Analyzing Fixed Income

Securities
Arun G Dsouza
JKSHIM
Fixed Income Security
• Fixed-Income security provides investors with a stream of fixed
periodic interest payments and the eventual return of principal
upon its maturity.
• Bonds are the most common type of fixed-income security, but
others include CDs, money markets, and preferred shares.
• Not all bonds are created equal. In other words, different bonds
have different terms as well as credit ratings assigned to them based
on the financial viability of the issuer.
• Companies raise capital by issuing fixed-income products to investors.
Bonds
• Bonds are units of corporate debt issued by companies and
securitized as tradeable assets.
• A bond is referred to as a fixed-income instrument since bonds
traditionally paid a fixed interest rate (coupon) to debtholders.
Variable or floating interest rates are also now quite common.
• Bond prices are inversely correlated with interest rates: when rates go
up, bond prices fall and vice-versa.
• Bonds have maturity dates at which point the principal amount must
be paid back in full or risk default.
Types of Bonds – Indian Bond Market
• Capital Gains Bonds (54 EC of IT Act 1961)
• Government Bonds
• Corporate Bonds
• Inflation linked bonds
• Convertible Bonds
• Sovereign Gold Bonds
• RBI Bonds
Types of bonds – General
Fixed Rate Bonds
In Fixed Rate Bonds, the interest remains fixed through out the tenure of the bond. Owing to a
constant interest rate, fixed rate bonds are resistant to changes and fluctuations in the market.
Floating Rate Bonds
Floating rate bonds have a fluctuating interest rate (coupons) as per the current market reference
rate.
Zero Interest Rate Bonds
Zero Interest Rate Bonds do not pay any regular interest to the investors. In such types of bonds,
issuers only pay the principal amount to the bond holders.
Inflation Linked Bonds
Bonds linked to inflation are called inflation linked bonds. The interest rate of Inflation linked bonds
is generally lower than fixed rate bonds.
Perpetual Bonds
Bonds with no maturity dates are called perpetual bonds. Holders of perpetual bonds enjoy interest
throughout.
Subordinated Bonds
Bonds which are given less priority as compared to other bonds of the company in cases of a close
down are called subordinated bonds. In cases of liquidation, subordinated bonds are given less
importance as compared to senior bonds which are paid first.
Types of bonds
Bearer Bonds
Bearer Bonds do not carry the name of the bond holder and anyone who possesses the bond
certificate can claim the amount. If the bond certificate gets stolen or misplaced by the bond holder,
anyone else with the paper can claim the bond amount.
War Bonds
War Bonds are issued by any government to raise funds in cases of war.
Serial Bonds
Bonds maturing over a period of time in installments are called serial bonds.
Climate Bonds
Climate Bonds are issued by any government to raise funds when the country concerned faces any
adverse changes in climatic conditions.
Infrastructure Bonds
Infrastructure bonds are borrowings to be invested in government funded infrastructure projects
within a country.
Bond Types
• Callable bonds are a tool used by issuers, especially at times of high
prevailing interest rates, where such an agreement allows the issuer to
buy back or redeem bonds at some time in the future. In this case, the
bondholder has essentially sold a call option to the company that
issued the bond, whether they realize it or not.
• Putable bonds provide more control of the outcome for the
bondholder. Owners of putable bonds have essentially purchased a put
option built into the bond. Just like callable bonds, the bond indenture
specifically details the circumstances a bondholder can utilize for the
early redemption of the bond or put the bonds back to the issuer.
Eurobond vs Foreign Bond
• A Eurobond is a debt instrument that's denominated in a currency
other than the home currency of the country or market in which it is
issued.
• Eurobonds are important because they help organizations raise
capital while having the flexibility to issue them in another currency.
• Eurobond refers only to the fact the bond is issued outside of the
borders of the currency's home country; it doesn't mean the bond
was issued in Europe.
• Foreign bonds: Foreign bonds are issued by foreign issuers in a foreign
national market and are denominated in the currency of that market.
Global bonds vs Parallel Bonds
• Global bonds—International bonds placed in both the Euromarkets
and domestic markets at the same time and are freely tradeable in
any of the major capital market centers.
• Parallel bonds—A parallel bond is a multinational issue consisting of
several loans sold simultaneously among various countries each of
which raises the loan in its own currency.
Bond Prices
• The value of the bond = Present Value of the cash flows expected from it.
• To determine the value of a bond we require:
o An estimate of expected cash flows
o An estimate of the required return
• For analysing the value of the bond we need to make following
assumptions:
• The coupon rate is fixed for the bond
• The coupon payments are made every year
• The bond will be redeemed at par on maturity.
Bond Price Conti……

