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Just as people need money, so do companies and governments. A company needs

funds to expand into new markets, while governments need money for everything
from infrastructure to social programs. The problem large organizations run into is that
they typically need far more money than the average bank can provide. The solution is
to raise money by issuing bonds (or other debt instruments) to a public market.
Thousands of investors then each lend a portion of the capital needed. A bond is
nothing more than a loan for which you are the lender. The organization that sells a
bond is known as the issuer. You can think of a bond as an IOU given by a borrower
(the issuer) to a lender (the investor.

.For example, say an investor buys a bond with a face value of Rs 1,000, a coupon of
8%, and a maturity of 10 years. This means the investor receives a total of Rs 80 (Rs
1,000 * 8%) of interest per year for the next 10 years. Actually, because most bonds
pay interest semi-annually, the investor receives two payments of Rs 40 a year for 10
years. When the bond matures after a decade, the investor gets your Rs 1,000 back.
The different types of bonds include government securities, corporate bonds,
commercial paper, treasury bills, strips etc. These bonds are either fixed interest bonds
or floating rate bonds. In fixed interest bonds, the interest component remains the same
throughout the tenure of the security. Say a 10-year bond issed today bears 8%

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interest. Even if 5 years hence, the interest rate in the economy goes down to 5%, this
8% bond will continue to earn the investor 8% interest. In a floating rate bond, the
interest rate varies depending on the interst rate of a security that the bond chooses to
benchmark it's interest rate to.



Ê




Bonds are debt and are issued for a period of more than one year. The US government,
local governments, water districts, companies and many other types of institutions sell
bonds. When an investor buys bonds, he or she is lending money. The seller of the
bond agrees to repay the principal amount of the loan at a specified time. Interest-
bearing bonds pay interest periodically.










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Bonds have many characteristics such as the way they pay their interest, the market
they are issued in, the currency they are payable in, protective features and their legal
status. Bond issuers may be governments, corporations, special purpose trusts or even
non-profit organizations. Usually it is the type of issuer or the particular nature of a
bond that sets it apart in its own category. We briefly discuss some of the main types
of bonds below:

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THERE ARE MANY TYPES OF BONDS FROM MANY DIFFERENT ISSUERS.

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Asset-backed securities are bonds that are based on underlying pools of assets. A
special purpose trust or instrument is set up which takes title to the assets and the cash
flows are "passed through" to the investors in the form of an asset-backed security.
The types of assets that can be "securitized" range from residential mortgages to credit
card receivables.

All asset-backed securities are securities which are based on pools of underlying
assets. These assets are usually illiquid and private in nature. A securitization occurs to
make these assets available for investment to a much broader range of investors. The
"pooling" of assets occurs to make the securitization large enough to be economical
and to diversify the qualities of the underlying assets.

 

Ê


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A supranational agency, such as the World Bank, levies assessments or fees against its
member governments. Ultimately, it is this support and the taxation power of the
underlying national governments that allow these organizations to make payments on
their debts.

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The "central" or national governments also have the power to print money to pay their
debts, as they control the money supply and currency of their countries. This is why
most investors consider the national governments of most modern industrial countries
to be almost "risk-free" from a default point of view.

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Provincial or state governments also issue debt, depending on their constitutional

ability to do this.Most investors consider provincial or state issuers to be very strong
credits because they have the power to levy income and sales taxes to support their
debt payments. Since they cannot control monetary policy like national governments,
they are considered lesser credits than national governments.

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Cities, towns, counties and regional municipalities issue bonds supported by their
property taxes. School boards also issue bonds, supported by their ability to levy a
portion of property taxes for education.

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Many government related institutions issue bonds, some supported by the revenues of
the specific institution and some guaranteed by a government sponsor. For example,
The Federal Business Development Bank (FBDB) and the Canadian Mortgage and
Housing Corporation (CMHC) bonds are directly guaranteed by the Federal
government. Provincial crown corporations such as Ontario Hydro and Hydro Quebec
are guaranteed by the Provinces of Ontario and Quebec respectively.

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A convertible bond is a bond that gives the holder the right to "convert" or exchange
the par amount of the bond for common shares of the issuer at some fixed ratio during
a particular period. As bonds, they have some characteristics of fixed income
securities. Their conversion feature also gives them features of equity securities.

Convertible bonds are bonds. They have a coupon payment and are legally debt
securities, which rank prior to all equity securities in a default situation. Their value,
like all bonds, depends on the level of prevailing interest rates and the credit quality of
the issuer.

