INDEX

Sr. No.

Topic

Page No.

1 2 ! $ 5 6 # '

Introduction Types of Bonds Ter" Structure %oupon &ate Deter"inant Interest &ate &is( )anage"ent &is( *ssociated +it, Bonds Difference .et+een Bond )ar(et / Stoc( )ar(et Bonds on N0SE Bi.1iograp,y

2-5 6-1 11-1# 1'-22 2!-25 26-2# 2'-!1 !2-!6 !-

INT&2D3%TI2N
A .ond is a security instrument which acknowledges that the issuer has borrowed money and must repay it to the bondholder at a specified rate of interest over a predetermined period of time. These securities are referred to as debt obligations, contrasted with stocks, which represent ownership in a corporation. Bonds fall into the three categories of their issuers: corporations; the U. . government and its agencies; and states, municipalities, and other local governments. !ach has features and advantages which should be evaluated when deciding upon which type of bond best suits your investment needs. The interest that a bond pays is called its yield; it"s e#pressed as a percentage of the bond"s face value. $or e#ample, a %&,''' bond with an () yield would pay %*'' in interest per year. Because the income from a bond doesn"t change from year to year, it"s known as a fixed-income security. The interest can be paid out in yearly payments, or coupons; bonds which do not pay out yearly but pay the principal and all accumulated interest at maturity are known as zero-coupon bonds. +t is important to be aware of the fundamental relationship between a bond"s yield and its maturity ,the predetermined time for payback-. .onger maturities generally translate to higher yields, because of the increased potential that, over time, a rise in interest rates will lower the bond"s price. /enerally, bond prices move in the opposite direction of interest rates. +f rates go up, the price of bonds declines. 0onversely, when interest rates go down, bond prices rise. Thus a bond is like a loan: the issuer is the borrower ,debtor-, the holder is the lender ,creditor-, and the coupon is the interest. Bonds provide the borrower with e#ternal funds to finance long1term investments, or, in the case of government bonds, to finance current e#penditure. 0ertificates of deposit ,02sor commercial paper are considered to be money market instruments and not bonds. Bonds must be repaid at fi#ed intervals over a period of time.

Bonds and stocks are both securities, but the ma3or difference between the two is that ,capital1- stockholders have an e4uity stake in the company ,i.e., they are owners-, whereas bondholders have a creditor stake in the company ,i.e., they are lenders-. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An e#ception is a consol bond, which is a perpetuity ,i.e., bond with no maturity-. Issuing Bonds Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. +n underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re1sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. 5rimary issuance is arranged by bookrunners who arrange the bond issue, have the direct contact with investors and act as advisors to the bond issuer in terms of timing and price of the bond issue. The bookrunners6 willingness to underwrite must be discussed prior to opening books on a bond issue as there may be limited appetite to do so. +n the case of /overnment Bonds, these are usually issued by auctions, where both members of the public and banks may bid for bond. ince the coupon is fi#ed, but the price is not, the percent return is a function both of the price paid as well as the coupon. 4eatures of Bonds The most important features of a bond are: No"ina15 Principa1 2r 4ace *"ount6 The amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. ome structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets such as a stock or commodity inde#, foreign e#change rate or a fund. This can result in an investor receiving less or more than his original investment at maturity.

Issue Price 6 The price at which investors buy the bonds when they are first issued, which will typically be appro#imately e4ual to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees. )aturity Date 6 The date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligation to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. 7ost bonds have a term of up to thirty years. ome bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. +n early 8''&, a market developed in euros for bonds with a maturity of fifty years. +n the market for U. . Treasury securities, there are three groups of bond maturities: short term ,bills-: maturities up to one year; medium term ,notes-: maturities between one and ten years; long term ,bonds-: maturities greater than ten years. %oupon 6 The interest rate that the issuer pays to the bond holders. Usually this rate is fi#ed throughout the life of the bond. +t can also vary with a money market inde#, such as .+B9:, or it can be even more e#otic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. 9n coupon dates the bond holder would give the coupon to a bank in e#change for the interest payment. The 78ua1ity7 of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. This will depend on a wide range of factors. Indentures and %o9enants ; An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement. 0ovenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. +n the U. ., federal and state securities and commercial laws
4

apply to the enforcement of these agreements, which are construed by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally re4uiring approval by a ma3ority ,or super1 ma3ority- vote of the bondholders. :ig, yie1d .onds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are more risky than investment grade bonds, investors e#pect to earn a higher yield. These bonds are also called 3unk bonds. %oupon Dates ; the dates on which the issuer pays the coupon to the bond holders. +n the U. . and also in the U.<. and !urope, most bonds are semi1 annual, which means that they pay a coupon every si# months. 2ptiona1ity6 9ccasionally a bond may contain an embedded option; that is, it grants option1like features to the holder or the issuer: %a11a.i1ity ; ome bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to as callable bonds. 7ost callable bonds allow the issuer to repay the bond at par. =ith some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high1 yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.

Puta.i1ity ; ome bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option. ,>ote: ?5utable? denotes an embedded put option; ?5uttable? denotes that it may be put.%a11 Dates *nd Put Dates;the dates on which callable and putable bonds can be redeemed early. There are four main categories. +. A Bermudan callable has several call dates, usually coinciding with coupon dates.

++. +++. +@.

