Investment Analysis and Equity Research

Investment analysis and Equity research
Contents
Unit 1 : Elements of Investment
Unit 2 : Various Financial Markets
Unit 3 : Fundamental Analysis
Unit 4 : Efficient Market Analysis and Bond Valuation

About the Subject

Investment analysis is a broad term for many different methods of evaluating investments,
industry sectors, and economic trends. It can include charting past returns to predict future
performance, selecting the type of investment that best suits an investor's needs, or evaluating
individual securities such as stocks and bonds to determine their risks, yield potential, or price
movements.
Equity research refers to the analysis of a company’s fundamentals, financial statement
analysis, financial modeling and scenario building for equity recommendations. It is the study of
a business and its environment in order to make a buy or sell decision about investing in its
shares.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
Sambalpur, Kolkata, Jamshedpur, Sikkim
Unit IV
EFFICIENT MARKET ANALYSIS & BOND
VALUATION
BOND CHARACTERISTICS
• A bond represents a security issued in connection with a borrowing arrangement. In essence, it is an “IOU”
issued by the borrower.
• A bond obligates the issuer to make specified payment ( interest & Principal ) to the bondholder.
• A bond may be described in terms of par value, coupon rate & maturity date.
Bonds have several features that investors should take into account. The popularity of this debt instrument can be
assigned to some intrinsic factors as mentioned below.
1. Face Value
Face value implies the price of a single unit of a bond issued by an enterprise. Principal, nominal, or par value is
used alternatively to refer to the price of bonds. Issuers are under a legal obligation to return this value to the
investor after a stipulated period.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
Bond example - an investor chooses to purchase a corporate bond at face value of Rs. 6,500. The company issuing
the bond is thus obliged to return Rs. 6,500 plus interest to the investor after maturity of the tenor. Note that the
face value of a bond is different from its market value as market operations influence the latter.
2. Interest or Coupon Rate