Bond Value with Annual Interest

P = C X PVIFA r,n + M X PVIF r,n
Where P = Value of the bond
C = Annual Coupon Payment
r = Periodic required return
M= Maturity Value

Bond Value with Semi Annual Interest

P = C/2 X PVIFA r/2,2n + M X PVIF r/2,2n
Future Value
The general form of equation for calculating the future value of
a lump sum after n periods may, therefore, be written as
follows:
F n  P(1  i ) n

The term (1 + i)n is the compound value

factor (CVF) of a lump sum of Re 1, and it always has
a value greater than 1 for positive i, indicating that
CVF increases as i and n increase.
Fn =P  CVFn,i
Exampl
e
If you deposited Rs 55,650 in a bank, which was paying a 15 per cent
rate of interest on a ten-year time deposit, how much would the
deposit grow at the end of ten years?
Future Value of an Annuity
Annuity is a fixed payment (or receipt) each year for a specified
number of years. If you rent a flat and promise to make a series of
payments over an agreed period, you have created an annuity.

 (1  i) n
Fn  A  i 
 
1 
The term within brackets is the compound value factor for an
annuity of Re 1, which we shall refer as CVFA.
Fn =A  CVFAn, i
Example
• Suppose that a firm deposits Rs 5,000 at the end of each year for four
years at 6 per cent rate of interest. How much would this annuity
accumulate at the end of the fourth year?
• If you deposit $20000 in a bank fixed deposit. How much the deposit
would grow after 5 years if the rate of interest is 9% that is
compounded semiannually?
• If you deposit $20000 in a bank fixed deposit. How much the deposit
would grow after 5 years if the rate of interest is 9% that is
compounded quarterly?
Present Value
Present value of a future cash flow (Inflow or Outflow) is the amount
of current cash that is of equivalent value to the decision-maker.
Discounting is the process of determining present value of a series
of future cash flows.
The interest rate used for discounting cashflow is also called the
discount rate.
Present Value of a Single Cash Flow
The following general formula can be employed to calculate the present
value of a lump sum to be received after some future periods:

Fn
P
(1  i) n
The term in parentheses is the discount factor or present value factor
(PVF), and it is always less than 1.0 for positive i, indicating that a future
amount has a smaller present value.

PV  Fn  PVFn,i
Example
• If a 5 year deposit made in a bank with 10% interest rate matures
with $12000 then what is the value of the deposit today?
• Mr. A wants to receive $50000 after 10 years. If the bank interest rate
is 9% then how much funds that needs to be deposited by Mr. A
today?
Present value of annuity
• The computation of the present value of an annuity can be
written in the following general form:

• P = A × PVAFn, i
Example
• A person receives an annuity of $5000 for four years with a interest
rate of 10%. What is present value of funds?
• Mr. A wants to receive 10000 every year for 10 years from now. If the
prevailing interest rate is 12% how much money he needs to invest?
Bond Price Conti……

Bond Value with Annual Interest

P = C X PVIFA r,n + M X PVIF r,n
Where P = Value of the bond
C = Annual Coupon Payment
r = Periodic required return
M= Maturity Value