A !uropean callable has only one call date. This is a special case of a Bermudan callable. An American callable can be called at any time until the maturity date. A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put ,sellthe bond ,back to the issuer- in the event of the beneficiary6s death or legal incapacitation. Also known as a ?survivor6s option?.

Sin(ing 4und provision of the corporate bond indenture re4uires a certain portion of the issue to be retired periodically. The entire bond issue can be li4uidated by the maturity date. +f that is not the case, then the remainder is called balloon maturity. +ssuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open market, then return them to trustees. Bonds can .e c1assified into fo11o+ing types depending on t,e type of issuer. Do"estic Bonds: 2omestic bonds are bonds which are issued within the domestic market and are denominated in the domestic currency. These are issued by a local borrower. $or instance, tate bank of +ndia issuing bonds to +ndian residents. 4oreign Bonds: These types of bonds are again denominated in domestic currency and in the local market, only difference being a foreign borrower. !#amples are: 0an(ee .onds: +ssued in U by a foreign borrower and are denominated in U Sa"urai .onds: +ssued in Aapan by a foreign borrower and are denominated in Aapanese Ben Euro.onds: !urobonds are bonds which are denominated in foreign currency and are issued by a foreign firm and sold to the home country residents. $or instance, A U denominated bond issued by a U firm in U< is a euro bond. ;1o.a1 .onds: These bonds are sold to many other markets as well as !uromarkets. /lobal bonds can be issued in same currency as the country of issuance, which is not the case with euro bonds,

41oating &ate .onds: $loating rate bonds are popularly known as floaters and are bonds interest rates of which depends on some reference rate. $or e#ample, coupon rates based on .+B9: can be .+B9:C Duoted margin. These interest rates are then reset periodically. +n other words, coupon rates are based on the rate calculated on the reset date. 41oaters can have special features like caps, floors and collars. %aps6 +t specifies the ma#imum coupon rate of the floater. This is attractive for the issuer as it restricts his liability and is therefore not so attractive for the investor. 41oors6 imilar to caps, floors specify the minimum rate of coupon and is therefore attractive for the investor. %o11ars6 These are combinations of caps and floors. There are also floaters known as +nverse $loaters. They are different from regular floaters in that they have coupon rates which are based on opposite direction of reference rate. They can be represented as ,some fi#ed percentage-1 reference rate. There can also be 2ual +nde#ed floaters which are based on more than one reference rates. So"e "ore types of .ond are as fo11o+s. %on9erti.1e Bond lets a bondholder e#change a bond to a number of shares of the issuer6s common stock. E<c,angea.1e Bond allows for e#change to shares of a corporation other than the issuer. The following descriptions are not mutually e#clusive, and more than one of them may apply to a particular bond. 4i<ed &ate Bonds have a coupon that remains constant throughout the life of the bond.

41oating &ate Notes =4rns> have a variable coupon that is linked to a reference rate of interest, such as .+B9: or !uribor. $or e#ample the coupon may be defined as three month U 2 .+B9: C '.8'). The coupon rate is recalculated periodically, typically every one or three months. ?ero-%oupon Bonds pay no regular interest. They are issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity ,and usually ta#ed as such-. The bondholder receives the full principal amount on the redemption date. An e#ample of Eero coupon bonds is eries ! savings bonds issued by the U. . government. Fero1coupon bonds may be created from fi#ed rate bonds by a financial institution separating ,?stripping off?- the coupons from the principal. +n other words, the separated coupons and the final principal payment of the bond may be traded separately. ee +9 ,+nterest 9nlyand 59 ,5rincipal 9nly-. 2t,er Inde<ed Bonds, for e#ample e4uity1linked notes and bonds inde#ed on a business indicator ,income, added value- or on a country6s /25. *sset-Bac(ed Securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. !#amples of asset1backed securities are mortgage1backed securities ,7B 6s-, collateraliEed mortgage obligations ,079s- and collateraliEed debt obligations ,029s-. Su.ordinated Bonds are those that have a lower priority than other bonds of the issuer in case of li4uidation. +n case of bankruptcy, there is a hierarchy of creditors. $irst the li4uidator is paid, then government ta#es, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main e#amples of subordinated bonds can be found in bonds issued by banks, and asset1backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later. Perpetua1 Bonds are also often called perpetuities or 65erps6. They have no maturity date. The most famous of these are the U< 0onsols, which are also known as Treasury Annuities or Undated Treasuries. ome of these were issued back in G((( and still trade today, although the amounts are now
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insignificant. ome ultra1long1term bonds ,sometimes a bond can last centuries: =est hore :ailroad issued a bond which matures in 8HIG ,i.e. 8*th century-- are virtually perpetuities from a financial point of view, with the current value of principal near Eero. Bearer Bond is an official certificate issued without a named holder. +n other words, the person who has the paper certificate can claim the value of the bond. 9ften they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. !specially after federal income ta# began in the United tates, bearer bonds were seen as an opportunity to conceal income or assets. U. . corporations stopped issuing bearer bonds in the GJI's, the U. . Treasury stopped in GJ(8, and state and local ta#1e#empt bearer bonds were prohibited in GJ(H. &egistered Bond is a bond whose ownership ,and any subse4uent purchaser- is recorded by the issuer, or by a transfer agent. +t is the alternative to a Bearer bond. +nterest payments, and the principal upon maturity, are sent to the registered owner. )unicipa1 Bond is a bond issued by a state, city, local government, or their agencies. +nterest income received by holders of municipal bonds is often e#empt from the federal income ta# and from the income ta# of the state in which they are issued, although municipal bonds issued for certain purposes may not be ta# e#empt. Boo(-Entry Bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more e#pensive, issuers ,and banks that used to collect coupon interest for depositors- have tried to discourage their use. ome book1entry bond issues do not offer the option of a paper certificate, even to investors who prefer them. Seria1 Bond is a bond that matures in installments over a period of time. +n effect, a %G'',''', &1year serial bond would mature in a %8',''' annuity over a &1year interval. &e9enue Bond is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue1 generating entity associated with the purpose of the bonds. :evenue bonds are
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typically ?non1recourse,? meaning that in the event of default, the bond holder has no recourse to other governmental assets or revenues.

