan Program (FFELP) loans are the most common form of student loans and are guaranteed by the U.S. Department of Education ("DOE") at rates ranging from 95%-98% (if the student loan is serviced by a servicer designated as an "exceptional performer" by the DOE the reimbursement rate was up to 100%). As a result, performance (other than high cohort default rates in the late 1980's) has historically been very good and investors rate of return has been excellent. Recent legislation passed on September 7, 2007 by the House of Representatives and U.S. Senate decreases lender special allowance payments, eliminates the exceptional performer designation, increases lender insurance rates and the lender paid origination fee for specific loans.
Project on Fixed Income A second, and faster growing, portion of the student loan market consists of non-FFELP or private student loans. Though borrowing limits on certain types of FFELP loans were slightly increased by the student loan bill referenced above, essentially static borrowing limits for FFELP loans and increasing tuition are driving students to search for alternative lenders. Students utlilize private loans to bridge the gap between amounts that can be borrowed through federal programs and the remaining costs of education.
Stranded cost utilities
Rate reduction bonds (RRBs) came about as the result of a 1992 National Energy Policy, which was designed to increase competition in the electricity market. To avoid any disruptions while moving from a noncompetitive to a competitive market place regulators have allowed utilities to recover certain "transition costs" over a period of time. These costs are considered nonbypassable and are added to all customer bills. Since consumers usually pay utility bills before any other, chargeoffs have historically been low. RRBs offerings are typically large enough to create reasonable liquidity in the aftermarket, and average life extension is limited by a "true up" mechanism.
There are many other cash-flow-producing assets, including manufactured housing loans, equipment leases and loans, aircraft leases, trade receivables, dealer floor plan loans, and royalties.
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Trading asset-backed securities
"In the United States, the process for issuing asset-backed securities in the primary market is similar to that of issuing other securities, such as corporate bonds, and is governed by the Securities Act of 1933, and the Securities Exchange Act of 1934, as amended. Publicly issued asset-backed securities have to satisfy standard SEC registration and disclosure requirements, and have to file periodic financial statements." "The Process of trading asset-backed securities in the secondary market is similar to that of trading corporate bonds, and also to some extent, mortgage-backed securities. Most of the trading is done in over-thecounter markets, with telephone quotes on a security basis. There appear to be no publicly available measures of trading volume, or of number of dealers trading in these securities." "A survey by the Bond Market Association shows that at the end of 2004, in the United States and Europe there were 74 electronic trading platforms for trading fixed-income securities and derivatives, with 5 platforms for asset-backed securities in the United States, and 8 in Europe." "Discussions with market participants show that compared to Treasury securities and mortgage-backed securities, many asset-backed securities are not liquid, and their prices are not transparent. This is partly because asset-backed securities are not as standardized as Treasury securities, or even mortgage-backed securities, and investors have to evaluate the different structures, maturity profiles, credit enhancements, and other features of an asset-backed security before trading it." The "price" of an asset-backed security is usually quoted as a spread to a corresponding swap rate. For example, the price of a credit card-backed,
Project on Fixed Income AAA rated security with a two-year maturity by a benchmark issuer might be quoted at 5 basis points (or less) to the two-year swap rate." "Indeed, market participants sometimes view the highest-rated credit card and automobile securities as having default risk close to that of the highest-rated mortgage-backed securities, which are reportedly viewed as substitute for the default risk-free Treasury securities."
Securitization is the process of creating asset-backed securities by transferring assets from the issuing company to a bankruptcy remote entity. Credit enhancement is an integral component of this process as it creates a security that has a higher rating than the issuing company, which allows the issuing company to monetize its assets while paying a lower rate of interest than would be possible via a secured bank loan or debt issuance by the issuing company.
On January 17, 2006, CDS Indexco and Markit launched ABX.HE, a synthetic asset-backed credit derivative index, with plans to extend the index to other underlying asset types other than home equity loans. ABS indices allow investors to gain broad exposure to the subprime market without holding the actual asset-backed securities.
A significant advantage of asset-backed securities is that they bring together a pool of financial assets that otherwise could not easily be traded in their existing form. By pooling together a large portfolio of these illiquid assets they can be converted into instruments that may be offered and sold freely in the capital markets. Their bankruptcy remoteness 27
Project on Fixed Income allows the investor to take on credit risk of the asset without taking on specific corporate credit risk of the originator. The tranching of these securities into instruments with different risk/return profiles facilitates marketing of the bonds to investors with different risk appetites and investing time horizons. Asset-backed securities enable the originators of the loans to enjoy most of the benefits of lending money without bearing the risks involved. They offer originators the following advantages:
Selling these financial assets to the pools reduces their risk-weighted assets and thereby frees up their capital, enabling them to originate still more loans.
Asset-backed securities lowers their risk. In a worst-case scenario where the pool of assets performs very badly, the owner of ABS would pay the price of bankruptcy rather than the originator.
The originators earn fees from originating the loans, as well as from servicing the assets throughout their life. "The financial institutions that originate the loans sell a pool of cashflowproducing assets to a specially created third party that is called a specialpurpose vehicle (SPV). The SPV is designed to insulate investors from the credit risk of the originating financial institution. The SPV then sells the pooled loans to a trust, which issues interest bearing securities that can achieve a credit rating separate from the financial institution that originates the loan. The typically higher credit rating is given because the securities that are used to fund the securitization rely solely on the cash flow created by the assets, not on the payment promise of the issuer. The monthly payments from the underlying assets—loans or receivables— typically consist of principal and interest, with principal being scheduled or unscheduled. The cash flows produced by the underlying assets can be allocated to investors in different ways. Cash flows can be directly passed 28
Project on Fixed Income through to investors after administrative fees are subtracted, thus creating a “pass-through” security; alternatively, cash flows can be carved up according to specified rules and market demand, thus creating "structured" securities."
________________________________________________________________________ It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. In this section, we will run through some bond price calculations for various types of bond instruments. Bonds can be priced at a premium, discount, or at par. If the bond's price is higher than its par value, it will sell at a premium because its interest rate is higher than current prevailing rates. If the bond's price is lower than its par value, the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond, given the bond's coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates. Fundamentally, however, the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: all we are doing is discounting the known future cash flows. Remember that to calculate present value (PV) - which is based on the assumption that each payment is re-invested at some interest rate once it is received--we have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield. (If the 29
Project on Fixed Income concepts of present and future value are new to you or you are unfamiliar with the calculations, refer to Understanding the Time Value of Money.) Here is the formula for calculating a bond's price, which uses the basic present value (PV) formula:
C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value
The succession of coupon payments to be received in the future is referred to as an ordinary annuity, which is a series of fixed payments at set intervals over a fixed period of time. (Coupons on a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired. The calculation assumes this time is the present.
You may have guessed that the bond pricing formula shown above may be tedious to calculate, as it requires adding the present value of each future coupon payment. Because these payments are paid at an ordinary annuity, however, we can use the shorter PV-of-ordinary-annuity formula that is mathematically equivalent to the summation of all the PVs of future cash flows. This PV-ofordinary-annuity formula replaces the need to add all the present values of the future coupon. The following diagram illustrates how present value is calculated for an ordinary annuity:
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Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods one, two and three. Notice how the present value decreases for those coupon payments that are further into the future the present value of the second coupon payment is worth less than the first coupon and the third coupon is worth the lowest amount today. The farther into the future a payment is to be received, the less it is worth today - is the fundamental concept for which the PV-of-ordinary-annuity formula accounts. It calculates the sum of the present values of all future cash flows, but unlike the bond-pricing formula we saw earlier, it doesn't require that we add the value of each coupon payment. (For more on calculating the time value of annuities, see Anything but Ordinary: Calculating the Present and Future Value of Annuities and Understanding the Time Value of Money. )
By incorporating the annuity model into the bond pricing formula, which requires us to also include the present value of the par value received at maturity, we arrive at the following formula: 31
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Let's go through a basic example to find the price of a plain vanilla bond.
Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. In our example we'll assume that coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in six months. Here are the steps we have to take to calculate the price: 1. Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten years, we will have a total of 20 coupon payments.
2. Determine the Value of Each Coupon Payment: Because the coupon payments are semi-annual, divide the coupon rate in half. The coupon rate is the percentage off the bond's par value. As a result, each semi-annual coupon payment will be $50 ($1,000 X 0.05).