The exchange feature of a convertible bond gives the right for the holder to convert the
par amount of the bond for common shares a specified price or "conversion ratio". For
example, a conversion ratio might give the holder the right to convert $100 par amount
of the convertible bonds of Ensolvint Corporation into its common shares at $25 per
share. This conversion ratio would be said to be " 4:1" or "four to one".

The share price affects the value of a convertible substantially. Taking our example, if
the shares of the Ensolvint were trading at $10, and the convertible was at a market
price of $100, there would be no economic reason for an investor to convert the
convertible bonds. Think of the opposite. When the share price attached to the bond is
sufficiently high or "in the money", the convertible begins to trade more like an equity.

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Ê


A high yield, or "junk", bond is a bond issued by a company that is considered to be a

higher credit risk. The credit rating of a high yield bond is considered "speculative"
grade or below "investment grade". This means that the chance of default with high
yield bonds is higher than for other bonds. Their higher credit risk means that "junk"
bond yields are higher than bonds of better credit quality. Studies have demonstrated
that portfolios of high yield bonds have higher returns than other bond portfolios,
suggesting that the higher yields more than compensate for their additional default
risk.

High yield or "junk" bonds get their name from their characteristics. As credit ratings
were developed for bonds, the credit rating agencies created a grading system to reflect
the relative credit quality of bond issuers. The highest quality bonds are "AAA" and
the credit scale descends to "C", and finally to the "D" or default category. Bonds
considered to have an acceptable risk of default are "investment grade" and encompass
"BBB" bonds and higher. Bonds "BB" and lower are called "speculative grade" and
have a higher risk of default.

Rule makers soon began to use this demarcation to establish investment policies for
financial institutions, and government regulation has adopted these standards. Since
most investors were restricted to investment grade bonds, speculative grade bonds
soon developed negative connotations and were not widely held in investment
portfolios. Mainstream investors and investment dealers did not deal in these bonds.
They soon became known as "junk" since few people would accept the risk of owning
them.

High yield bond investment relies on credit analysis. Credit analysis is very similar to

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equity analysis in that it concentrates on issuer fundamentals, and a "bottom-up"

process. It is concentrated on the "downside" risk of default and the individual
characteristics of issuers. Portfolios of high yield bonds are diversified by industry
group, and issue type. Due to the high minimum size of bond trades and the specialist
credit knowledge required, most individual investors are best advised to invest through
high yield mutual funds.

   Ê


The creditworthiness of corporate bonds are tied to the business prospects and
financial capacity of the issuer.

The business prospects of companies are dependent on the economy and the
competitive situation of industries. Issuers are grouped by industry, for example real
estate, resource and retail bonds. Industries with stable revenues and earnings are
called "non-cyclicals", where as those whose revenues and earnings rise and fall with
the economy and commodity prices are called "cyclicals".

Issuers are also grouped by their credit ratings. Companies that have financial risk
because of high levels of debt and variable revenues and earnings are called "below
investment grade" or "junk" bonds because of their speculative nature. Higher quality
bonds are considered "investment grade".

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Ê




An inflation-linked bond is a bond that provides protection against inflation. Most

inflation-linked bonds, the Canadian "Real Return Bond "(RRB), the British
"Inflation-linked Gilt"and the new U.S. Treasury "inflation-protected security" (IPS)
are principal indexed. This means their principal is increased by the change in inflation
over a period. As the principal amount increases with inflation, the interest rate is
applied to this increased amount. This causes the interest payment to increase over
time. At maturity, the principal is repaid at the inflated amount. In this fashion, an
investor has complete inflation protection, as long as the investor's inflation rate equals
the CPI.

We must compare an inflation-linked bond to a conventional or "nominal" bond to

understand it properly. A normal bond pays its coupon on a fixed principal amount.
Using the Government of Canada 8% bond maturing in 2023 as an example, we are
due 8%, or $8 on every $100 of principal, each year until we are finally repaid our
principal of $100 at maturity. Contrast this with the Canadian RRB, the 4.25%
maturing in 2021. It pays a 4.25% "real" interest rate or $4.25 on its principal each
year. But the principal increases with inflation, which is based on the Canadian CPI.
For example, the CPI, was 1.8% in 1995, the principal amount was increased by 1.8%.
Since its issue in November 1991, the RRB has seen its principal amount increase by
8% to $108. At maturity, when the principal will be repaid by the Canadian
government, the principal amount will have increased to well over $200.