T,e ter" structure of interest rate

The term structure of interest rates, also known as the yield curve, is a very common bond valuation method. 0onstructed by graphing the yield to maturities and the respective maturity dates of benchmark fi#ed1income securities, the yield curve is a measure of the market6s e#pectations of future interest rates given the current market conditions. Treasuries, issued by the federal government, are considered risk1free, and as such, their yields are often used as the benchmarks for fi#ed1income securities with the same maturities. The term structure of interest rates is graphed as though each coupon payment of a noncallable fi#ed1income security were a Eero1coupon bond that KmaturesL on the coupon payment date. The e#act shape of the curve can be different at any point in time. o if the normal yield curve changes shape, it tells investors that they may need to change their outlook on the economy.
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There are three main patterns created by the term structure of interest rates: 1> Nor"a1 0ie1d %ur9e6 As its name indicates, this is the yield curve shape that forms during normal market conditions, wherein investors generally believe that there will be no significant changes in the economy, such as in inflation rates, and that the economy will continue to grow at a normal rate. 2uring such conditions, investors e#pect higher yields for fi#ed income instruments with long1term maturities that occur farther into the future. +n other words, the market e#pects long1term fi#ed income securities to offer higher yields than short1 term fi#ed income securities. This is a normal e#pectation of the market because short1term instruments generally hold less risk than long1term instruments; the farther into the future the bond6s maturity, the more time and, therefore, uncertainty the bondholder faces before being paid back the principal. To invest in one instrument for a longer period of time, an investor needs to be compensated for undertaking the additional risk. :emember that as general current interest rates increase, the price of a bond will decrease and its yield will increase.

2> 41at 0ie1d %ur9e6 These curves indicate that the market environment is sending mi#ed signals to investors, who are interpreting interest rate movements in various ways. 2uring such an environment, it is difficult for the market to determine whether interest rates will move significantly in either direction farther into the future. A flat yield curve usually occurs when the market is making a transition that emits different but simultaneous indications of what interest rates will do. +n other words, there may be some signals that short1term interest rates will rise and
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other signals that long1term interest rates will fall. This condition will create a curve that is flatter than its normal positive slope. =hen the yield curve is flat, investors can ma#imiEe their riskMreturn tradeoff by choosing fi#ed1income securities with the least risk, or highest credit 4uality. +n the rare instances wherein long1term interest rates decline, a flat curve can sometimes lead to an inverted curve.

!> In9erted 0ie1d %ur9e6 These yield curves are rare, and they form during e#traordinary market conditions wherein the e#pectations of investors are completely the inverse of those demonstrated by the normal yield curve. +n such abnormal market environments, bonds with maturity dates further into the future are e#pected to offer lower yields than bonds with shorter maturities. The inverted yield curve indicates that the market currently e#pects interest rates to decline as time moves farther into the future, which in turn means the market e#pects yields of long1term bonds to decline. :emember, also, that as interest rates decrease, bond prices increase and yields decline. Bou may be wondering why investors would choose to purchase long1term fi#ed1income investments when there is an inverted yield curve, which indicates that investors e#pect to receive less compensation for taking on more risk. ome investors, however, interpret an inverted curve as an indication that the economy will soon e#perience a slowdown, which causes future interest rates to give even lower yields. Before a slowdown, it is better to lock money into long1term investments at present prevailing yields, because future yields will be even lower.

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T,e T,eoretica1 Spot &ate %ur9e6 Unfortunately, the basic yield curve does not account for securities that have varying coupon rates. =hen the yield to maturity was calculated, we assumed that the coupons were reinvested at an interest rate e4ual to the coupon rate, therefore, the bond was priced at par as though prevailing interest rates were e4ual to the bond6s coupon rate. The spot1rate curve addresses this assumption and accounts for the fact that many Treasuries offer varying coupons and would therefore not accurately represent similar noncallable fi#ed1income securities. +f for instance you compared a G'1year bond paying a N) coupon with a G'1year Treasury bond that currently has a coupon of *), your comparison wouldn6t mean much. Both of the bonds have the same term to maturity, but the *) coupon of the Treasury bond would not be an appropriate benchmark for the bond paying N). The spot1rate curve, however, offers a more accurate measure as it ad3usts the yield curve so it reflects any variations in the interest rate of the plotted benchmark. The interest rate taken from the plot is known as the spot rate.