3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. If we left the required yield at 12%, our bond price would be very low and inaccurate. Therefore, the required semi-annual yield is 6% (0.12/2).
4. Plug the Amounts Into the Formula:
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From the above calculation, we have determined that the bond is selling at a discount; the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. The bond must sell at a discount to attract investors, who could find higher interest elsewhere in the prevailing rates. In other words, because investors can make a larger return in the market, they need an extra incentive to invest in the bonds.
Accounting for Different Payment Frequencies In the example above coupons were paid semi-annually, so we divided the interest rate and coupon payments in half to represent the two payments per year. You may be now wondering whether there is a formula that does not require steps two and three outlined above, which are required if the coupon payments occur more than once a year. A simple modification of the above formula will allow you to adjust interest rates and coupon payments to calculate a bond price for any payment frequency:
Project on Fixed Income Notice that the only modification to the original formula is the addition of "F", which represents the frequency of coupon payments, or the number of times a year the coupon is paid. Therefore, for bonds paying annual coupons, F would have a value of one. Should a bond pay quarterly payments, F would equal four, and if the bond paid semi-annual coupons, F would be two.
Pricing Zero-Coupon Bonds So what happens when there are no coupon payments? For the aptly-named zero-coupon bond, there is no coupon payment until maturity. Because of this, the present value of annuity formula is unnecessary. You simply calculate the present value of the par value at maturity. Here's a simple example:
Example 2(a): Let's look at how to calculate the price of a zero-coupon bond that is maturing in five years, has a par value of $1,000 and a required yield of 6%.
1. Determine the Number of Periods: Unless otherwise indicated, the required yield of most zero-coupon bonds is based on a semi-annual coupon payment. This is because the interest on a zero-coupon bond is equal to the difference between the purchase price and maturity value, but we need a way to compare a zero-coupon bond to a coupon bond, so the 6% required yield must be adjusted to the equivalent of its semi-annual coupon rate. Therefore, the number of periods for zero-coupon bonds will be doubled, so the zero coupon bond maturing in five years would have ten periods (5 x 2).
2. Determine the Yield: The required yield of 6% must also be divided by two because the number of periods used in the calculation has doubled. The yield for this bond is 3% (6% / 2).
3. Plug the amounts into the formula:
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You should note that zero-coupon bonds are always priced at a discount: if zerocoupon bonds were sold at par, investors would have no way of making money from them and therefore no incentive to buy them.
Pricing Bonds between Payment Periods Up to this point we have assumed that we are purchasing bonds whose next coupon payment occurs one payment period away, according to the regular payment-frequency pattern. So far, if we were to price a bond that pays semiannual coupons and we purchased the bond today, our calculations would assume that we would receive the next coupon payment in exactly six months. Of course, because you won't always be buying a bond on its coupon payment date, it's important you know how to calculate price if, say, a semi-annual bond is paying its next coupon in three months, one month, or 21 days.
Determining Day Count To price a bond between payment periods, we must use the appropriate daycount convention. Day count is a way of measuring the appropriate interest rate for a specific period of time. There is actual/actual day count, which is used mainly for Treasury securities. This method counts the exact number of days until the next payment. For example, if you purchased a semi-annual Treasury bond on March 1, 2003, and its next coupon payment is in four months (July 1, 2003), the next coupon payment would be in 122 days:
Project on Fixed Income Time Period = Days Counted March 1-31 = 31 days April 1-30 = 30 days May 1-31 = 31 days June 1-30 = 30 days July 1 = 0 days Total Days = 122 days
To determine the day count, we must also know the number of days in the sixmonth period of the regular payment cycle. In these six months there are exactly 182 days, so the day count of the Treasury bond would be 122/182, which means that out of the 182 days in the six-month period, the bond still has 122 days before the next coupon payment. In other words, 60 days of the payment period (182 - 122) have already passed. If the bondholder sold the bond today, he or she must be compensated for the interest accrued on the bond over these 60 days.
(Note that if it is a leap year, the total number of days in a year is 366 rather than 365.)
For municipal and corporate bonds, you would use the 30/360 day count convention, which is much simpler as there is no need to remember the actual number of days in each year and month. This count convention assumes that a year consists of 360 days and each month consists of 30 days. As an example, assume the above Treasury bond was actually a semi-annual corporate bond. In this case, the next coupon payment would be in 120 days. Time Period = Days Counted March 1-30 = 30 days April 1-30 = 30 days May 1-30 = 30 days June 1-30 = 30 days July 1 = 0 days 36
Project on Fixed Income Total Days = 120 days
As a result, the day count convention would be 120/180, which means that 66.7% of the coupon period remains. Notice that we end up with almost the same answer as the actual/actual day count convention above: both day-count conventions tell us that 60 days have passed into the payment period.
Determining Interest Accrued Accrued interest is the fraction of the coupon payment that the bond seller earns for holding the bond for a period of time between bond payments. The bond price's inclusion of any interest accrued since the last payment period determines whether the bond's price is “dirty” or “clean.” Dirty bond prices include any accrued interest that has accumulated since the last coupon payment while clean bond prices do not. In newspapers, the bond prices quoted are often clean prices.
However, because many of the bonds traded in the secondary market are often traded in between coupon payment dates, the bond seller must be compensated for the portion of the coupon payment he or she earns for holding the bond since the last payment. The amount of the coupon payment that the buyer should receive is the coupon payment minus accrued interest. The following example will make this concept more clear.
Example 3: On March 1, 2003, Francesca is selling a corporate bond with a face value of $1,000 and a 7% coupon paid semi-annually. The next coupon payment after March 1, 2003, is expected on June 30, 2003. What is the interest accrued on the bond?
1. Determine the Semi-Annual Coupon Payment: Because the coupon payments are semi-annual, divide the coupon rate in half, which gives a rate of 3.5% (7% / 2). Each semi-annual coupon payment will then be $35 ($1,000 X 0.035).
Project on Fixed Income 2. Determine the Number of Days Remaining in the Coupon Period: Because it is a corporate bond, we will use the 30/360 day-count convention.
Time Period = Days Counted March 1-30 = 30 days April 1-30 = 30 days May 1-30 = 30 days June 1-30 = 30 days Total Days = 120 days
There are 120 days remaining before the next coupon payment, but because the coupons are paid semi-annually (two times a year), the regular payment period if the bond is 180 days, which, according to the 30/360 day count, is equal to six months. The seller, therefore, has accumulated 60 days worth of interest (180120).
3. Calculate the Accrued Interest: Accrued interest is the fraction of the coupon payment that the original holder (in this case Francesca) has earned. It is calculated by the following formula:
In this example, the interest accrued by Francesca is $11.67. If the buyer only paid her the clean price, she would not receive the $11.67 to which she is entitled for holding the bond for those 60 days of the 180-day coupon period.
Now you know how to calculate the price of a bond, regardless of when its next 38
Project on Fixed Income coupon will be paid. Bond price quotes are typically the clean prices, but buyers of bonds pay the dirty, or full price. As a result, both buyers and sellers should understand the amount for which a bond should be sold or purchased. In addition, the tools you learned in this section will better enable you to learn the relationship between coupon rate, required yield and price as well as the reasons for which bond prices change in the market. Example 4 : Calculating the Purchase Price for a Bond with Accrued Interest You purchase a corporate bond with a settlement date on September 15 with a face value of $1,000 and a nominal yield of 8%, that has a listed price of 100-08, and that pays interest semi-annually on February 15 and August 15. How much must you pay? The semi-annual interest payment is $40 and there were 31 days since the last interest payment on August 15. If the settlement date fell on a interest payment date, the bond price would equal the listed price: 100.25% x $1,000.00 = $1,002.50 (8/32 = 1/4 = .25, so 100-08 = 100.25% of par value). Since the settlement date was 31 days after the last payment date, accrued interest must be added. Using the above formula, with 184 days between coupon payments, we find that:
Accrued Interest = $40 x
31 ─── = $6.74 184
Therefore, the actual purchase price for the bond will be $1,002.50 + $6.74 = $1,009.24 BOND YIELD Yield to Maturity (YTM) : Interest rate that makes the present value of bond payment equal to its price.