Bonds accrue fixed or floating rates of interest across their tenure, payable periodically to creditors. Bond interest
rates are also called coupon rates as per the tradition of claiming interests on paper bonds in the form of coupons.
Interest earned on a bond depends on various aspects such as tenure, the issuer’s repute in the public debt
market.
3. Tenure of Bonds
Tenure or term refers to the period after which bonds mature. These are financial debt contracts between issuers
and investors. Financial and legal obligations of an issuer to the investor or creditor are valid only until the tenure’s
end.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
They can thus be segregated as per the tenure applicable for them. Bonds with maturity periods below 5 years are
called short-term bonds, whereas a tenure of 5-12 years is attributed to intermediate-term bonds. Long-term
bonds refer to the ones with terms higher than 12 years. Also, longer tenures suggest the participation of issuing
companies in prevailing businesses in the trade market in the long-term.
4. Credit Quality
The credit quality of a bond refers to the creditors’ consensus on the performance of a company’s assets in the
long-term. It is determined by the degree of confidence that investors have in an organisation’s bonds. Credit rating
agencies classify bonds based on the risk of a company defaulting on debt repayment.
These agencies assign risk grading to private players in the market and categorise bonds into investment grade and
non-investment grade debt instruments. Investment grade securities are susceptible to lower yields due to a steady
market risk factor, whereas non-investment grade securities offer high returns at considerable risks.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
5. Tradable Bonds
Bonds are tradable in the secondary market. The ownership can thus shift among various investors within a given
tenure. These creditors often sell their bonds to other entities when market prices exceed the nominal values as
they have an option to secure bonds with high yield and appropriate credit ratings.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
TYPES OF BOND
Government Bonds The largest borrowers in India, and in most other countries, are the central and state
governments. The Government of India periodically issues bonds which are called government securities (G-secs)
or gilt-edged securities. These are essentially medium to long-term bonds issued by the Reserve Bank of India on
behalf of the Government of India. Interest payments on these bonds are typically semi- annual. State
governments also sell bonds. These are also essentially medium to long- term bonds issued by the Reserve Bank of
India on behalf of state governments. Interest payments on these bonds are typically semi-annual.
Apart from the central and state governments, a number of governmental agencies issue bonds that are
guaranteed by the central government or some state government. Interest payments on these bonds are typically
semi-annual.
Corporate Bonds Companies, like the governments, borrow money by issuing bonds called corporate bonds (also
called corporate debentures). Internationally, a secured corporate debt instrument is called a corporate bond
whereas an unsecured corporate debt instrument is called a corporate debenture. In India, corporate debt
instruments have traditionally been referred to as debentures, although typically they are secured. For the sake of
simplicity, we will refer to all corporate debt instruments as corporate bonds.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
TYPES OF BOND
A wide range of innovative bonds have been issued in India, particularly from the early 1990s. This
innovation has been stimulated by a variety of factors, the most important being the increased volatility of interest
rates and changes in the tax and regulatory framework. A brief description of various types of corporate bonds is
given below.
• Straight Bonds The straight bond (also called plain vanilla bond) is the most populartype of bond. It pays a fixed
periodic (usually semi-annual) coupon over its life and returns the principal on the maturity date.
• Zero Coupon Bonds. A zero coupon bond (or just zero) does not carry any regular interest payment. It is issued at
a steep discount over its face value and redeemed at face value on maturity. For example, the Industrial
Development Bank of India (IDBI) issued deep discount bonds in 1996 which have a face value of Rs. 200,000
and a maturity period of 25 years. The bonds were issued at Rs. 5,300. These bonds also had call and put
options.
• Floating Rate Bonds Straight bonds pay a fixed rate of interest. Floating rate bonds, on the other hand, pay an
interest rate that is linked to a benchmark rate such as the Treasury bill interest rate. For example, in 1993 the
State Bank of India came out with the first ever issue of floating interest rate bonds in India. It issued 5 million
(Rs.1000 face value) unsecured, redeemable, subordinated, floating interest rate bonds carrying interest at
three percent per annum over the bank's maximum term deposit rate.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
TYPES OF BOND
• Bonds with Embedded Options Bonds may have options embedded in them. These options give certain rights to
investors and/or issuers. The more common types of bonds with embedded options are:
• Convertible Bonds Convertible bonds give the bond holder the right (option) to convert them into equity
shares on certain terms.
• Callable Bonds Callable bonds give the issuer the right (option) to redeem them prematurely on certain
terms.
• Puttable Bonds Puttable bonds give the investor the right to prematurely sell them back to the issuer on
certain terms.
• Commodity-Linked Bonds The payoff from a commodity linked bond depends to a certain extent on the price of
a certain commodity. For example, in June 1986, Standard Oil Corporation issued zero coupon notes that would
mature in 1992. The payoff from each note was defined as: $1,000+ 200 [Price per barrel of oil in dollars-$25].
The second term of the payoff, however, was subject to a floor of zero-s.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
RISK IN BOND
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
RISK IN BOND
1. Inflation Risk/Purchasing Power Risk
Inflation risk refers to the effect of inflation on investments. When inflation rises, the purchasing power of bond
returns (principal plus coupons) declines. The same amount of income will buy lesser goods. E.g., when the
inflation rate is 4%, every $1000 return from the bond investment will be worth only $960.
2. Interest rate risk

Bonds are mostly fixed income securities, meaning that they offer a fixed rate of interest throughout their term.
Now, when you purchase a bond from the bond market for a specific price, you basically agree to receive a fixed
rate of interest.
If the interest rate in the market rises, the bond’s price would fall since the interest rate of the bond won’t be
attractive anymore. And if the interest rate in the market falls, the bond’s interest rate would appear more
attractive and so its price would also go up.
Interest rate risk is the risk of the bond’s price falling after you purchase it as a result of an increase in the market
interest rates.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
RISK IN BOND
3. Call Risk
Call risk is specifically associated with the bonds that come with an embedded call option. When market rates
decline, callable bond issuers often look to refinance their debt, thus calling back the bonds at the pre-specified call
price. This often leaves the investors in the lurch, who are forced to reinvest the bond proceeds at lower rates. Such
investors are, however, compensated by high coupons. The call protection feature also protects the bond from
being called for a particular period giving investors some relief.
4. Reinvestment risk
Say that you invested in a bond that pays 8% interest rate for a tenure of 10 years. Upon maturity, you receive the
proceeds and choose to invest in a bond again. But by this time, the interest rate has fallen to 6%. This bond risk is
what is termed as reinvestment risk.
To put it simply, the risk of not being able to invest the proceeds received from a bond in another bond that pays
the same or higher rate of interest is called reinvestment risk.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
RISK IN BOND
5. Credit Risk
Credit risk results from the bond issuer’s inability to make timely payments to the lenders. This leads to
interrupted cash flow for the lender, where losses might range from moderate to severe. Credit history and
capacity to repay are the two most important factors determining credit risk.
6. Liquidity Risk
Liquidity risk arises when bonds become difficult to liquidate in a narrow market with very few buyers and sellers.
Narrow markets are characterized by low liquidity and high volatility.
7. Market Risk/Systematic Risk