The spot1rate curve is created by plotting the yields of Eero1coupon Treasury bills and their corresponding maturities. The spot rate given by each Eero1 coupon security and the spot1rate curve are used together for determining the value of each Eero1coupon component of a noncallable fi#ed1income security. :emember, in this case, that the term structure of interest rates is graphed as though each coupon payment of a noncallable fi#ed1income security were a Eero1coupon bond. T1bills are issued by the government, but they do not have maturities greater than one year. As a result, the bootstrapping method is used to fill in interest
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rates for Eero1coupon securities greater than one year. Bootstrapping is a complicated and involved process and will not be detailed in this section ,to your reliefO-; however, it is important to remember that the bootstrapping method e4uates a T1bill6s value to the value of all Eero1coupon components that form the security.

T,e %redit Spread The credit spread, or 4uality spread, is the additional yield an investor receives for ac4uiring a corporate bond instead of a similar federal instrument. As illustrated in the graph below, the spread is demonstrated as the yield curve of the corporate bond and is plotted with the term structure of interest rates. :emember that the term structure of interest rates is a gauge of the direction of interest rates and the general state of the economy. 0orporate fi#ed1income securities have more risk of default than federal securities and, as a result, the prices of corporate securities are usually lower, while corporate bonds usually have a higher yield.

=hen inflation rates are increasing ,or the economy is contracting- the credit spread between corporate and Treasury securities widens. This is because investors must be offered additional compensation ,in the form of a higher coupon rate- for ac4uiring the higher risk associated with corporate bonds. =hen interest rates are declining ,or the economy is e#panding-, the credit spread between $ederal and corporate fi#ed1income securities generally narrows. The lower interest rates give companies an opportunity to borrow
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money at lower rates, which allows them to e#pand their operations and also their cash flows. =hen interest rates are declining, the economy is e#panding in the long run, so the risk associated with investing in a long1term corporate bond is also generally lower. >ow you have a general understanding of the concepts and uses of the yield curve. The yield curve is graphed using government securities, which are used as benchmarks for fi#ed income investments. The yield curve, in con3unction with the credit spread, is used for pricing corporate bonds. >ow that you have a better understanding of the relationship between interest rates, bond prices and yields, we are ready to e#amine the degree to which bond prices change with respect to a change in interest rates. T,ere are t,ree .asic t,eories t,at descri.e t,e ter" structure of interest rates and e<p1ain t,e s,ape of t,e yie1d cur9e. 1. Pure E<pectations T,eory: The e<pectations ,ypot,esis ,also known as the un.iased e<pectations t,eory, or pure e<pectations t,eory- imagines a yield curve that reflects what bond investors e#pect to earn on successive investments in short1term bonds during the term to maturity of the long1term bond.

+t suggests that the term structure of interest rates is based on investor e#pectations about future rates of inflation and corresponding future interest rates, assuming that the real interest rate is the same for all maturities. According to the theory, forward rates exclusively represent expected future rates. Thus, the entire term structure at a given time reflects the market's current expectations of the family of future short-term rates. Under this view, a rising term structure must indicate that increasing rates of inflation are e#pected, and the market e#pects short1term rates to rise throughout the relevant future. imilarly, a flat term structure reflects an e#pectation that future short1term rates will remain relatively constant, while a falling term structure must reflect an e#pectation of decreasing rates of inflation and that future short1term rates will decline steadily.

This theory suffers from one serious shortcoming: it says nothing about the risks inherent in investing in bonds and like instruments. +f forward rates were
15

perfect predictors of future interest rates, then the future prices of bonds would be known with certaintyO

2. @i8uidity Preference :ypot,esis According to the 1i8uidity preference ,ypot,esis ,also known as the "aturity pre"iu" t,eory-, long1term bonds are more risky than short1term bonds because:

.ong1term bonds are less li4uid. .ong1term bonds are more sensitive to changes in interest rates. The longer the maturity of a bond, the greater the price volatility when interest rates change.

All else e4ual, rational investors will prefer the less risky, short1term bonds. Therefore, long1term bonds should always provide a maturity premium to compensate for the li4uidity risk. Based on this theory, an upward sloping yield curve may be caused by one of the following two reasons: G. $uture interest rates will rise, or 8. $uture interest rates will be unchanged or fall, but the maturity premium will increase fast enough with maturity so as to cause the yield curve to slope upward. $lat or downward sloping yield curves are mainly caused by declining future short1term interest rates. !. )ar(et Seg"entation T,eory: Both of the above theories assume that an investor holding bonds of one maturity can switch to holding bonds of another maturity. The market segmentation theory contends that shape of the yield curve is determined by supply of and demand for securities within each maturity sector. +t believes that the yield curve mirrors the investment policies of institutional investors who have different maturity preferences.

Banks need li4uidity and prefer to invest in short1term bonds, while corporations with seasonal fund needs prefer to issue short1term bonds. .ife insurance companies prefer to invest in long1term bonds to match their long1term liabilities, while real estate companies prefer to issue long1term bonds due to their long pro3ect cycles.
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The bond market is segmented based on the maturity preferences of investors and issuers. =ithin each market segment, the prevailing yields are determined by the supply and demand for the bonds. An upward sloping yield curve indicates that: 2emand outstrips supply for short1term bonds, causing low short1term rates. upply outstrips demand for long1term bonds, resulting in high long1 term rates. +f the yield curve is flat, that means both short1term and long1term bonds are in e4uilibrium so interest rates are the same for all maturities. Bou should be able to draw similar conclusions for other types of yield curves. T,e Preferred :a.itat T,eory6 The 5referred Pabitat Theory is a variant of the market segmentation theory. +t also asserts that investors prefer to invest in particular maturity ranges. Powever, it argues that investors will shift out of their preferred maturity sectors if they are given a sufficient high maturity premium. +n contrast, the market segmentation theory asserts that investors will always stick to their preferred maturity sectors.

