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SA Sem 3

Bond

Bond is a generally a long term debt instrument or security. Bonds issued by government do not have any risk of default.

Hence Govt. bond interest rate is taken as risk free rate (Rf)

Bonds of public sector companies in India are generally secured, but still not absolutely free from risk of default

**The secured bonds of private sector companies are also called debentures.
**

Secured debentures. Unsecured debentures.

More on Bond

Government Bonds are also called GILT edged securities. Tbills are short term securities issued by RBI. Currently 91 & 364 days are only traded.

**Tbills are issued at a discount. Yield of Tbill:
**

FV Yield = Price -1 X 365 No. of days

Coupon rate on central govt. dated securities is higher than discount rate on Tbills as maturity is longer. Hence investors require liquidity premium.

Features of Bond or Debentures

Face value: also called par value. Bonds are generally issued at face value of Rs 100 or Rs 1000 and interest is paid on face value. Interest (Coupon) rate: it is fixed and known to bond holders.

Interest paid is tax deductible.

Maturity: A bond is generally issued for a specified period of time. It is repaid on maturity. Redemption (maturity) value: value that bond holder will get on maturity.

Bond may be redeemed at par, premium (more) or discount (less than par)

Features of Bond or Debentures

Market Value: bond may be traded in a stock exchange. The price at which it is currently sold or bought.

It may be different from par value or redemption value.

Call option: the option entitles the issuer to call back the bond and redeem them before maturity. (rates coming down)

Put Option: the investor can put the bonds back to issuer (rates hiked)

Types of Bond

Secured and Unsecured (secured by collateral assets or not) Senior and Subordinate (Like, Ordinary share and pref share) Registered and unregistered (based on transferability) Convertible and Non convertibles (coveted to equity share or not after specific period of time)

Floating rate bonds (based on fixed interest rate or floating) Indexed Bonds (interest benchmark as index)

Bond Values

The

present value of a bond (debenture) is the discounted value of its cash flows;

i.e. PV of annual interest payments + PV of terminal or maturity value.

V0 =

C1 (1 + kd)1

+

C2 (1 + kd)2

+

C3 (1 + kd)3

+ ««.. +

Cn (1 + kd)n

F

+

(1 + kd)n

**C = coupon rate; F = Maturity Value; kd = discount rate; n = no. of years to maturity
**

The

appropriate discount rate would depend upon the risk of the bond. The risk

in holding a govt. bond is less than the risk associated with a debenture issued by any company.

By

comparing the present value of a bond with its current market value it can be

determined whether bond is overvalued or undervalued.

Sum

The debenture of MIS Ltd is selling at a discount of 5% from its face value. The face value of the debenture is Rs 100, coupon rate is 8% and the interest payments are made at the end of every 6 months. The next interest payment will fall due at the end of 6 months from now. The debenture will be redeemed in two equal installments; the first installment will be payable at the end of 5 years and 6 months from now, and the second installment will be payable at the end of 6 years and 6 months from now. You are required to determine the yield that you will realize if you invest in the debenture now and hold it till maturity.

Sum

Suppose

an investor is considering the purchase of a 5 year, Rs 1000 par

value bond, bearing a nominal rate of interest of 7% per annum. The investor¶s required rate of return is 8%. What should he be willing to pay now to purchase the bond if it matures at par.

Different rates corresponding to bonds

Yield to maturity (ytm): it is the measure of a bond¶s rate of return that considers both the interest income and any capital gain or loss.

It is bond¶s internal rate of return.

Current yield: (not same as ytm); Current yield only considers annual interest, and does not account for capital gain or loss.

Yield to call: a number of companies issue bonds with buy back or call options. Thus a bond can be called or redeemed before maturity.

Example to illustrate the different yields

Suppose the market price of a bond is Rs 883.4/-; Face value being Rs 1000. The bond will pay interest at 6% per annum for 5 years, after which it is to be redeemed at par. The company makes a provision to buy back the bonds after 3 years at par.

Classification of Bonds

Bonds with maturity Pure discount/ deep ± discount/ zero ± coupon bonds:

bonds that don¶t carry explicit rate of interest. It provides for a payment of lump sum amount at a future date in exchange for a current price of bond.