Market risk is the probability of losses due to market reasons like slowdown and rate changes. Market risk affects
the entire market together. In a bond market, no matter how good an investment is, it is bound to lose value when
the market declines. Interest rate risk is another form of market risk.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
RISK IN BOND
8. Default risk
Bonds are generally rated by credit agencies. These ratings basically indicate the entity’s ability to repay the
principal along with interest to the investors on time. However, despite the ratings, there may be times when the
entity is not in a position to repay its contractual obligations on time. The risk of the bond issuing entity not being
able to repay its obligations is what is known as default risk.
9. Rating Risk
Bond investments can also sometimes suffer from rating risk where a slew of factors specific to the bond and the
market environment affect the bond rating, thus decreasing the bond value and demand of the bond.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
BOND PRICE
The value of a bond- or any asset, real or financial- is equal to the present value of the expected cash flows
expected from it. Hence, determining the value of a bond requires:
 An estimate of expected cash flows
 An estimate of the required return
To simplify our analysis of bond valuation we will make the following assumptions:
 The coupon interest rate is fixed for the term of the bond
 The coupon payments are made every year and the next coupon payment is receivable exactly a year from
now
 The bond will be redeemed at par on maturity
Given these assumptions, the cash flow for a noncallable bond comprises of an annuity of a fixed coupon interest
payable annually and the principal amount payable at maturity. Hence the value of bond is:
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
BOND PRICE
Where P is the value (in rupees), n is the number of year to maturity, C is the annual coupon payment(in rupees), r
is the periodic required return, M is the maturity value, and t is the time period when the payment is received.
Since the stream of annual coupon payments is an ordinary annuity, we can apply the formula for the
[present value of an ordinary annuity. Hence the bond value is given by the formula:
To illustrate hoe to compute the value of a bond, consider a 10-year, 12 % coupon bond with a par value
of 1,000. Let us assume that the required yield on this bond is 13%. The cash flows for this bond are as follows:
 10 annual coupon payments of ₹120
 ₹1000 principal repayment 10 years from now
The value of bond is:
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
RELATIONSHIP BETWEEN BOND PRICE AND TIME