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Deter"inants of %oupon &ate of Bond

;ro+t, &ate of Econo"y /rowth rate of economy can be considered as one of the critical factor for determination of coupon rate of bond. Pigh economy growth leads to high demand of funds may leads to high rate of coupon for bond and vice versa a healthy economic growth leads to high li4uidity in the market. Inf1ation +nflation is rise in general level of prices of goods and services over time. 2ebtors may be helped by inflation due to reduction of the real value of debt burden. o the burden will be shifted to the investors. .ow grade bonds are by definition sub3ect to default risk; hence low grade investors will be primarily concerned with the risk of default. 2eflationary episodes pose particular problems for low grade firms since there is a lack of pricing power in the broader macro economy. Pence, higher risk firms are particularly vulnerable to the economic environment within a deflationary environment. Pigh grade bonds are alternatively the sub3ect of a very low level of default risk. The primary concern for investors in high grade debt is the risk of inflation, since bonds generally perform poorly under inflationary conditions. =hen there is inflation, there is rising risk in the economy, so the credit spread has to widen to compensate the investors for the risk. Ta< &is( +f Bonds were originally issued with certain ta# e#emption features and subse4uently there developed an uncertainty regarding their ta# status in future, it could to lead to a price loss. @i8uidity ris( .i4uidity risk is the risk that the lender might not be able to li4uidate the debt on short notice. The difference in interest rate due to li4uidity risk is called li4uidity spread. +nstruments such as bonds have active secondary markets.
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9ther instruments such as savings deposits are easily transferable to cash. 9ne the other hand H'1year U /overnment avings Bond is nontransferable. +t can only be redeemed at half price before maturity. The savings bond will obviously offer a higher return. Another interesting phenomenon observed from li4uidity spread is that on1the1 run securities ,primary market- have lower interest rates compare to the off1the1 run securities ,secondary market-. This implies that there is a higher demand for on1the1run securities De"and / Supp1y of Bond According to demand Q supply of bonds in the will decides the rate of coupon of bond. Pigh demand of Bonds leads to lower coupon rate and vice versa. =hen 2emand for bond is high: * c,ange in +ea1t,. As wealth increases, people will buy more bonds at each and every price, and the demand for bonds rises, or shifts right. o when an e#panding economy increases both income and wealth, we e#pect bond demand to increase too. * c,ange in e<pected interest ratesAreturns. $or bonds with more than a year to maturity, rising interest rates in the future will decrease the value of the bond ,and hence the e#pected return-. At each and every price, fewer bonds will be demanded. Bond demand will fall, or shift left when e#pected future interest rates fall. The siEe of the decrease will be larger for longer term bonds. * c,ange in e<pected inf1ation. +f investors e#pect the inflation rate to rise, then they e#pect the real return on their bond to fall, as future payments are able to buy less. Pigher inflation e#pectations decrease bond demand. * c,ange in t,e re1ati9e ris( of .onds. At any given price or e#pected return, if bonds become riskier than other assets, people will switch to less risky assets. An increase in the relative risk of bonds with decrease bond demand. * c,ange in t,e re1ati9e 1i8uidity of .onds. +f it becomes harder to resell bonds in the bond market relative to other assets, people will switch to assets that are easier to resell. A decrease in the relative li4uidity of bonds will decrease bond demand. =hen of upply of bond is high

* c,ange in .usiness conditions. $irms issue bonds to finance the purchase of capital e4uipment and the e#pansion of production. This makes sense only if this e#pansion is e#pected to be profitable. As economic conditions become more favorable, e#pected profitability rises
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and bond supply will increase or shift right. Also ta# incentives for borrowing can also be considered a business condition. R* c,ange in e<pected inf1ation. =hile rising inflation decreases the real return for those who buy bonds, it decreases the real cost of borrowing for those who issue bonds: $or a given nominal interest rate ,and bond price-, higher inflation means a lower real interest rate. Thus, higher e#pected inflation increases bond supply. R* c,ange in go9ern"ent .orro+ing. +f the government runs budget deficits, the U. . Treasury must issue additional bonds to finance the shortfall in ta# revenue. At each and every bond price, the 4uantity supplied increases.