Bond Value with Semi Annual Interest

P = C/2 X PVIFA r/2,2n + M X PVIF r/2,2n
Illustration on Bond Valuation
• Consider a 10 year, 12% coupon bond with a par value of 1000. The
required rate of return on this bond is 13%. Determine the value of
the bond.
• A bond has a face value of ₹100 with a coupon rate of 14%. The
maturity period of the bond is 12 years determine the value of the
bond if the required rate of return is 12%.
• Consider an eight year, 12% coupon bond with a par value of₹100 on
which interest payable is semi-annual. The required rate of return on
this bond is 14% what is the value of the bond.
Illustration on Bond Valuation
• A Rs. 1000 par value bond carries coupon rate of 9% per annum and is
redeemable after 3 years at par. The required rate of return is 12%,
what is the value of the bond if:
i. Interest is payable annually
ii. Interest is payable semi-annually
iii. Interest is payable quarterly basis
Interaction between bond value, required rate
of return and time to maturity
I. Relationship between bond value and interest rate
• A Rs. 1000 par value bond carries coupon rate of 9% per annum and is
redeemable after 3 years at par. The bond pays interest annually.
what is the value of the bond if:
i. The required rate is 6%
ii. The required rate is 9%
iii. The required rate if 15%
Interaction between bond value, required rate
of return and time to maturity
I. Relationship between bond value and interest rate
Interaction between bond value, required
rate of return and time to maturity
• II. Interaction between Coupon rate, Required rate of return and bond
value:
o Par Value Bond = Interest Rate = Coupon Rate
o Discounted Bond = Interest Rate > Coupon Rate
o Premium Bond = Interest Rate < Coupon Rate
Illustrations
• A bond of ₹1000 face value carrying a coupon rate of 14% is
redeemable at par after 10 years. Interest is payable annually. Find
the intrinsic value of the bond if required rate of return is (a) 12% (b)
14% (c) 16%.
• A bond having a face value of ₹1000 carrying a coupon rate of 14% is
redeemable after 10 years. Interest is payable annually. Find out the
intrinsic value of the bond if required rate of return is 16% and the
bond is redeemable at ₹950 and at ₹1050.
Interaction between bond value, required rate of return and time to maturity
• III. Bond value and time (Convergence of Bond Price to redemption
value at maturity)
Illustrations
• A ₹1000, 12% bond is redeemable at par after 10 years. Interest is
payable annually. Required rate 15%. Calculate the intrinsic value of
the bond is there is:
a) 10 years to maturity
b) 5 years to maturity
c) 2 years to maturity
d) 1 year to maturity
e) What is its value at the time of maturity?
Valuing a zero coupon bond (DDBs)
• A ₹100000 face value DDB is redeemable at par after 25 years. The
required rate of return is 9% p.a. Calculate the intrinsic value of this
DDB. Should an investor buy this bond if it is available at a price of
₹12,000 now? What should be the issue price of this bond if the
company wants to give a return of 15% to the bondholders?
Bond Yields
• A bond's yield refers to the expected earnings generated and
realized on a fixed-income investment over a particular period of
time, expressed as a percentage or interest rate.
• There are numerous methods for arriving at a bond's yield, and each
of these methods can shed light on a different aspect of its potential
risk and return.
• Certain methods lend themselves to specific types of bonds more
than others, and so knowing which type of yield is being conveyed is
key.
Current Yield
• When the current market price changes the current yield on the bond
also changes.
• There is an inverse relationship between current yield and current
market price. An increase in yield results in a decline in bond prices
and vice versa.
• It provides a basic idea about the rate of return from the bond.
• It ignores the future cash flows associated with the bond. (Limitation)
Yield to Maturity (YTM)
• Yield to maturity (YTM) is the total return anticipated on a bond if the
bond is held until its matures.
• Yield to maturity is considered a long-term bond yield but is
expressed as an annual rate.
• It is the internal rate of return (IRR) of an investment in a bond if the
investor holds the bond until maturity, with all payments made as
scheduled and reinvested at the same rate.
• Yield to maturity is also referred to as "book yield" or "redemption
yield."
Yield to Maturity (YTM)
• Buy a bond if YTM > Required Rate
• Do Not Buy a bond if YTM < Required Rate
• Indifferent if YTM = Required Rate

Important points about YTM assuming the redemption value is equal to par
value of the bond:
o If MP is equal to Par Value of the bond then YTM will be equal to Coupon Rate.
o If MP is greater than Par value of the bond then YTM will be less than coupon
rate.
o If MP is less than the Par Value of the bond then YTM will be greater than
coupon rate.
Methods of calculation: YTM
• Trial and Error Method

Interpolation
Formula

• Approximation Method
Illustrations - YTM
• A company has a ₹1000 par value bond currently selling at ₹900. The
coupon rate is 9%p.a payable annually and maturity period is 6 years.
The bond is redeemable at par. Find YTM of the bond. Should an
investor buy this bond if his required rate of return is 12%?
• An investor wants to buy a bond currently selling at ₹800. Its face
value is ₹1000 and the coupon rate is 8%. The bond will be redeemed
at par after 8 years. Advise whether the investor should buy this bond
if his required rate of return is 12%.
Yield to Call
• The term "yield to call" refers to the return a bondholder receives if the
security is held until the call date, prior to its date of maturity. 
• Yield to call is applied to callable bonds, which are securities that let
bond investors redeem the bonds (or the bond issuer to repurchase
them) early, at the call price.
• Calculating the yield to call on callable bonds is important because it
reveals rate of return the investor will receive, assuming:
1.The bond is called on the earliest possible date
2.The bond is purchased at the current market price
3.The bond is held until the call date
Term structure of Interest rates
• The term structure of interest rates refers to different interest
rates that exist over different term-to-maturity loans.
• In the most basic sense, theories to explain the term structure
are still based on interest rates equating the supply and
demand for loanable funds.
• Different rates may exist over different terms because of
expectations of changing inflation and differing preferences
regarding longer-term vs. shorter-term saving.
• Two main theories exist to enrich this explanation and help
explain different rates over different maturity terms.
Term structure of Interest rates
The term structure of interest rates
Sample Term Structure is the relation between different
11% interest rates for different term-to-
maturity loans.
S pot Rate