Example 1: 39
Project on Fixed Income Bond Selling at $ 1276.76 Coupon: 8% Maturity: 30 years Payment: semiannual
t 1 (1 r )
1000 (1 r ) 60
r = 3% per half year Annual percentage rate or BEY = 3% x 2 = 6% Effective Annual Yield = (1.03)2 – 1 : 6.09% Current Yield =
$80 6.27% $1276.76
Yield to Call (YTC) for callable bond Example 2: First call in year 10 and call price is $1100 Yield to Call Coupon # of period Final Payment Price $40 20 period 1100 $1150 Yield to Mat. $40 60 period 1000 $1150
t 1 (1 r )
$1000 (1 r ) 60
r = 6.82% per annum YTC: 40
Project on Fixed Income 20 40
t 1 (1 r )
$1100 (1 r ) 20
r = 6.64% per annum
Repurchase agreement (REPO)
Repurchase agreements (RPs or repos) are financial instruments used in the money markets and capital markets. A more accurate and descriptive term is Sale and Repurchase Agreement, since what occurs is that the cash receiver (seller) sells securities now, in return for cash, to the cash provider (buyer), and agrees to repurchase those securities from the buyer for a greater sum of cash at some later date, that greater sum being all of the cash lent and some extra cash (constituting interest, known as the repo rate). There is little that prevents any security from being employed in a repo; so, Treasury or Government bills, corporate and Treasury / Government bonds, and stocks / shares, may all be used as securities involved in a repo. A reverse repo is simply a repurchase agreement as described from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a 'repo', while the buyer in the same transaction would describe it a 'reverse repo'. So 'repo' and 'reverse repo' are exactly the same kind of transaction, just described from opposite viewpoints. A repo is economically similar to a secured loan, with the buyer receiving securities as collateral to protect against default. However, the legal title to the securities clearly passes from the seller to the buyer, or "investor". Coupons (installment payments that are payable to the owner of the securities) which are paid while the repo buyer owns the securities are, in fact, usually passed directly onto the repo seller which might seem counterintuitive, as the ownership of the collateral technically rests with the buyer during the repo agreement. It is 41
Project on Fixed Income possible to instead pass on the coupon by altering the cash paid at the end of the agreement, though this is more typical of Sell/Buy Backs. Although the underlying nature of the transaction is that of a loan, the terminology differs from that used when talking of loans due to the fact that the seller does actually repurchase the legal ownership of the securities from the buyer at the end of the agreement. So, although the actual effect of the whole transaction is identical to a cash loan, in using the 'repurchase' terminology, the emphasis is placed upon the current legal ownership of the collateral securities by the respective parties. There are three types of repo maturities: overnight, term, and open repo. Overnight refers to a one-day maturity transaction. Term refers to a repo with a specified end date. Open simply has no end date. Although repos are typically short-term, it is not unusual to see repos with a maturity as long as two years. Repo transactions came into focus within the financial press due to the technicalities of settlements following the collapse of Refco. Occasionally, a party involved in a repo transaction may not have a specific bond at the end of the repo contract. This may cause a string of failures from one party to the next, for as long as different parties have transacted for the same underlying instrument. The focus of the media attention centers on attempts to mitigate these failures.
Types of repo and related products
Repo transactions occur in three forms: specified delivery, tri-party, and held in custody. The third form is quite rare in development markets primarily due to risks. The first form requires the delivery of a prespecified bond at the onset, and at maturity of the contractual period. Tri-party essentially is a basket form of transaction, and allows for a wider range of instruments in the basket or pool. Tri-party utilizes a tri-party agent and is a very efficient form of transaction.
Project on Fixed Income Due bill/hold in-custody repo In a due bill repo, the collateral pledged by the (cash) borrower is not actually delivered to the cash lender. Rather, it is placed in an internal account ("held in custody") by the borrower, for the lender, throughout the duration of the trade. This has become less common as the repo market has grown, particularly owing to the creation of centralized counterparties. Due to the high risk to the cash lender, these are generally only transacted with large, financially stable institutions. Tri-party repo The distinguishing feature of a tri-party repo is that a custodian bank or international clearing organization acts as an intermediary between the two parties to the repo. The tri-party agent is responsible for the administration of the transaction including collateral allocation, marking to market, and substitution of collateral. Both the lender and borrower of cash enter into these transactions to avoid the administrative burden of bi-lateral repos. In addition, because the collateral is being held by an agent, counterparty risk is reduced. A tri-party repo may be seen as the outgrowth of the due bill repo, in which the collateral is held by a neutral third party. Whole loan repo A whole loan repo is a form of repo where the transaction is collateralized by a loan or other form of obligation (e.g. mortgage receivables) rather than a security. Equity repo The underlying security for most repo transactions is in the form of government or corporate bonds. Equity repos are simply repos on equity securities such as common (or ordinary) shares. Some complications can arise because of greater complexity in the tax rules for dividends as opposed to coupons. 43
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Sell/buy backs and buy/sell backs
A sell/buy back is the spot sale and a forward repurchase of a security. The basic motivation of sell/buy backs is generally the same as for a classic repo, i.e. attempting to benefit from the lower financing rates generally available for collateralized as opposed to non-secured borrowing. The economics of the transaction are also similar with the interest on the cash borrowed through the sell/buy back being implicit in the difference between the sale price and the purchase price. There are a number of differences between the two structures. A repo is technically a single transaction while a sell/buy back is a pair of transactions (a sell and a buy). A sell/buy back does not require any special legal documentation while a repo generally requires a master agreement to be in place between the buyer and seller (typically the SIFMA/ICMA commissioned Global Master Repo Agreement (GMRA)). Any coupon payment on the underlying security during the life of the sell/buy back will generally be passed back to the seller of the security by adjusting the cash paid at the termination of the sell/buy back. In a repo, the coupon will be passed on immediately to the seller of the security. A buy/sell back is the equivalent of a reverse repo. Securities lending The general motivation for repos is the borrowing or lending of cash. In securities lending, the purpose is to temporarily obtain the security for other purposes, such as covering short positions or for use in complex financial structures. Securities are generally lent out for a fee. Securities lending trades are governed by different types of legal agreements than repos.
United States Federal Reserve use of repos
Project on Fixed Income Repurchase agreements when transacted by the Federal Open Market Committee of the Federal Reserve in open market operations adds reserves to the banking system and then after a specified period of time withdraws them; reverse repos initially drain reserves and later add them back. Under a repurchase agreement ("RP" or "repo"), the Federal Reserve (Fed) buys US Treasury securities, U.S. agency securities, or mortgage-backed securities from a primary dealer who agrees to buy them back, typically within one to seven days; a reverse repo is the opposite. Thus the Fed describes these transactions from the counterparty's viewpoint rather than from their own viewpoint. If the Federal Reserve is one of the transacting parties, the RP is called a "system repo," but if they are trading on behalf of a customer (e.g. a foreign central bank) it is called a "customer repo." Until 2003 the Fed did not use the term "reverse repo" - which it believed implied that it was borrowing money (counter to its charter) - but used the term "matched sale" instead.
Bonds Future & Options
Bond Futures A bond future is a contractual obligation for the contract holder to purchase or sell a bond on a specified date at a predetermined price. A bond future can be bought in a futures exchange market and the prices and dates are determined at the time the future is purchased. Bond contracts are standardized, and are overseen by a regulatory agency that ensures a certain level of equality and consistency. However, this form of derivative can be risky because it involves trading at a future date with only current information. The risk is potentially unlimited, for either the buyer or seller of the bond because the price of the underlying bond may change drastically between the exercise date and the initial agreement. 45
Project on Fixed Income Some of the examples of bond futures are : Ten year US Treasury bond futures, Five year US Treasury bond futures, Two year US Treasury bond futures…..
In finance, a bond option is an OTC-traded financial instrument that facilitates an option to buy or sell a particular bond at a certain date for a particular price. It is similar to a stock option with the difference that the underlying asset is a bond. Bond options can be valued using the Black model. The present market value for the bond is referred to as the spot price while the future value as per the option is referred to as the strike price. Types A European bond option is an option to buy or sell a bond at a certain date in future for a predetermined price only at the maturity of the option. Example Trade Date: 1 March 2003 Maturity Date: 6 March 2006 Option Buyer: Bank A Underlying asset: FNMA Bond. Spot Price: $101 , Strike Price: $102 On the Trade Date, Bank A enters into an option with Bank B to buy certain FNMA Bonds from Bank B for the Strike Price mentioned. Bank A pays a premium to Bank B which is the premium percentage multiplied by the face value of the bonds. At the maturity of the option, Bank A either exercises the option and buys the bonds from Bank B at the predetermined strike price, or chooses not to exercise the option. In either case, Bank A has lost the premium to Bank B. Embedded option 46
Project on Fixed Income The term "bond option" is also used for option-like features of some bonds. These are an inherent part of the bond, rather than a separately traded product.