The demand for bonds is the same as the supply of bond. Those who buy bonds are providing loans to others and are receiving interest. The supply of bonds is the same as the demand for bond. Those who supply or issue bonds are borrowing money and paying interest. %redit &is( :atings affect a bond6s yield, or the percentage return investors can e#pect on the bond. A highly rated bond typically has a lower yield. That6s because the issuer does not have to offer as high a coupon rate to attract investors. A lower rated bond typically has a higher yield. That6s because investors need e#tra incentive to compensate for the higher risk. /enerally, credit rating is the opinion of rating agencies on the degree of certainty of debt servicing of corporations, which takes account of both the default probability and the recovery rate. Powever, this rating does not change in response to changes in the macro1 economic conditions. Therefore, it is suggested that the credit rating would e#plain spreads, but only to a limited degree. The default rate for a particular rating for any given period is the number of defaults among the credits carrying that rating, as percentage of the total number of outstanding credits carrying that rating. >ormally the 2efault rate rises as the rating changes from AAA to the lower category. The higher the probability of default higher is the risk in the bond which leads to increase in the spread. o theoretically we can say that; 2efault rate and 0redit spread are positively related, default rate being one of the most important factors in determining 0redit spread of the bond. Tenure of Bond
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>ormally as the tenure of the bond increases, the risk also increases hence the credit spread should also increase. :esearch states that corporate rates are cointegrated with government rates and the relation between credit spreads and Treasury rates depends on the time horiEon. +n the short1run, an increase in Treasury rates causes" credit spreads to narrow. This effect is reversed over the long1run and higher rates cause spreads to widen. &is( free rate +n the 7erton framework the risk free rate has an impact upon the value of the corporate bond for two reasons. $irst, an increase in the risk free rate implies that the price of the put option will decrease because the discounted present value of e#pected future cash flows will have decreased. The corporate bond investors e#perience a net increase in the value of their long corporate bond position. The price of the corporate bond increases and the spread over an e4uivalent risk1less bond tightens. The second effect arises from the structural assumption that the firms" risk1 neutral growth path is a positive function of the risk free rate. As the risk free rate increases firm value increases, again lowering the price of a put option on the firm. The overall effect of an increase in the risk free rate is to decrease the effective costs of insurance against default on the firm"s debt. The price of a put option to protect against that default has fallen as the risk free rate has increased. +ncreases in the risk free rate reduce the price of the put option, implying that the corporate bond will increase in value, the corporate yield will fall and the spread over an e4uivalent risk free bond will tighten. Pere we take the interest rate on central government securities, which is the weighted average of the central government securities with different maturities. Better results are e#pected by taking the corresponding value of the interest rate for different maturities and issuance time. But the result would be almost the same. 4oreign E<c,ange &ate =4ore<> The foreign e#change rate is an indirect factor which influences the credit spread. There is lot of funds flowing from the foreign countries in form of volatile $++s. =hen the rupee is appreciated the foreign investment would be increased and if rupee is depreciated, funds will flow out. This is due to the fact that the appreciation of the rupee denotes the strengthening of the +ndian economy so the funds flow in. +n the regression analysis we have used percentage change in the dollar value of the rupee ,:sM%-.
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Interest &ate &is( )anage"ent

+nterest rate risk management comprises the various policies, actions and techni4ues that an institution can use to reduce the risk of diminution of its net e4uity as a result of adverse changes in interest rates. @arious aspects of interest rate risk include the following: 1. &e-pricing risk: @ariations in interest rates e#pose the institutionSs income and the underlying value of its instruments to fluctuations. This arises from timing differences in the maturity of fi#ed rates and the re1 pricing of the floating rates of the institution"s assets, liabilities and off1 balance sheet position 2. 0ie1d %ur9e ris(: This risk emanates from the changes in the slope and shape of the yield curve. !. Basis &is( =spread ris(>: Arises when assets and liabilities are priced off different yield curves and the spread between these curves shifts. =hen this yield curve spreads change, income and market values may be negatively affected. uch situations arise when an asset that is re1priced regularly ,say- based on the inflation inde# is funded by a liability that is re1priced based ,say- on the central bank accommodation rate $. 2ptiona1ity: 9ptions may be embedded within otherwise standard instruments. The latter may include various types of bonds or notes with caller put provisions, non1maturity deposit instruments that give the depositor has the right to withdraw their money, or loans that borrowers may pre pay without penalty. 4ra"e+or( for I&) Broad principles to the foundation for interest rate risk management. Board of 2irectors to approve strategies and policies for interest :ate 7anagement. enior 7anagement to take steps to monitor and control these risks.
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 Board to rate e#posure in order to monitor and control the same. enior management should ensure that structure of the bank"s business and the level of interest rate is effectively managed. Appropriate policies and procedures are in place to control these risks. :esources are available for evaluating and controlling this risk. Banks should clearly define individuals or committees who are responsible for managing risk. :isk management function should be independent of position taking function to avoid conflict of interest. +:7 policies and procedures are clearly defined and appropriate to the level of comple#ity of the operations of the bank. These can be applied on a consistent base at the group level and as appropriate at the level of the individual affiliates. Banks must understand the risk in new products before they are introduced and sub3ect to ade4uate controls. 7a3or hedging or risk management strategies should be approved in advance, by the Board or appropriate committee. Banks should have interest rate risk measurement system that captures all material sources of interest rate risk and that assess the effect of interest rate changes in ways that are consistent with the scope of their activities. The assumptions underlying the model should be clearly understood by the risk managers. Banks must establish and enforce operating limits and other practices that maintain e#posure within levels consistent internal policies. Banks must measure their vulnerability to loss under stressful market conditions. This should include a breakdown of all underlying assumptions. The result there from must be factored into the policies and the limits determined. Banks must have ade4uate information systems for measuring, monitoring, controlling and reporting interest rate risk. Timely reporting to senior management and board cannot be over emphasiEed.
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 Banks must have ade4uate internal control systems including independent review of the system. upervisory authorities must obtain from the bank ade4uate and timely reports with which to evaluate the level of interest rate risk. The information must take the range maturities and currencies in each bank"s portfolio. +t must include all off balance sheet items as well as other well other relevant factors. Banks must hold capital commensurate with the level of interest rate risk they run.