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A bond issued in a currency other than the currency of the country or market in which
it is issued.

Usually, a Eurobond is issued by an international syndicate and categorized according

to the currency in which it is denominated. A eurodollar bond that is denominated in
U.S. dollars and issued in Japan by an Australian company would be an example of a
Eurobond. The Australian company in this example could issue the Eurodollar bond in
any country other than the U.S.

Eurobonds are attractive financing tools as they give issuers the flexibility to choose
the country in which to offer their bond according to the country's regulatory
constraints. They may also denominate their Eurobond in their preferred currency.
Eurobonds are attractive to investors as they have small par values and high liquidity.

, 
Ê-  ÊÊ




Extendible and retractable bonds have more than one maturity date. An extendible
bond gives its holder the right to extend the initial maturity to a longer maturity date.
A retractable bond gives its holder the right to advance the return of principal to an
earlier date than the original maturity. Investors use extendible/retractable bonds to
modify the term of their portfolio to take advantage of movements in interest rates.
The characteristics of these bonds are a combination of their underlying terms. When

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interest rates are rising, extendible/retractable bonds act like bonds with their shorter
terms When interest rates fall, they act like bonds with their longer terms.

Extendible/retractable bonds are created by issuers because they pay a lower interest
rate on these bonds than would otherwise be case or they "sweeten" the issue with this
feature, making the issue easier to sell. Buyers are attracted to these bonds because the
extension or retraction option is attractive to them.

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An extendible bond gives its holder the right to "extend" its initial maturity at a
specific date or dates. The investor initially purchases a shorter term bond combined
with the right to extend its term to a longer maturity date. An investor purchases an
extendible bond to have the ability to take advantage of potentially falling interest
rates without assuming the risk of a long term bond. As interest rates fall, the price of a
shorter term bond rises less than the price of a longer term bond. This means the
extendible bond begins to behave or "trade" as a longer term bond. On the other hand,
if interest rates rose, the extendible bond would behave as a shorter term bond.

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With a retractable bond, an investor owns a longer term bond with the right to "retract"
it at a specific date. Consider an investor that believes that interest rates will rise and
bond prices will fall, but is not willing or able to sell out of bonds completely. This
investor can buy a longer term retractable bond which behaves initially as a similar
term long term bond. As interest rates rise the bond falls in price. Once its price is low
enough, it will begin to behave as a short term bond and its price fall will be much less
than a normal long term bond. At worst, the investor can retract it at the retraction date

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and receive the par amount back to reinvest.

  
  Ê


{ero coupon or strip bonds are fixed income securities that are created from the cash
flows that make up a normal bond.

The cash flows of a normal bond consist of the regular interest or "coupon" payments,
that take place over the term of the bond, and the principal repayment that occurs at
maturity of the bond. For example, the cash flows of the Government of Canada 8%
bond with a maturity date of June 1, 2023 are:

$4 every December and June 1st up to and including June 1, 2023, representing 4% of
the $100 par value; and

$100 on June 1, 2023, representing the repayment of the principal or par amount of the
bond

Taken individually, each of these payments is an obligation of the issuer, in this case,
the Government of Canada. The process of "stripping" a bond involves deppositing
bonds with a trustee and having the trustee separate the bond into its individual
payment components. This allows the components to be registered and traded as
individual securities. The interest payments are known as "coupons" after their source
of cash flow, and the final payment at maturity is known as the "residual" since it is
what is left over after the coupons are stripped off. Both coupons and residuals are
known as "zero coupon" bonds or "zeros".

Conceptually, a zero coupon security is just like a Treasury Bill or "T-Bill". The

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investor pays something up front in exchange for a promise to receive $100 on the
maturity date. Take our example of the coupons and residual generated by stripping
the Canada 8% of 2023. If we start on December 1, 1996 the first two payments are
identical to a 6 month and 1 year T-Bill. An investor would receive $100 on June 1st
and December 1st for each $100 par amount she purchased of these terms of coupons.

The longer coupons get a bit more complicated. Take the coupon due on December 1,
2001, five years from December 1, 1996. What do we pay for this $100? First of all,
we need to consider what interest rate would be appropriate. Reflecting on the term
structure of interest rates, we know that we should use the yield on a similar term
Government of Canada bond. Being bond market fans, we just happen to know that
there is a Government of Canada issue the 9.75% of December 1, 2001. We also know
that it currently yields 5.6% semiannually.