A callable bond allows the issuer to buy back the bond at a predetermined price at certain time in future. The holder of such a bond has, in effect, sold a call option to the issuer. Callable bonds cannot be called for the first few years of their life. This period is known as the lock out period.
A puttable bond allows the holder to demand early redemption at a predetermined price at certain time in future. The holder of such a bond has, in effect, purchased a put option on the bond. Uses The major advantage of a bond option is the Locking-in price of the underlying bond for future thereby reducing the credit risk associated with the fluctuations in the bond price.
The Development of Bond market in India
The debt market is much more popular than the equity markets in most parts of the world. In India the reverse has been true. Nevertheless, the Indian debt market has transformed itself into a much more vibrant trading field for debt instruments from the rudimentary market about a decade ago. The sections below encompass the transformation of government and corporate debt markets in India along with a comparison of the developments in equity market. Developments in Government Bond Market Prior to 1992, money was collected and lent according to Plan. Lacunae in institutional infrastructure and inefficient market practices characterized the government securities market. Infact the sole objective pursued was to keep the cost of government borrowing as low as possible. If planning went awry, the 47
Project on Fixed Income government sent word to its banker. The central bank made a few phone calls to the heads of banks and bonds were issued and the money arranged. No questions asked, no explanations given. The GOI bond market did not use trading on an exchange. It featured bilateral negotiation between dealers. The market thus lacked price-time priority and the bilateral transactions imposed counterparty credit risk on participants. This narrowed down the market into a “club” with homogeneous credit risk. This was the state of the government debt market in India ten years ago. The major thrust of Financial Reforms commenced in 1992. This was when the contours of the debt market began taking shape. The idea of the financial reform movement was to have more and more different markets and not necessarily have whole financial intermediation left to the banks. The reform process attempted at doing away with regulations in favour of controls based on market forces i.e. an era where the interest rates are governed more by the market forces of demand and supply and less by centralized supervision. Slowly, but steadily, the market grew, adding fresh players and novel instruments. Several measures have added greater transparency and have brought the issuances closer to the market levels.
The major reforms that took place in the 1990’s were:
• Introduction of the auction system for sale of dated government securities in June1992. This signaled the end of the era of administered interest rates.
• The RBI moved to computerize the SGL and implement a form of a ‘delivery versus payment’ (DvP) system. The DvP enabled mitigating of settlement risk in securities and ensured the smoothness of settlement by synchronizing the payment and delivery of securities. • Innovative products in form of Zero Coupon Bonds and Capital Indexed Bonds (Ex. Inflation Linked) were issued to attract a wider gamut of investors. 48
Project on Fixed Income However, the pace of innovation suffered due to non-sophistication of the markets and lack of persistence with some of the new bonds like Inflation Indexed bonds after the initial lukewarm response.
• The system of Primary Dealers was established in March 1995. These primary dealers have since then acquired a large chunk of share in the GOI bond market and have played the role of market makers.
• The RBI setup “trade for trade” regime, a strong regulatory system which required that every trade must be settled with funds and bonds. All forms of netting were prohibited.
• Wholesale Debt Market (WDM ) segment was set up at NSE, A limited degree of transparency came about through the WDM at NSE, where roughly half the trading volume of India’s GOI bond market is reported.
• The Ways And Means agreement put an end to issuance of ad hoc treasury bills, the governments favourite instrument of funding its profligacy.
• Interest Income in G-Secs was exempted from the purview of TDS.
• FIIs with 100% Debt Schemes were allowed to invest in GOI Securities and TBills while other FIIs were allowed 30% investment in these instruments. • Dematerialised forms of securities in G-Secs was done through the SGL and Constituents SGL accounts.
The above-mentioned measures have served in bringing about greater market orientation of the sovereign issues. This is particularly important as the sovereign borrowing parameters have a direct bearing on the cost of capital for other nonsovereign issuers. The Primary market for G-Secs registered an almost ten-fold 49
Project on Fixed Income increase between 1990-91 and 1998-99. The broadening of themarket was also apparent from the fact that RBI’s participation, as reflected by absorption of primary issues, came down from 45.90% in 1992-93 to 0.74% in 1994-95.
Though significant improvements have been made in the primary market, the secondary market continued to be plagued by certain shortcomings like dominance of a few players (acted as a deterrent to lending width in the market), strategy of holding to maturity by leading players (prevented the improvement in the depth of the market), the pre-1992 “telephone market” continued to exist (prevents information dissemination and hence price discovery is limited) and low retailparticipation in G-Secs continues to exist even today. Experts believe that there is tremendous potential for widening the investor base for Government securities among retail investors. This requires a two-pronged approach, increasing their awareness about Government securities as an option for investment and improving liquidity in the secondary market that will provide them with an exit route. Also infrastructure is seen as the vital element in the further development and deepening of the market.
Corporate Bond Market
In the last decade, market related borrowings by the corporate sector have remained depressed as a plethora of Financial Institutions were available for disbursal of credit. These Institutions managed to mobilize a significant amount of domestic savings and route them for corporate consumption.
Also the reforms abolished the office of the Controller of Capital Issues (CCI), which meant that companies were free to price their equity issues as per the market appetite. This led to a slew of primary issue of equity and the relative 50
Project on Fixed Income attractiveness of issue of debt yielded way to equities. In fact, even debt issues were made with attached sweeteners like convertible portion of the fixed income instrument. In addition, several relaxations in regulations post 1992 have encouraged Indian corporates to raise debt from overseas capital markets leading to further shunning of the domestic debt market by creditworthy issuers. Therefore, the corporate debt market in India has continued to be dominated by the PSU’s.
In the recent past, the corporate debt market has seen high growth of innovative asset-backed securities. The servicing of debt and related obligations for such instruments is backed by some sort of financial assets and/or credit support from a third party. Over the years greater innovation has been witnessed in the corporate bond issuances, like floating rate instruments, zero coupon bonds, convertible bonds, callable (put-able) bonds and step-redemption bonds. For example, step bonds issued by ICICI in 1998, paid progressively higher rates of interest as the maturity approached while the IDBI’s step bond was issued with a feature to pay out the redemption amount in instalments after an initial holding period. The deep discount bond issued by IDBI in the same year had two put and call options before maturity.
What these innovative issues have done is that they have provided a gamut of securities that caters to wider segment of investors in terms of maintaining a desirable risk-return balance. Over the last five years, corporate issuers have shown a distinct preference for private placements over public issues. This has further cramped the liquidity in the market. While private placement has grown 6.23 times to Rs. 62461.80 crores in 2000-2001 since 1995-96, the corresponding increase in public issues of debt has been merely 40.95 percent from the 1995-96 levels.
The dominance of private placement in total issuances is attributable to a number of factors. 51
Project on Fixed Income First, the lengthy issuance procedure for public issues, in particular, the information disclosure requirements, provide a strong incentive for eligible entities to opt for the private placement route. Secondly, the costs of a public issue are considerably higher than those for a private placement. Thirdly, the amounts that can be raised through private placements are typically larger than those that can be garnered through a public issue. Also, a corporate can expect to raise debt from the market at finer rates than the prime-lending rate of banks and financial institutions only with a AAArated paper. This limits the number of entities that would find it profitable to enter the market directly.
Thus the public issues market has over the years been dominated by financial institutions, which is exemplified by the fact that ICICI and IDBI accounted for the entire debt offerings in 1998–99 and all but one issue in 1999–20001. Another interesting fact is that inspite of dominating the public issues market even financial institutions have raised significantly larger amounts through the private placement route.
Further the secondary market for non-sovereign debt, especially corporate paper remains plagued by inefficiencies. The primary problem is the total lack of market making in these securities, which consequently lead to extremely poor liquidity. The biggest investors in this segment of the market, namely LIC, GIC and UTI prefer to hold the instruments to maturity, thereby truncating the supply of paper in the market.
The secondary market for corporate did receive a boost with the waiver on stamp duty payment on transfer of debt securities, as long as they are dematerialized debentures, in the Finance Bill 2000.