Banks must release to the public information on the level of interest rate risk and the policies for its management.

upervisory authorities should assess the internal measurement system of banks ade4uately capture the interest risk in their banking book. +f there is inade4uacy then the banks must bring up their system.

Banks must furnish the results of their internal measurement systems to the supervisory authority. +f the supervisory authority determines that the bank is not carrying capital commensurate with the risk, it should direct that the bank either reduce the risk or increase the capital.

&is( *ssociated +it, In9esting in Bonds

Interest &ate &is(
24

 The price of the bond will change in the opposite direction from the change in interest rate. As interest rate rises the bond price decreases and vice versa. +f an investor has to sell a bond prior to the maturity date, it means the realiEation of capital loss. This risk depends on the type of the bond; callable puttable etcTTTT

&ein9est"ent Inco"e or &ein9est"ent &is( The additional income from such reinvestment called interest on interest depends on the prevailing interest rate levels at the time of reinvestment.
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%a11 &is( The issuer usually retains this right in order to have fle#ibility to refinance the bond in the future is market interest rate drops below the coupon rate 2isadvantage for investors for callable bond: cash flow pattern not known with certainty, interest rate drop, and capital appreciation will reduce. %redit &is( +f the issuer of a bond will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. Bield U market yield C risk associated with credit risk Inf1ation &is( 5urchasing power risk arises because of the variation in the value of cash flow from the security due to inflation. E<c,ange &ate &is( :isk associated with the currency value for non1rupee denominated bonds. e.g.: U Treasury bond. @i8uidity &is( +t depends on the siEe of the spread between bids and asks price 4uoted. =ider the spread is risky. $or investors keeping till maturity, this is unimportant. 7arket to market should be calculated portfolio value.
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Bo1ati1ity &is( @alue of bond will increase when e#pected interest rate volatility increases.

C,at is t,e difference .et+een t,e .ond "ar(et and t,e stoc( "ar(etD 7any people think that the bond market and the stock market is one and the same. +n fact, many people who invest in bond market and the stock market either with their own personal investment account or retirement plans also cannot tell the difference between the two. Although, most people have a general idea that stock market is associated with risk while bonds offer relatively more safety.

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Bond market versus stock market is a crucial differentiating factor as both markets can earn you money but they are different in terms of the potential risks and rewards. .et us try and understand the difference between the bond market and the stock market. =hen you buy a share of stock, you actually end up taking the ownership in the company whose stock you are investing in. This means that you will end up sharing the profits as well as the losses incurred by the company in the years to come. +f a company"s revenue decreases, it would ultimately affect the stock price of that company leading to a decline in the stock price. Powever, if the company"s revenue increases, the stock price would go up because the company is generating more profits. Trading hours of bond markets vary from country to country. At the >ew Bork tock !#change ,>B !-, which is the largest centraliEed bond market, trading hours are between J.H' A7 to *.'' 57. 9n the other hand, a bond does not allow you ownership in a company. +f a company wants to raise money without dividing itself, they can decide to sell bonds instead of issuing stocks. o, when you buy a bond of a company, you become more like a creditor than an owner in the company, and you are paid back over the life of the bond. As a bondholder, you will earn a return on your money, which is a fi#ed percentage, and this return is paid annually. o, if a bond is for G' years, you will get interest for each of those G' years and then your principal amount ,the amount you invested- is returned to you at the time of e#piration of the bond. The bond market is where investors go to trade ,buy and sell- debt securities, prominently bonds. The stock market is a place where investors go to trade ,buy and sell- e4uity securities like common stocks and derivatives ,options,
28

futures etc-. tocks are traded on stock e#changes. +n the United tates, the prominent stock e#changes are: >asda4, 2ow, Q5 &'' and A7!V. These markets are regulated by the ecurities !#change 0ommission , !0-. The differences in the bond and stock market lie in the manner in which the different products are sold and the risk involved in dealing with both markets. 9ne ma3or difference between both markets is that the stock market has central places or e#changes ,stock e#changes- where stocks are bought and sold. Powever, the bond market does not have a central trading place for bonds; rather bonds are sold mainly over1the1counter ,9T0-. The other difference between the stock and bond market is the risk involved in investing in both. +nvesting in bond market is usually less risky than investing in a stock market because the bond market is not as volatile as the stock market is.

hort term Treasury yields haven"t moved from the recessionary lows, but the five and ten year bonds are back in recessionary ranges. The thirty year hasn"t
29

moved down as much in yields, but that could change 4uickly if shorter maturities continue their downward trend as investors reach for yield ,or if deflation does, in fact, ensue-. The stock market sees these low yields and argues that an upward sloping curve is bullish for the economy. Also, arguments e#ist that investing in dividend paying stocks is better than investing in poor yielding bonds. This is true unless we see an economic slowdown or deflation. +n either case, e4uities will lose value. +n the short term, you have greater chances of losing money in the stock market than the bond market. Powever, in order to figure out which is a better investment opportunity, you should study your risk tolerance along with the kind of returns you are looking for and according make the choice of investing either in the bond market or the stock market. B2NDS 2N N0SE 3.S. ;o9ern"ent Bonds These are bonds which are issued by the U. . Treasury. They6re grouped in three categories.