Since the price of a bond must equal its par value at maturity (assuming that there is no risk of default), the bond
prices changes with time. For example, a bond that is redeemable for Rs.1000 (which is its par value) after five
years when it matures, will have a price of Rs.1,000 at maturity, no matter what the current price is. If its current
price is, say, Rs.1,100, it is said to be a premium bond. If the required yield does not change between now and the
maturity date, the premium will decline over time as shown by curve A in Exhibit 11.3.
On the other hand, if the bond has a current price of say Rs.900, it is said to be a discount bond. The
discount too will disappear over time as shown by curve B in Exhibit 11.3. Only when the current price is equal to
par value - in such a case the bond is said to be a par bond-there is no change in price as time passes, assuming
that the required yield does not change between now and the maturity date. This is shown by the dashed line in
Exhibit 11.3.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
BOND YIELDS
Bonds are generally traded on the basis of their prices. However, they are usually not compared in terms of prices
because of significant variations in cash flow patterns and other features. Instead, they are typically compared in
terms of yields.
In the previous section we learned how to determine the price of a bond and discussed how price and
yield were related. We now discuss various yield measures.
The commonly employed yield measures are: current yield, yield to maturity, yield to call, and realised
yield to maturity. Let us examine how these yield measures are calculated.
Current Yield: The current yield relates the annual coupon interest to the market price. It is expressed as:
For example, the current yield of a 10 year, 12% coupon bond with a par value of ₹1000 and selling for ₹950 is
12.6%.
The current yield calculation reflects only the coupon interest rate. It does not consider the capital gain (or loss)
that an investor will realise if the bond is purchased at a discount (or premium) and held till maturity. It also ignores
the time value of money. Hence it is an incomplete and simplistic measure of yield.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
BOND YIELDS
Yield to Maturity: When you purchase a bond, you are not quoted a promised rate of return. Using the information
on bond price, maturity date, and coupon payments, you figure out the rate of return offered by the bond over its
life. Popularly referred to as the yield to maturity (YTM), it is the discount rate that makes the present value of the
cash flows receivable from owning the bond equal to the price of the bond. Mathematically, it is the interest rate
(r) which satisfies the equation:
where P is the price of the bond, C is the annual interest (in rupees), M is the maturity value (in rupees), and n is
the number of years left to maturity.
The computation of YTM requires a trial and error procedure. To illustrate this, consider a Rs. 1,000 par
value bond, carrying a coupon rate of nine percent, and maturing after eight years. The bond is currently selling for
Rs. 800. What is the YTM on this bond? The YTM is the value of r in the following equation.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
BOND YIELDS
Let us begin with a discount rate of 12 %. Putting a value of 12 % for r we find that the right-hand side of the above
expression is:
Since this value is greater than ₹800, we have to try a higher value for r. Let us try 114 %. This makes the right-hand
side equal to:
Since this value is less than ₹800, we try a lower value for r. Let us try r = 13 %. This makes the right-hand side
equal to:
Thus r lies between 13 percent and 14 percent. Using a linear interpolation' in the range 13 percent to 14 percent,
we find that r is equal to 13.2 percent:
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
BOND YIELDS
An Approximation If you are not inclined to follow the trial-and-error approach described above, you can employ
the following formula to find the approximate YTM on a bond :
where YTM is the yield to maturity, C is the annual interest payment, M is the maturity value of the bond, P is the
present price of the bond, and n is the years to maturity.
This formula was suggested by Gabriel A. Hawawini and Ashok Vora, in an article published in the Journal
of Finance March 1982 issue.
While the approximate YTM formula gives a close approximation, note that theformula tends to
understate the exact YTM when the bond trades at a discount (below its par value). The opposite happens when
the bond trades at a premium (above its par value).
To illustrate the use of this formula, let us consider the bond discussed above. The approximate YTM of
the bond works out to:
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
BOND YIELDS
Thus, we find that this formula gives a value which is very close to the true value. Hence it is very useful.
The YTM calculation considers the current coupon income as well as the capital gain or loss the investor
will realise by holding the bond to maturity. In addition, it takes into account the timing of the cash flows.
The YTM of a bond is the internal rate of return on an investment in the bond. It can be interpreted as
the compound rate of return over the life of the bond, assuming that all the coupons can be reinvested at a rate of
return equal to the YTM of the bond.
Yields are reported in the financial press on an annualised basis. Annualisation, however, is done by
simply doubling the semi-annual yield. Thus, if the semi-annual yield is, say, four percent, the annualised yield,
referred to as the annual percentage rate or APR is stated as eight percent. Essentially, APR is based on simple
interest - annualised yields based on simple interest are also called bond equivalent yields. However, if you want to
calculate the effective annual yield of a bond you have to use compound interest. If the bond earns 4 percent
every six months, then one rupee of investment grows to 1x (1.04)² = 1.0816 after one year. Hence, the effective
annual yield works out to 8.16 percent
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
BOND PRICES AND BOND YIELDS DURATION

• What Is the Relationship Between Bond Price and Bond Yield?
Bond price and bond yield are inversely related. As the price of a bond goes up, the yield decreases. As the price of a
bond goes down, the yield increases. This is because the coupon rate of the bond remains fixed, so the price in
secondary markets often fluctuates to align with prevailing market rates.
• Why Do Bond Prices Fall When Yields Rise?
When interest rates across the market go up, there become more investment options to earn higher rates of interest.
A bond that issues 3% coupon payments may now be "outdated" if interest rates have increased to 5%. To compensate
for this, the bond will be sold at a discount in secondary market. Although the coupon rate will remain 3%, the lower
price of the bond means the investor will earn a higher yield.
• Are High Yields Good for Bonds?
It depends. If you're an investor looking to enter a bond investment via secondary markets, you'll likely be able to buy
a bond at a discount. If you're holding onto an older bond and its yield is increasing, this means the price has gone
down from what you paid for it. However, you'll still earn the coupon rate from your initial investment.
In addition, high yields are directionally related to the risk of the bond. You may be able to secure a very high yield for
a junk bond, but this doesn't mean it's a good investment. In general, higher yields reflect greater risk for bonds. For
risk-adverse investors looking for safer investments, a lower yield may actually be preferable.
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.
THANK YOU
CA Ashok Agrawal
Mob. :7008512312
Founder Partner
Kedia Agrawal & Co.

Investment Analysis and Equity Research

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Investment analysis and Equity research

Unit 2 : Various Financial Markets

Unit 3 : Fundamental Analysis

Unit 4 : Efficient Market Analysis and Bond Valuation

About the Subject

2. Interest or Coupon Rate

2. Interest rate risk

7. Market Risk/Systematic Risk

RELATIONSHIP BETWEEN BOND PRICE AND TIME

BOND PRICES AND BOND YIELDS DURATION

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