Valuation, V = Face value or Maturity value 0 (1 + kd)n

, where, n = terms to mature kd = ytm

Perpetual bonds/ consol:

**Has an indefinite life; hence it has no maturity value; only interest payments Valuation, V = 0
**

Interest

kd

, where, kd = ytm

Accrued Interest

Suppose a bond pays interest semi annually on July 1 and Jan 1. If a person sells the bond on May 1, he gets no interest for holding the bond for 4 months, whereas the buyer gets the interest for 6 months (Jan 1 ± July 1) though he actually holds the bond for 2 months (May 1 ± July1). In India it¶s a practice to give the seller the interest for holding the bond for these 4 months (in Govt. Securities) and this is known as Accrued interest. It is paid in addition to the market price of bonds.

Effects of different factors on Bond value

Bond value is inversely proportional to interest rate. Relationship between required rate of return and coupon rate

If kd = C.rate; V0 = par value If kd > C.rate; V0 is available at a discount If kd < C.rate; V0 is at a premium

Intensity of interest rate risk is higher on bonds with longer maturities, (under normal market conditions).

This is a normal expectation as short term instrument generally hold less risk than long term ones; as future is uncertain.

i.e. investors of bonds are subjected to interest rate risk

**Convertibles ² a hybrid security
**

A

convertible debenture is a debenture that can be changed into a specific number

**of ordinary shares at the option of the owner.
**

The

most notable feature is that it promises a fixed income associated with

debenture as well as chance of capital gains associated with equity share after the owner has exercised his conversion option.

Conversion

ratio: number of ordinary shares that investor can receive when he

**exchanges his debentures.
**

Conversion Conversion Value

doubt

Price: Price paid for the ordinary shares at the time of conversion. Value (1 debenture¶s): Conversion ratio*market price of the share.

of Non-Convertible: (w/o feature of conversion): same as bonds

Sum

Sozomon Limited issued partly convertible debenture of Rs 1000 face value carrying 10% interest payable semiannually. 50% of the debenture will be converted into 10 equity shares of Rs 10 face value. Rest of the portion will be redeemed at the end of 8th year at par. The expected market price of the equity share at the end of 4th year is Rs 80. An investor expects annual rate of return of 14% on debt component and 12% on equity component.

What is the value of this debenture.

Sum

M/s Vishal Ind. have issued earlier a 11.5% convertible bond of FV Rs 1000 maturing in 2012. After a period of 3 years on the option of the investor each of these bonds can be converted into 50 equity shares of FV Rs 10 at a premium of Rs 10 each. The investment value of similar non-convertible bond is Rs 870. The current market prices of the bond and the share are Rs 970 and Rs 18.50 respectively. The dividend per share for 2005 ± 2006 is Rs 2.12. Calculate: Premium over conversion value Premium over investment value Conversion parity price of share Break even period.

Check mum

Why issue Convertible debentures?

Sweetening debentures to make them attractive

Avoiding immediate dilution of earnings

Using low cost capital initially (interest on debt is tax deductible)

Warrant

A

warrant entitles the purchaser to buy a fixed number of ordinary shares at a

**particular price on or before a specified time period.
**

E.g.

Deepak Fertilizers and Petrochemicals Corp Ltd issued 14%, Rs 100 debentures

**of Rs 190 crore in Jan 1987. Each debenture had 3 parts:
**

Part

A of Rs 20 which will compulsorily and automatically be converted into one

**equity share with face value of Rs 10 at a premium of Rs 10 on 1st Jan 1990.
**

Part

B of Rs 30 which will compulsorily and automatically be converted into one

**equity share with face value of Rs 10 at a premium of Rs 20 on 1st Jan 1991.
**

Part

C of Rs 50 which will have a detachable warrant attached to it. Warrant will

entitle the holder to apply for 1 equity share of Rs 10 between 1993 and 1995 at a price to be approved by Controller of Capital Issues but not exceeding Rs 50. The warrant will be separately listed and traded on stock exchanges.

Characteristics of Warrants

Exercise

Price: Price at which holder can exercise the warrant and purchase the shares known as the strike price or the exercise price.

Here price cannot exceed Rs 50.

Exercise

ratio: Number of ordinary shares that can be purchased at the exercise price per warrant.

Here 1 equity share in exchange of 1 warrant, i.e. 1:1.

Expiration

date: It is the date when the option to buy shares in exchange for warrant expires.

Here it is end of 1995. Here it is a detachable warrant since it will be separately listed and traded.