10%
9%
8% If we observe r1 = 8%,
7% r2 = 9%, r3 = 9.5%,
1 2 3 4 5 r4 = 9.75% and
Term to Maturity (Years) r5 = 9.875% then the current term
structure of interest rates is
represented by plotting these “spot
The curve plotted through the above rates” against their terms-to-
points is also called the “yield curve” maturity.
Types of yield curves
Spot Rates
• The spot interest rate is the rate of return earned when the investor buys
and sells the bond without collecting coupon payments. 
• The spot rate rt for year t, may be viewed as the rate of interest on a bond
that makes only a single payment at time t.
• Such bonds are called as STRIPS (Separate Trading of Registered Interest and
Principal of securities)
• For Example: In US you can request, the US Treasury to convert a normal
coupon bond into a package of mini bonds, each of which provides just one
cash payment.
• Like a $1000 par value bond with a coupon rate of 4.5% maturing in 2025
may be exchanged for ten semi-annual coupon strips, each paying $22.50
and principal strip paying $1000.
Forward Rate
• A forward rate is an interest rate applicable to a financial transaction that will take
place in the future.
• Forward rates are calculated from the spot rate and are adjusted for the cost of
carry to determine the future interest rate that equates the total return of a
longer-term investment with a strategy of rolling over a shorter-term investment.
• Suppose the spot rate for the first year is 7% and the spot rate over the period of
two year is 8%. This means that if you invest Re.1 for 1 year, your investment will
grow to Rs. 1.07 and if you invest Re.1 in a two year zero coupon bond, your
investment will grow to Rs.1.1664. Which means in two years = Rs. 1.1664 = Re. 1
(1.07) (1.0901)
• The hypothetical rate over the second year, 9.01 percent, is called the forward
rate.
Calculating the forward rates

• Where fn = forward rate, y = spot rate

• Assume the following spot rates:
Year 1 2 3 4
Spot Rate 7.5% 8% 8.5% 9%

• Calculate the forward rates over each of the four years

The term structure: Theories
• Expectations Theory:
• Expectations theory predicts future short-term interest rates based on
current long-term interest rates
• The theory suggests that an investor earns the same amount of
interest by investing in two consecutive one-year bond investments
versus investing in one two-year bond today
• In theory, long-term rates can be used to indicate where rates of
short-term bonds will trade in the future
The term structure: Theories
• Liquidity Preference Theory:
• Liquidity Preference Theory is a model that suggests that an investor
should demand a higher interest rate or premium on securities with
long-term maturities that carry greater risk because, all other factors
being equal, investors prefer cash or other highly liquid holdings.
• According to the liquidity preference theory, interest rates on short-
term securities are lower because investors are not sacrificing
liquidity for greater time frames than medium or longer-term
securities. 
The term structure: Theories
• Preferred Habitat Theory:
• The preferred habitat theory says that investors prefer shorter
maturity bonds over longer-term ones.
• Investors are only willing to buy outside of their preferences if enough
of a risk premium (higher yield) is attached to those bonds.
• An implication of this theory can help explain why yields on long-term
bonds are usually higher.
• Meanwhile, market segmentation theory suggests that investors only
care about yield, willing to buy bonds of any maturity.
Different types of risks in bond investment
• Interest Rate Risk
• Reinvestment Rate Risk
• Inflation Risk
• Default Risk
• Call Risk
• Liquidity Risk
Duration
• Duration shows the effective maturity period of the bond
• Duration represents length of time that elapses before the ‘average’
amount of PV from the bond is received
• Bonds effective maturity may not be same as maturity period
• Duration of a bond is the weighted average maturity of its cash flow
stream, where weights are proportional to the PV of cash flows.
Illustration on Duration
• A ₹100 Par value bond having coupon rate of 10% p.a and 5 years to
maturity is currently selling at ₹86. Its yield to maturity is 14%.
Calculate the duration of the bond.
• A $1000 par value has a coupon rate of 12%. The time to maturity is 7
years and it is currently selling at $950. The YTM for the bond is 15%.
Calculate the duration of the bond.
Modified Duration
• Modified duration expresses the measurable change in the value of a
security in response to a change in interest rates.
• Modified duration follows the concept that interest rates and bond
prices move in opposite directions.
• This formula is used to determine the effect that a 100-basis-point
(1%) change in interest rates will have on the price of a bond.
• For example is Modified Duration is 2.3% then 1% change in yield will
on an average change the bond price by 2.3% in the opposite
direction.
Duration & MD – Illustrations
• Consider the following two bonds:
Particulars A B
Years to Maturity 5 years 5 years
Coupon Rate 12% 15%
Face Value 100 100
Current Price 80 90
YTM 15% 20%

• Calculate Duration and Modified Duration.

END OF THE SUBJECT