Development of Equity Market vs. the Debt Market:
Project on Fixed Income During this decade of financial reforms development in equity market has been striking as compared to relatively minor changes in the debt market. In terms of sheer market size, the equity market saw a drop from 42% of GDP in 1993–94 to 28.6% of GDP in 2000-01. Over the same period, the GOI bond market saw an increase in market size, fueled by large fiscal deficits, from 28% of GDP in 1993– 94 to 36.7% of GDP in 2000–01. Other things being equal, this should have generated an improvement in liquidity of the GOI bond market and a reduction in liquidity in the equity market. Instead, changes in market design on the equity market over this period gave the opposite outcome, where the improvement in liquidity on the equity market was superior to that observed on the GOI bond market. The reasons for this have been manifold:
• Foreign capital inflows into the GOI bond market are relatively undesireable to policy-makers.This is in contrast with capital inflows into the equity market, where policy-makers seek to have the largest possible capital inflows. Hence, infirmities in the market design on the GOI bond market do not generate an important opportunity cost as far as harnessing foreign capital inflows are concerned.
• In the presence of “development finance institutions” and banks, firms in India are seen as having access to debt financing, access to debt finance was therefore not seen as a major bottleneck hindering investment. Hence, the lack of a liquid bond market was not keenly seen as a constraint in investment and growth.
• In the case of the GOI bond market, the benefits from a non-transparent market with entry barriers accrue primarily to banks and PDs. The PDs are largely the creation of RBI and public sector banks have extremely close ties with RBI. The RBI is the regulator for G-Secs market. Thus the development of equity markets took precedence over development of debt market in India but the future does seem promising for the debt market.
Project on Fixed Income
Retail Debt Market of India
With a view to encouraging wider participation of all classes of investors across the country (including retail investors) in government securities, the Government, RBI and SEBI have introduced trading in government securities for retail investors. Trading in this retail debt market segment (RDM) on NSE has been introduced w.e.f. January 16, 2003. Trading shall take place in the existing Capital Market segment of the Exchange. In the first phase, all outstanding and newly issued central government securities would be traded in the retail segment. Other securities like state government securities, T-Bills etc. would be added in subsequent phases. Trading Trading in the Retail Debt Market takes place in the same manner in which the trading takes place in the equities (Capital Market) segment. The RETDEBT Market facility on the NEAT system of Capital Market Segment is used for entering transactions in RDM session.
Members eligible for trading in RDM segment Market Timings and Market Holidays Trading Parameters Trading System Trading Cycle
Members eligible for trading in RDM segment Trading Members who are registered members of NSE in the Capital Market segment and Wholesale Debt Market segment are allowed to trade in Retail Debt Market (RDM) subject to fulfilling the capital adequacy norms.
Trading Members with membership in Wholesale Debt Market segment only, 54
Project on Fixed Income can participate in RDM on submission of a letter in the prescribed format as per Circular No. NSE/CMTR/3860 dated January 11, 2003. Market Timings and Market Holidays Trading in RDM segment takes place on all days of the week, except Saturdays and Sundays and holidays declared by the Exchange in advance (The holidays on the RDM segment shall be the same as those on the Equities segment). The market timings of the RDM segment are the same as the Equities segment, viz.: Normal Market Open : 09:55 hours Normal Market Close : 15:30 hours
Note: The Exchange may however close the market on days other than the above schedule holidays or may open the market on days originally declared as holidays. The Exchange may also extend, advance or reduce trading hours when its deems fit and necessary.
The trading parameters for RDM segment are as below: Face Value Permitted Lot Size Tick Size Operating Range Mkt. Type Indicator Book Type Rs. 100/10 Rs. 0.01 +/- 5% D (RETDEBT) RD
Trading System Trading in RDM takes place on the 'National Exchange for Automated Trading' (NEAT) system, a fully automated screen based trading system, which adopts the principle of an order driven market.The RETDEBT Market facility on the NEAT system of Capital Market Segment is used for entering transactions in RDM session. Trading Cycle
Project on Fixed Income Trading in Retail Debt Market is permitted under Rolling Settlement, where in each trading day is considered as a trading period and trades executed during the day are settled based on the net obligations for the day. Settlement is on a T+2 basis i.e. on the 2nd working day. For arriving at the settlement day all intervening holidays, which include bank holidays, NSE holidays, Saturdays and Sundays are excluded. Typically trades taking place on Monday are settled on Wednesday, Tuesday's trades settled on Thursday and so on.
Clearing & Settlement (Retail Debt Market)
National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed in Retail Debt Market.
Salient features of Clearing and Settlement in Retail Debt Market segment
Clearing and settlement of all trades in the Retail Debt Market shall be subject to the Bye Laws, Rules and Regulations of the Capital Market Segment and such regulations, circulars and requirements etc. as may be brought into force from time to time in respect of clearing and settlement of trading in Retail Debt Market (Government securities).
Settlement in Retail Debt Market is on T + 2 Rolling basis viz. on the 2nd working day. For arriving at the settlement day all intervening holidays, which include bank holidays, NSE holidays, Saturdays and Sundays are excluded. Typically trades taking place on Monday are settled on Wednesday, Tuesday's trades settled on Thursday and so on.
Clearing and settlement would be based on netting of the trades in a day. NSCCL shall compute member obligations and make available reports/data by T+1. The obligations shall be computed separately for this market from the obligations of the equity market.
Project on Fixed Income The settlement schedule for the Retail Debt Market (Government Securities) Sr.No. 1 2 3 4
Funds settlementand securities settlement shall be through the existing clearing banks and depositories of NSCCL, in a manner similar to the Capital Market segment. The existing clearing bank accounts shall be used for funds settlement.
The existing CM pool account with the depositories that is currently operated for the CM segment, will be utilized for the purpose of settlements of securities.
In case of short deliveries, unsettled positions shall be closed out. The close out would be done at Zero Coupon Yield Curve (ZCYC) valuation for prices plus a 5% penalty factor. The buyer shall be eligible for the highest traded price from the trade date to the date of close out or closing price of the security on the close out date plus interest calculated at the rate of overnight FIMMDA-NSE MIBOR for the close out date whichever is higher and the balance shall be credited to the Investor Protection Fund.
Members may please note that the penal actions and penalty points shall be similar to as in Capital Markets.
Listing All Government securities and Treasury bills are deemed to be listed on the Exchange automatically, as and when they are issued. Initially, 85 central government securities would be traded in the retail debt 57
Project on Fixed Income market segment. The Exchange will introduce additional securities for trading from time to time. Other securities like state government securities, T-Bills etc. would be added in subsequent phases. Security Details
Every security will be identified with a unique symbol and series. The nomenclature of the symbol will be as follows:
First 4 characters - Coupon Rate (without the decimal point) Next character - Month of Maturity ( A - Jan, B - Feb, C - Mar, etc.) Next 2 characters - Year of Maturity (03 - 2003, 04 - 2004, etc.)
In cases where more than one security have the same characteristic, then the last character shall have an additional character descriptor, viz. A/B etc.
Example: Security Name GOI Loan 5.75% 2003 GOI Loan 6.65% 2009 Maturity date Symbol 12-May-2003 0575E03 05-Apr-2009 0665D09
GOI Loan 11.50% 2011 05-Aug-2011 1150H11
All government securities will be traded under the series GC Face Value of all the securities is 100 Permitted Lot size of all the securities is 10
Business Growth in RDM Segment
Month / Year 2007-2008 2006-2007 No of trades 0 4 Traded quantity 0 12,120 Traded Value (Rs.lakhs) 0.00 13.69
Project on Fixed Income
2005-2006 2004-2005 2003-2004 0 31 912 0 122,390 372,820 0.00 149.27 464.41
Wholesale Debt Market of India
The Wholesale Debt Market segment deals in fixed income securities and is fast gaining ground in an environment that has largely focussed on equities.
The Wholesale Debt Market (WDM) segment of the Exchange commenced operations on June 30, 1994. This provided the first formal screen-based trading facility for the debt market in the country.
This segment provides trading facilities for a variety of debt instruments including Government Securities, Treasury Bills and Bonds issued by Public Sector Undertakings/ Corporates/ Banks like Floating Rate Bonds, Zero Coupon Bonds, Commercial Papers, Certificate of Deposits, Corporate Debentures, State Government loans, SLR and Non-SLR Bonds issued by Financial Institutions, Units of Mutual Funds and Securitized debt by banks, financial institutions, corporate bodies, trusts and others.