3.S. Treasury .i11s -- "aturities fro" ' days to one year 3.S. Treasury notes -- "aturities fro" t+o to 1 years 3.S. Treasury .onds -- "aturities fro" 1 to ! years

Treasury are widely regarded as the safest bond investments, because they are backed by ?the full faith and credit? of the U. . government. +n other words, unless something apocalyptic occurs, you6ll most certainly get paid back. ince bonds of longer maturity tend to have higher interest rates ,coupons- because you6re assuming more risk, a H'1year Treasury has more upside than a J'1day T1bill or a five1year note. But it also carries the potential for considerably more downside in terms of inflation and credit risk
30

0ompared to other types of bonds, however, even that H'1year Treasury is considered safe. And there6s another benefit to Treasury: The income you earn is e#empt from state and local ta#es.

)unicipa1 Bonds 7unicipal bonds are a step up on the risk scale from Treasury, but they make up for it in ta# trickery. Thanks to the U. . 0onstitution, the federal government can6t ta# interest on state or local bonds ,and vice versa-. Better yet, a local government will often e#empt its own citiEens from ta#es on its bonds, so that many municipals are safe from city, state and federal ta#es. ,This happy state of affairs is known as being triple ta#1free.These breaks, of course, come at a cost: Because ta#1free income is so enticing to high1income investors, triple ta#1free municipals generally offer a lower coupon rate than e4uivalent ta#able bonds. But depending on your ta# rate, your net return may be higher than it would be on a regular bond.

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%orporate Bonds 0orporate bonds are generally the riskiest fi#ed1income securities of all because companies 11 even large, stable ones 11 are much more susceptible than governments to economic problems, mismanagement and competition. That said, corporate bonds can also be the most lucrative fi#ed1income investment, since you are generally rewarded for the e#tra risk you6re taking. The lower the company6s credit 4uality, the higher the interest you6re paid. 0orporates come in several maturities:

S,ort ter"6 one to fi9e years Inter"ediate ter"6 fi9e to 15 years @ong ter"6 1onger t,an 15 years

The credit 4uality of companies and governments is closely monitored by two ma3or debt1rating agencies: tandard Q 5oor6s and 7oody6s. They assign credit ratings based on the entity6s perceived ability to pay its debts over time. Those ratings 11 e#pressed as letters ,Aaa, Aa, A, etc.- 11 help determine the interest rate that company or government has to pay. 0orporations, of course, do everything they can to keep their credit ratings high 11 the difference between an A rating and a Baa rating can mean millions of
32

dollars in e#tra interest paid. But even companies with less1than1investment1 grade ,Ba and below- ratings issue bonds. These securities, known as high1 yield, or ?3unk,? bonds, are generally too speculative for the average investor, but they can provide spectacular returns.

Apart from the above mentioned bonds there are various other bonds such as 4edera1 *gency Bonds +n addition to the U. . Treasury and local municipalities, other government agencies ,usually at the federal level- issue bonds to finance their activities. These agency bonds help support pro3ects relevant to public policy, such as farming, small business, or loans to first1time home buyers. Agency bonds are no small matter, however 11 according to the Bond 7arket Association, agency bonds worth %(*& billion are now outstanding in the market. These bonds do not carry the full1faith1and1credit guarantee of government1issued bonds ,for e#ample U. . Treasuries-, but investors are likely to hold them in high regard because they have been issued by a government agency. That translates into more favourable interest rates for the agency, and the opportunity to support sectors of the economy that might not otherwise be able to find affordable sources of funding.

Among the federal agencies that issue bonds are:

$ederal >ational 7ortgage Association ,$annie 7ae33

$ederal Pome .oan 7ortgage 0orporation ,$reddie 7ac$arm 0redit ystem $inancial Assistance 0orporation $ederal Agricultural 7ortgage 0orporation ,$armer 7ac$ederal Pome .oan Banks tudent .oan 7arketing Association , allie 7ae0ollege 0onstruction .oan +nsurance Association ,0onnie .eemall Business Administration , BATennessee @alley Authority ,T@A-

=hile most investors in federal agency securities are institutional, individuals can also invest in this segment of the debt securities market.

&e9enue Bonds A municipal debt on which the payment of interest and principal depends on revenues from the particular asset that the bond issue is used to finance. !#amples of such pro3ects are toll roads and bridges, housing developments, and airport e#pansions. :evenue bonds are generally considered of lower 4uality than general obligation bonds, but there is a great amount of variance in risk depending on the particular assets financed.

E8uity Inde< Notes !4uity +nde#1.inked >otes pay a variable returned based upon the performance of an e4uity market inde#, such as the tandard Q 5oors &'' 0omposite 5rice +nde# of U. . stocks, measured from a predetermined level. These notes are issued so that a conservative investor may participate in e4uity market returns while at the same time ensuring that principal will be repaid at maturity regardless of the e4uity market6s performance. This feature eliminates the risk of losing principal that is inherent in traditional stock and mutual fund investments. These notes usually have a maturity of anywhere between two1and1eight years. Typical notes allow an investor the choice of ,i- holding the note to maturity
34

and receiving any variable return at maturity, ,ii- selling the note in the secondary market prior to maturity, or ,iii- electing to receive early payment of variable return prior to maturity based on any inde# performance up to the time of election and receiving the principal amount at maturity.

So9ereign Bonds A so9ereign .ond is a bond issued by a national government. The term usually refers to bonds issued in foreign currencies, while bonds issued by national governments in the country6s own currency are referred to as government bonds. The total amount owed to the holders of the sovereign bonds is called so9ereign de.t.

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