Characteristics of Warrants

The exercise price can be fixed below the ordinary share¶s market price prevailing at that time; this will encourage some holders to exercise the warrant. Others may keep holding and wait till expiration date with the expectation of ordinary share price to rise ( as they buy at lower exercise price). If the ordinary share price is more than the exercise price between 1993 and 1995, then holders will exercise their warrant and buy shares at the exercise price (lower than ordinary share market price). Thus company raises additional capital at the time of exercise.

Valuation of Warrants

Theoretical

Value = (Share price ± exercise price) * Exercise ratio

Suppose

share price of DFPC on Dec 1992 is Rs 65, and exercise price is

fixed at Rs 50, then theoretical value of each warrant = (65 ± 50)*1 = Rs 15/-

If

share price is less than exercise price, then theoretical value = zero, instead

of being negative.

(% gain will observed by exercising warrant)

Premium

= Warrant¶s market value ± warrant¶s theoretical value warrant¶s theoretical value

Types of Warrants

Detachable

warrant: Which can be detached from the debenture and

can be separately traded in the stock market. Here the debenture holder may sell his warrant in the market when its price increases but continue holding the debenture.

Non

detachable warrant: Which cannot be separately traded

Rights

of warrant: warrant entitles purchase of ordinary shares.

Hence the holders are not shareholders until they exercise the warrant. Thus they do not have rights of voting or dividends till they exercise the warrant and buy ordinary shares at exercise price.

**Difference between CD & Warrants
**

If

Convertible debentures are exercised company is not

raising any additional capital whereas by the exercise of warrants company is able to raise additional capital (@ of exercise price).

In

Warrants new shares are issued thereby raising the

capital.

Kavya

Alloys Ltd has announced a rights issue of PCD to part finance

its Rs 11 crore vertical integration program. As per the terms of the issue 14% PCDs of Rs 100 each will be issued at par. The convertible part of the debenture (Part A) of Rs 40 each will be converted into two equity shares of Rs 10 each, 12 months from the date of allotment. The non convertible part (B) of Rs 60 each will be redeemed after 7 years. Interest is paid semiannually and the required rate of return is 24% compounded semi annually.

Part A Year end EPS; Bonus ratio Part B Month Avg. P/E ratio 31.3.98 4 31.3.99 3.1 1:3

doubt

31.3.2000 3.5 31.3.2001 4.1

Jan 2001 Feb 2001 Mar 2001 Apr 2001 May 2001 13 12.4 11.6 10.5 9.5

Bond Theorems

Theorem1:

If a bonds market price increases,

**then its yield must decrease and vice versa
**

i.e.

yield and price are inversely related.

Bond price

Yield

Bond Theorems

Theorem2:

If a bonds yield does not change over its life then the

size of its discount or premium will decrease as its life gets shorter. Price of a premium bond Par value Premium Discount Price of a discount bond

Today

Maturity date

Bond Theorems

Theorem3:

If a bonds yield does not change over its life then the

size of its discount or premium will decrease at an increasing rate as its life gets shorter. Price of a premium bond Par value Premium Discount Price of a discount bond

Today

Maturity date

Bond Theorems

Theorem4: A decrease in a bonds yield will raise the bonds

price by an amount that is greater than the corresponding fall in the bonds price that would occur if there was an equal sized increase in bonds yield. X Bond price Y Yield (5%)

(5%) Where X>Y

Bond Theorems

Theorem5: The percentage change in a bonds price owing

to change in its yield will be smaller if its coupon rate is higher.

Assumption: There is at least one coupon payment left besides the one at maturity. This theorem does not apply for 1 year bond or perpetual bonds.

**Risks associated with bonds
**

Interest rate risk risk

Default

**Interest rate risk
**

Investors

are subject to interest rate risk: reinvestment of annual

interest and the capital gain or loss on sale of the bond at the end of holding period.

When

interest rate rises ± there is a gain on reinvestment and a

loss on liquidation and vice versa.

Duration

For

any bond there is a holding period for which these two effects

exactly balance each other. What is lost on reinvestment is exactly compensated by a capital gain on liquidation and vice versa. For this holding period there is no interest rate risk. This is called Duration.

Duration

is the time (in years) taken for the price of a bond to

be repaid by the bonds internal cash flows.

Duration

is used to immunize a bond portfolio from interest rate

risk by setting the investment horizon equal to bond¶s duration.