Large investors and a high average trade value characterize this segment. Till recently, the market was purely an informal market with most of the trades directly negotiated and struck between various participants. The commencement of this segment by NSE has brought about transparency and efficiency to the debt market, along with effective monitoring and surveillance to the market. Market Timings Trading in the WDM segment is open on all days except Saturdays, Sundays and other holidays, as specified by the Exchange. The market timings are as given below: Trading Days Same day Settlement Other day Settlement 59
Monday to Friday 10.00 a.m. to 3.00 p.m. 10.00 a.m. to 5.45 p.m.
Project on Fixed Income Trading on WDM segment is divided into three phases as under: 1. Pre-Open 2. Market Open 3. SURCON Pre-Open Market Phase The pre-open period commences from 9.00 a.m. This period allows the trading member/Participant to: § set up counter party exposure limits § set up Market Watch (the security descriptor) § make inquiries Market Open Phase The system allows for inquiries of the following activities when the market is open for trading: 1. Order Entry 2. Order Modification 3. Order Cancellation 4. Negotiated Entry 5. Trade Cancellation 6. Setting up counter party exposure limits Post Market Phase (also called SURCON) During the period of SURCON (SURveillance and CONtrol) a trading member gets only inquiry access with a facility to request for trade cancellation. On completion of SURCON the trading system processes data and gets the system ready for the next day. Listing All Government securities and Treasury bills are deemed to be listed automatically as and when they are issued. Other securities, issued publicly or placed privately, could be listed or admitted for trading, if eligible, as per rules of the Exchange by following prescribed procedure.
Certain securities like Treasury Bills and other securities issued by Government of India and certain Corporate and PSU debt securities available in demat form are eligible for Repo. Every security in the trading system is given a symbol representative of the security.
The market capitalisation of the securities on the WDM segment has been 60
Project on Fixed Income increasing steadily. The segment has also seen a marked increase in the number of securities available for trading other than the traditional instruments like Govt. securities and T-bills. Brokerage Rates The Exchange has specified the maximum rates of brokerage chargeable by trading members in relation to trades done in securities available on the WDM segment of the Exchange.
Govt. Of India Securities and T-Bills Order Value upto Rs.10 million More than 10 million upto 50 million More than 50 million upto 100 million More than 100 million State Govt. Securities & Institutional Bonds Order Value upto Rs.2.5 million More than 2.5 million upto 5 million More than 5 million upto 10 million More than 10 million upto 50 million More than 50 million upto 100 million More than 100 million PSU & Floating Rate Bonds Order Value upto Rs.10 million More than 10 million upto 50 million More than 50 million upto 100 million More than 100 million Commercial paper and Debentures 50 ps. per Rs.100 25 ps. per Rs.100 15 ps per Rs.100 10 ps per Rs.100 1% of the order value 50 ps. per Rs.100 30 ps. per Rs.100 25 ps per Rs.100 15 ps per Rs.100 10 ps per Rs.100 5 ps per Rs.100 25 ps. per Rs.100 15 ps. per Rs.100 10 ps per Rs.100 5 ps per Rs.100
Business Growth in WDM Segment
Market Capitalisation (Rs.crores) Number of Trades Net Traded Value (Rs.crores) Average Daily Value (Rs.crores) Average Trade Size (Rs.crores)
The income fund I invested in returned only 5% last year. I would be better off investing in the fixed deposit of my neighborhood bank. I can get 9.5% for a one-year deposit. This used to be a familiar argument till some time back. Then came the FMPs – or the fixed maturity plans from mutual funds. These FMPs looked like Godsend for the mutual fund sellers. Why? Based on the interest rate scenario at the time of launch, the returns to the investor can be easily predicted. That gives a lot of comfort to the conservative predictabilityloving fixed income investor. Let us explain this and that should start with an understanding of how fixed income instruments (and the fixed income funds) work.
Project on Fixed Income Fixed income mutual funds, popularly known as income funds or debt funds, invest in debt securities issued by either the Government or companies, including banks. These debt securities are also known as debentures or bonds if the term is longer than one year, and treasury bills, commercial papers or certificates of deposit if the term is less than one year. The debt securities are obligations on part of the issuer to pay the principal and interest thereon as per an agreed time schedule. This concept of debt securities is quite familiar to most investors, as majority of the Indians have invested in these investment options, either through bank deposits, or small saving schemes, etc. All the fixed deposits or other such fixed income investments have a face value on which interest is calculated. Investors are mostly concerned with face value, interest rate, frequency of interest payment, the time period, safety of the investment option and maturity value. Most often these investments are held till maturity. Income funds invest in such debt securities and hence the investors expect the funds also to behave in exactly the same manner as the fixed income securities. However, the income funds exhibit a different behavior and hence it is important to understand the same. Since most of the investors hold on to their fixed income investments till maturity, one does not have to worry about the realizable value in the interim period before maturity. However, the income funds may not (and often do not) hold the investments till maturity and hence when they exit any instrument, the transaction will happen at the market price, which could be different from the face value or the purchase price. This difference between the face value (or purchase price) and the market price arises out of a few things, e.g. the accrued interest component yet to be paid, the interest rate scenario in the market for similar securities, the credit worthiness of the issuer at the time of valuation, the liquidity of the instrument and the overall liquidity situation in the market. Factors like poor liquidity for the specific instrument, lower credit of the issuer, higher interest rate for similar securities 63
Project on Fixed Income would reduce the relative attractiveness of the debt instrument in question, lowering the market price of the said security. Sensitivity to changes in interest rates in the market for similar securities is the most common factor affecting the market price of a debt security under normal circumstances. The market price of a security moves in the opposite direction of the move in the interest rate in the market. Let us say, there is a debenture “A” held by an investor giving interest rate of 9% for a 3-year holding period. Now, the interest rate for debentures with 3 year maturity goes up to 9.5%, our debenture “A” will become less attractive compared to the market. Hence no new buyer may be interested in buying the same and the holders of the bond may consider shifting to the debentures offering higher interest rate. The price of the debenture “A” will fall due to this. The fall in the price will be to such an extent that after the fall, the debenture “A” will also become as attractive as any other debenture in the market. Similarly, had the interest rate in the market gone down, debenture “A” would have become more sought after and hence its price would go up. As can be seen, the future earnings from the debenture will change in line with the interest rates in the market. If the market rates go up, the future earnings would go up and vice versa. However, the market price of the security would have gone down (or up) if the market interest rates have gone up (or down). In other words, for an existing investor, the value of the holdings would go down immediately when the market interest rates move up, but the future earnings would be higher and vice versa. Thus, it actually does not make sense to look at the past performance of a debt fund in isolation while taking an investment decision. The past performance of the fund has to be seen in light of various things like the quality of the portfolio (credit quality of debt securities in the portfolio), maturity profile of the portfolio, liquidity of the underlying debt
Project on Fixed Income securities and the relative performance of the fund with respect to a relevant benchmark. Most often, we are faced with options to invest either in a fixed deposit or a debt fund. While the potential future earning from a fixed deposit (the interest rate) is known to an investor, the same from a debt fund is unknown. In such a scenario, one resorts to looking at the past performance of a debt fund – and that is where one is comparing future returns (from fixed deposit) with the past returns (from a debt fund). As explained earlier, if the future returns from debt funds get adjusted whenever there is a change in market interest rates (the same does not happen to one’s existing fixed deposits), and the said adjustment happens through change in market price of the security, it is unfair to compare future returns of a fixed deposit with past performance of a debt fund. What one needs to compare is the easily available number called YTM (yield-to-maturity) of the debt fund portfolio with the interest rate offered by the fixed deposits. However, while looking at investment in debt funds, one need to keep a certain time horizon in mind as the YTM or the interest accrual happens at an incremental rate, the adjustment in value of securities (and hence the fund’s NAV) may be much bigger than the accrual for many days. A holding period in line with the maturity of the portfolio may offer returns close to the portfolio YTM less the expenses.
Why invest in fixed-income?
Fixed-income instruments in India typically include company bonds, fixed deposits and government schemes. Low risk tolerance One of the key benefits of fixed-income instruments is low risk i.e. the relative safety of principal and a predictable rate of return (yield). If your risk tolerance 65
Project on Fixed Income level is low, fixed-income investments might suit your investment needs better.
Use our RiskAnalyser to evaluate your risk tolerance level. Our AssetAllocator will suggest what portion of your investments should be in fixed-income securities based on your risk tolerance and risk capacity levels. Need for returns in the short-term Investment in equity shares is recommended only for that portion of your wealth for which you are unlikely to have a need in the short-term, at least five-years (to understand why read Investing in Equities). Consequently, the money that you are likely to need in the short-term (for capital or other expenses), should be invested in fixed-income instruments. Predictable versus Uncertain Returns Returns from fixed-income instruments are predictable i.e. they offer a fixed rate of return. In comparison, returns from shares are uncertain. If you need a certain predictable stream of income, fixed-income instruments are recommended.
Best Government Schemes
While evaluating Best Government Schemes, we consider only two of the three important factors for analysing investment opportunities - returns and liquidity. The third factor - risk - is not relevant and the risk of all government securities is the same.
As per our analysis, the best government schemes evaluated on returns and liquidity are -
1. Returns: Public Provident Fund (PPF)
2. Liquidity: Post Office Monthly Income Scheme 66
Project on Fixed Income A brief description of both these schemes is given below. 1. Public Provident Fund (PPF) Best fixed-income investment for high tax payers
PPF is a very attractive fixed income investment for small investors primarily because of An 8% post-tax return - effective pre-tax rate of 11.43%+ assuming a 30% tax ra A tax-deduction - from your taxable income for the year, subject to a maximum Rs 70,000 for a tax deduction Low risk - risk attached is Government risk So, what's the catch? Lack of liquidity is a big negative. You can withdraw your investment made in Year 1 only in Year 7 (although there are some loan options that begin earlier). If you are willing to live with poor liquidity, you should invest as much as you can in this scheme before looking for other fixed income investment options.
2. Post Office Monthly Income Scheme Offers regular income, no TDS
The monthly income scheme offers 8% monthly interest and a 10% bonus if you hold your investment for the entire term of 6 years. This scheme is best suited for retired individuals or individuals who have regular income needs. Besides the low (Government) risk, the fact that there is no tax deducted at source (TDS) in this scheme is another attractive feature.
Project on Fixed Income
Risk associated with Bonds
Although debt market instruments offer safe returns, they are not entirely risk free. There are several risks associated, arising mainly from change in external factors. Change in interest rate is the most influential risk, which primarily affects bond prices. We had earlier analysed the impact of interest rate risk and effect of other factors like monetary policy, fiscal policy, economic growth and inflation on bond prices. The purpose of this article is to highlight some of the other market related risks, which also influence bond prices. Some of the key risks factors associated with bond valuations are listed as follows: 1. Interest rate risk 2. Reinvestment rate risk 3. Yield curve risk 4. Call and prepayment risk 5. Credit risk 6. Liquidity risk 7. Exchange rate risk 8. Risk associated with inflation and erosion of purchasing power 9. Risk due to political & regulatory events and government actions Interest rate risk: Since we had already mentioned about interest rate risk in our previous articles, we will not go in its detail analysis. But just to refresh our memories, there is an inverse relationship between changes in interest rates and bond prices. The value of a bond is the sum total of the present value of its fixed future cash flows, discounted at the appropriate current market interest rate. Therefore, when the interest rate increases, a bond's value drops and vice-versa. A bond with longer maturity and higher yield will normally have less impact on price due to change in interest rates. On the other hand, an instrument with shorter maturity and low yield will tend to have larger impact on its price. The price volatility for low maturity and low yield instrument would however be on 68
Project on Fixed Income the lower side, as future cash inflows are lower compared to bond with long maturity period.
Maturity Date 22-Nov-07 15-May-06 26-Jul-03 1-Sep-02 13-Dec-10 22-Apr-05 24-May-13 30-May-13 30-May-21 Coupon Rate Last traded Years to Yield to (%) price (Rs) Maturity Maturity (%) 6.8 6.8 6.5 11.2 8.8 9.9 9 9.8 10.3 74 84.5 90.1 102.6 103.9 107.6 108.4 112.7 114.2 5.9 4.4 1.5 0.6 8.9 3.3 11.4 11.4 19.4 22.7 15.7 12 9.7 6.7 5.9 4.6 3.3 3
Source: NSE web site Let's take the practical example in order to understand the relationship between maturity, bond price and yield. As can be seen from the table above, bond having the highest yield to maturity (YTM) of 22.7% and longer duration (in this case 6 years) will be relatively more volatile compared to a bond having short maturity and low YTM (6.5% instrument having YTM of 12%). However, impact on price due to change in interest rate will be more on bond having a short maturity and low yield. Call and prepayment risk: The issuer can call a bond if the call price is below the theoretical market price due to falling interest rates. This is due to the fact that if interest rate declines issuer can raise fresh funds at lower interest rates and would repay the loans raised earlier carrying higher interest rates. Also, the possibility of a call limits or caps the potential for price appreciation (if interest rate falls bond price can rise near the call price and not more than that). In India bonds issued with call options are generally not traded in markets (not listed). IDBI Flexibond 1992 issue (interest rate of about 16.5%) is the latest example of issuer calling the bond. The bond was originally issued for 25 years tenure, with a put and call option after every five years. The decision of the institution has come in the wake of softer interest rate scenario. IDBI could now raise fresh 69
Project on Fixed Income funds by about 500 basis points lower than the earlier 16% debt. Thus before investing in a non-government bond, the investor should evaluate the terms given for call option by the issuer which is likely to impact investor's future cash inflow. Reinvestment risk: The bondholder is exposed to the risk of investing the proceeds of the bond (or coupon payments) at lower interest rates after the bond is called. This is known as reinvestment risk. The risk is intense for those investors who depend on a bond's coupon payments for most part of their returns. Reinvestment risk becomes more problematic with longer time horizons and when the current coupons being reinvested are relatively large. Home loan and personal finance companies are generally affected when home and auto buyers prepay their loans. In the lower interest rate environment, the finance companies get back their money sooner than expected, which adversely affects their future revenues. Credit risk: For a bond investor, there are primarily three types of credit risk: default risk, credit spread risk and downgrade risk. Default risk is defined as the possibility that the issuer will fail to meet its obligations (timely payment of interest and principal) under the indenture.
Credit spread risk is the excess return earned by a bond investor above the return on a benchmark, default free security (G-Sec). This is to compensate the investor for risk of buying a risky security. Interest rates on bonds issued by corporates are therefore generally higher compared to return from G-Secs. Yield on a risk bond = Yield on a default free bond + Risk premium Downgrade risk: It is the risk that a bond is reclassified as a riskier security by a credit rating agency. The rating agency considers many factors for evaluating the credit worthiness of a particular instrument. This includes the economic environment at large, the ability of the issuer to make good on its promise and 70
Project on Fixed Income the general political condition in the country. When an issue is re-categorized or its credit rating is changed, the yield adjusts immediately to reflect the new rating. Liquidity risk: It is the risk that represents the likelihood that an investor will be unable to sell the security quickly and at a fair price. Illiquid security will also have the risk of large price volatility. Quantitatively liquidity risk can be estimated through Bid-ask spread. Bid price represents the price at which dealers are willing to buy the security from traders/investors and ask price represents the price at which they are willing to sell the security to investors. The bid price is lower than the ask. The spread between these two prices is known as the bidask spread and it is used as a measure of a security's liquidity. High spreads signal an illiquid market. Investors like liquid markets so that they can buy and sell securities quickly and at a fair price. Liquidity may also improve as more participants actively engage in trading a security. For example, a 10.2% bond has the YTM of just 2.7%, but it is one of the most actively traded instruments with a longer maturity period. Thus it offers good liquidity to investors who can buy/sell the instrument easily. On the other hand instrument with a coupon rate of 10.8% with a maturity period of 13 years, although offers high YTM of 6.5%, has a relatively low liquidity. Maturity Date 11-Jun-10 11-Sep-26 24-Jun-06 19-May-15 5-Aug-11 19-Jun-08 23-May-03 21-May-05 Coupon Last Last Current Years to Rate traded traded yield Maturity (%) qty (nos.) price (Rs) (%) 11.5 10.2 13.9 10.8 11.5 12.1 11 10.5 2,500 1,500 1,200 100 54 50 45 115.5 115 121.4 108 117.1 116.4 99.8 10 8.9 11.4 10 9.8 10.4 11 9.5 8.4 24.7 4.5 13.4 9.6 6.4 1.4 3.4 Yield to Maturity (%) 3.5 2.7 2.8 6.5 2.7 3.6 11.1 5 71
28 110.4 Source: NSE web site
Project on Fixed Income Exchange rate risk: When bond payments (coupons/principal) are denominated in a currency other than the home currency of the bond holder, the investor bears the risk of receiving an uncertain amount when these payments are converted into the home currency. For example if rupee appreciates against the foreign currency (US$) of the bond payments, each US$ will be worth less in terms of rupee. This uncertainty related to adverse exchange rate movements in known as the exchange-rate risk or simply the currency risk. Inflation risk: It refers to the possibility that prices of general goods and services will increase in the economy. Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. This is known as the inflation risk. For example, if a risk free bond has a coupon rate of 7.5%, and prices increase at the rate of 4% per year, the investor's real return is 3.5%. Higher inflation rates result in a reduction of the purchasing power of bond payments (principal and interest). Event risk: These are generally related to the occurrence of a particular event and its impact on bond price. These can be listed as disasters, corporate restructuring, regulatory issues and political risk. Disasters (earthquakes or industrial actions) may impair the ability of a corporation to meet its debt obligations. Corporate restructuring (mergers, spin offs) may affect the obligations of the company by impacting its cash flow or the underlying assets that serve as a collateral. Regulatory issues such as environmental and other restrictions may impose compliance costs on the issuer, impacting its cash flow negatively. Political risk consisting of changes in the government or restrictions imposed on foreign exchange flows can limit the ability of the borrower to meet its foreign exchange obligations. Volumes in the debt market are improving on increasing demand from banks. With credit growth in the system tinkering down, banks are investing in government securities over and above the minimum requirement for SLR. This has offered the good liquidity to the markets. Although, the bias is towards softer 72
Project on Fixed Income interest rates, retail investor should take into account the above risk factors before investing into a debt instrument. This is due to the fact that actual yield earned is determined by the price of a bond which is again the factor of the above listed risks.