Duration

Macaulay Duration: created by Fredrick Macaulay

**C1t1 C2t 2 Cn t n RVt n ... t1 t2 tn tn (1 y ) (1 y ) (1 y ) (1 y ) D! P0
**

C = coupon payments y = ytm t1 ± n = years to maturity RV= redemption value

Duration

Macaulay

Duration is a measure of the effective maturity of a bond

defined as: the weighted average of the times until each payment, with weights proportional to the present value of the payment.

The

**Short cut formula for duration of a bond:
**

D= rc rd X PVIFA rd, n X (1 + rd) + 1 ± rc rd rc = Current yield rd = ytm n = terms to maturity Xn

Note: Short cut formula is used only when the bond is redeemable at maturity.

Duration

Modified

Duration: It is the modified Macaulay duration

which accounts for changing interest rates.

Dmod !

D y 1 f

D = Macaulay Duration y = ytm f = frequency of compounding

**Duration of a cash flow
**

e.g. Duration of a liability

**Immunization Use of Duration
**

Duration is used in immunization, where a portfolio of bonds is constructed to fund a known liability. Suppose a pension fund has a liability of 100mn at the end of 5 years. The fund manager can immunize this liability by buying a 5 year Zero coupon bond (as Duration = 5years)*. [* Duration of zero coupon bond = maturity period.] If the fund manager has to cater to a series of payments, then he needs to match the liability duration with the duration of the bonds.

duration

Bond price

P

Actual bond price Duration y

Duration Wandering

Duration changes or wanders with passage of time. Thus it becomes necessary for the investor to monitor and adjust the duration annually or at intervals by rebalancing the portfolio.

Rebalancing means that the investor has to sell a part of the portfolio and buy other securities so that the duration of the new portfolio matches the new duration of the liability.

Convexity

The

theorem 1 and 4 have led to convexity.

It

implies that bonds price and yield are inversely related but the fall in

price with an equivalent increase in yield is not equal to the rise in price for an equivalent decrease in yield i.e. the relation is not linear but convex in nature.

**The degree of convexity shows how much a bond¶s yield changes in
**

response to a change in price. Thus convexity is the measure of risk.

Convexity

P+

P P-

y-

y

y+

Convexity

Convexity A

is used to compare bonds.

bond with greater convexity is lesser affected by

**interest rates than the bond with lower convexity.
**

i.e.

bonds with lesser convexity will have higher

**price regardless of rise or fall in interest rate.
**

I.e.

bonds with higher convexity have lesser volatility

when there is interest rate change.

Convexity

Bond 1 and 2 has same price and convexity when yield is y. For a large increase in y, price of both bonds will fall But price of Bond 2 will decrease more than bond 1 because of lesser convexity.

P P1 P2 Bond 1 (higher convexity) Bond 2 (lower convexity) duration y y+

Sum

Sharma is required to make payments at the end of each year for next 6 yrs. Year 1 2 3 4 5 6 Payments (lakh) 25.50 19.25 18.25 17.50 19.50 17.50 He is planning to immunize his liability by investing in following bonds:

Bond X: 11% coupon bond of FV Rs 1000 maturing after 5 years, redeemable at 5% premium and currently traded at Rs 966.38. Bond Y: 13% coupon bond of FV Rs 1000 maturing after 3 years, redeemable at 5% discount and currently traded at Rs 988.66. Calculate proportion of funds invested in each bond so that his payments are Immunized. (interest rate is 12%.)

**Interest rate elasticity
**

(P0

IE =

P0

(Ytm

Or,

(P0

P0

= IE X

(Ytm

Ytm

Ytm

Interest rate elasticity is always negative, due to the inverse relation between yield and price of bonds. It indicates that if there is 1% change in ytm, what will be the % change in price of bond.

Interest rate elasticity

**Interest rate elasticity in terms of Duration and ytm.
**

Ytm 1 + Ytm

IE

=

-D X

Sum

A bond with FV Rs 500 and a coupon rate of 12% is currently quoting in the market at Rs 420. Term = 4 yrs. The holder of this bond has an applicable tax rate of 30% and a capital gains tax of 15%. Interest is payable annually.

Calculate interest rate risk when market interest rate falls by 200bp. Calculate interest rate risk when market interest rate rises by 100bp.

BOND RATINGS

Bonds are rated as to their riskiness by several firms (CRISIL, ICRA ) Bonds with the highest rating are rated AAA or P1 (short term). As bonds become riskier their ratings drop. Riskiness is the chance of default.

Investment grade bonds must be rated at least BBB. Bonds rated lower than BBB are vulnerable to default risk.

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