How to measure the risk ?
VAR (Value at Risk) Value at risk (VAR or sometimes VaR) has been called the "new science of risk management", but you do not need to be a scientist to use VAR. The most popular and traditional measure of risk is volatility. The main problem with volatility, however, is that it does not care about the direction of an investment's movement: a stock can be volatile because it suddenly jumps higher. Of course, investors are not distressed by gains! For investors, risk is about the odds of losing money, and VAR is based on that common-sense fact. By assuming investors care about the odds of a really big loss, VAR answers the question, "What is my worst-case scenario?" or "How much could I lose in a really bad month?" Now let's get specific. A VAR statistic has three components: a time period, a confidence level and a loss amount (or loss percentage). Keep these three parts in mind as we give some examples of variations of the question that VAR answers:
What is the most I can - with a 95% or 99% level of confidence - expect to lose in dollars over the next month? What is the maximum percentage I can - with 95% or 99% confidence expect to lose over the next year?
You can see how the "VAR question" has three elements: a relatively high level of confidence (typically either 95% or 99%), a time period (a day, a month or a year) and an estimate of investment loss (expressed either in dollar or percentage terms). Methods of Calculating VAR Institutional investors use VAR to evaluate portfolio risk, but in this introduction we will use it to evaluate the risk of a single index that trades like a stock: the Nasdaq 100 Index, which trades under the ticker QQQQ. The QQQQ is a very popular index of the largest non-financial stocks that trade on the Nasdaq exchange.
Project on Fixed Income There are three methods of calculating VAR: the historical method, the variancecovariance method and the Monte Carlo simulation. 1. Historical Method The historical method simply re-organizes actual historical returns, putting them in order from worst to best. It then assumes that history will repeat itself, from a risk perspective. The QQQ started trading in Mar 1999, and if we calculate each daily return, we produce a rich data set of almost 1,400 points. Let's put them in a histogram that compares the frequency of return "buckets". For example, at the highest point of the histogram (the highest bar), there were more than 250 days when the daily return was between 0% and 1%. At the far right, you can barely see a tiny bar at 13%; it represents the one single day (in Jan 2000) within a period of five-plus years when the daily return for the QQQ was a stunning 12.4%!
Notice the red bars that compose the "left tail" of the histogram. These are the lowest 5% of daily returns (since the returns are ordered from left to right, the worst are always the "left tail"). The red bars run from daily losses of 4% to 8%. Because these are the worst 5% of all daily returns, we can say with 95% confidence that the worst daily loss will not exceed 4%. Put another way, we expect with 95% confidence that our gain will exceed -4%. That is VAR in a nutshell. Let's re-phrase the statistic into both percentage and dollar terms: With 95% confidence, we expect that our worst daily loss will not exceed 4%. If we invest $100, we are 95% confident that our worst daily loss will not exceed $4 ($100 x -4%). 74
Project on Fixed Income You can see that VAR indeed allows for an outcome that is worse than a return of -4%. It does not express absolute certainty but instead makes a probabilistic estimate. If we want to increase our confidence, we need only to "move to the left" on the same histogram, to where the first two red bars, at -8% and -7% represent the worst 1% of daily returns: With 99% confidence, we expect that the worst daily loss will not exceed 7%. Or, if we invest $100, we are 99% confident that our worst daily loss will not exceed $7.
2. The Variance-Covariance Method
This method assumes that stock returns are normally distributed. In other words, it requires that we estimate only two factors - an expected (or average) return and a standard deviation - which allow us to plot a normal distribution curve. Here we plot the normal curve against the same actual return data:
The idea behind the variance-covariance is similar to the ideas behind the historical method - except that we use the familiar curve instead of actual data. The advantage of the normal curve is that we automatically know where the worst 5% and 1% lie on the curve. They are a function of our desired confidence and the standard deviation ( ):
Project on Fixed Income
The blue curve above is based on the actual daily standard deviation of the QQQ, which is 2.64%. The average daily return happened to be fairly close to zero, so we will assume an average return of zero for illustrative purposes. Here are the results of plugging the actual standard deviation into the formulas above:
3. Monte Carlo Simulation
The third method involves developing a model for future stock price returns and running multiple hypothetical trials through the model. A Monte Carlo simulation refers to any method that randomly generates trials, but by itself does not tell us anything about the underlying methodology. For most users, a Monte Carlo simulation amounts to a "black box" generator of random outcomes. Without going into further details, we ran a Monte Carlo simulation on the QQQ based on its historical trading pattern. In our simulation, 100 trials were conducted. If we ran it again, we would get a different result-although it is highly likely that the differences would be narrow. Here is the result arranged into a histogram (please note that while the previous graphs have shown daily returns, this graph displays monthly returns):
Project on Fixed Income
To summarize, we ran 100 hypothetical trials of monthly returns for the QQQ. Among them, two outcomes were between -15% and -20%; and three were between -20% and 25%. That means the worst five outcomes (that is, the worst 5%) were less than -15%. The Monte Carlo simulation therefore leads to the following VAR-type conclusion: with 95% confidence, we do not expect to lose more than 15% during any given month.
Summary Value at Risk (VAR) calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. We looked at three methods commonly used to calculate VAR. But keep in mind that two of our methods calculated a daily VAR and the third method calculated monthly VAR.
References : Reuters Bloomberg 77
Project on Fixed Income Wikipedia Investopedia Moneycontrol NSE BSE Schaeffersresearch
• Bond: Bonds are debt and are issued for a period of more than one year.
• Convertible Bond: Bonds that can be converted into common stock at the option of the holder.
• Corporate Bond: Debt obligations issued by corporations.
• Debt Market: The market for trading debt instruments.
• Equity: The portion in an account that reflects the customer’s ownership interest.
• Equity Market: Also called the stock market, the market for trading equities.
• FII: Foreign Institutional Investors
• G-Secs: The Reserve Bank of India (RBI) issues bonds known as Government of India Securities (G-Secs) on behalf of the Government of India.
Project on Fixed Income • Inflation-Indexed Bonds: When one buys Inflation-Indexed securities, the interest is paid on the inflation-adjusted principal amount.
• Redemption: The retiring of a debt instrument by paying cash.
• Secondary Market: The market in which securities are traded after the initial (or primary) offering. Gauged by the number of issues traded. The over-the-counter market is the largest secondary market.
• Step-up Bond: A bond that pays a lower coupon rate for an initial period which then increases to a higher coupon rate.
• Zero Coupon Bonds: Such a debt security pays an investor no interest. It is sold at a discount to its face price and matures in one year or longer.