 

Ê


A "foreign currency" bond is a bond that is issued by an issuer in a currency other than
its national currency. Issuers make bond issues in foreign currencies to make them
more attractive to buyers and to take advantage of international interest rate
differentials. Foreign currency bonds can "swapped" or converted in the swap market
into the home currency of the issuer. Bonds issued by foreign issuers in the United
States market in U.S. dollars are known as "Yankee" bonds. Bonds issued in British
pounds in the British bond market are known as "Bulldogs". Yen denominated bonds
by foreign issuers are known as "Samurai" bonds.

The "euromarket" is another major source of foreign currency bond issues. European

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investors will buy the bonds of well known issuers like Ford, Toyota or General
Electric or their international subsidiaries, in many different currencies depending on
their currency views.

Foreign currency bonds have a vocabulary all their own. Bonds issued in foreign
currencies are given the names listed beside the currencies below:

"Yankee Bonds" for U.S. dollar

"Samurai Bonds" for Japanese Yen

"Bulldog Bonds" for British pounds; and

"Kiwi Bonds" for New {ealand dollars

Foreign currency bonds have a much different risk and return profile than domestic
bonds. Not only is their price affected by movements in a foreign country's interest
rate, they also change in value depending on the foreign exchange rates. In Canada, for
example, the Canadian dollar has moved upwards to 4% in U.S. dollar terms in very
short periods of time. This exchange rate movement would result in price changes of
4% in Canadian dollars which completely overwhelms the coupon income of a bond.
Studies have shown that the longer term risk and return characteristics of foreign
bonds in domestic currencies are closer to domestic equity returns than domestic fixed
income returns.

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Ê



Every fund's prospectus outlines important information that can help you find the
fund that may be right for you. The characteristics explained below are important
factors that can help you evaluate your bond fund investment. Prospectuses for
both Fidelity funds and FundsNetwork funds can be found in Products > Mutual
Funds. Or use the Fund Evaluator to find a fund that meets the criteria.


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Bond funds have specific investment goals, such as pursuing high income or
preservation of capital. Bond funds may follow different investment guidelines in
order to pursue those goals. For example, some funds may limit their investments
to U.S. government and government agency investments while other funds may
invest in different bond sectors including corporate, government, government
agency, and mortgage-backed bonds. The prospectus will state the fund's goals
and investment guidelines.

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A bond fund maintains a dollar-weighted average maturity, which is the average of

all the current maturities of the individual bonds in the fund. The longer the
average maturity, the more sensitive the fund will be to changes in interest rates.
Funds with "short-term," "intermediate-term," or "long-term" in their names
indicate the average maturity the fund targets.

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Duration estimates how much a bond's price fluctuates with changes in

comparable interest rates. If rates rise 1.00%, for example, a fund with a 5-year
duration is likely to lose about 5.00% of its value. Other factors also can influence
a bond fund's performance and share price. A bond fund's actual performance may
differ.

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The average credit quality of a bond fund will depend on the credit quality of the
underlying securities in the portfolio. Bond credit ratings can range from
speculative to very high credit quality. Bonds rated medium to high credit quality
are commonly referred to as "investment grade-quality." Bonds rated below
investment grade-quality are commonly called "high yield" bonds or "junk" bonds.
Funds that invest in lower-quality securities have the potential for higher yields
and returns, but will also likely experience greater share price volatility.

The credit quality of a bond is reflected in ratings assigned by independent rating

companies such as Standard & Poor's and Moody's. These rating companies use a
letter scale to indicate credit quality, with the highest credit quality being AAA.
Bonds in default are assigned C and D ratings. This rating system can give
investors important information on the creditworthiness of a bond.

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It's important to look at a fund's total return over time. Total return takes into
account the value (or price) of the underlying bonds held by the fund in addition to
income distributions from those bonds. Investors interested in income may want to
look at the fund's 30-day yield. However, keep in mind that yield by itself does not
tell the entire story. Higher yields usually come with strings attached. For
example, the fund may achieve higher yields through investments in lower-quality
securities, which may make the share price (or value) of your bond fund
investment more volatile.

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All mutual funds have operating expenses that include the costs of managing a
fund. Some bond funds have sales charges, or loads, that are deducted from the
amount of your initial investment. Some funds may charge a redemption fee for
shares sold within a certain time period. Others may charge a small annual account
fee. Make sure you are aware of all expenses before you invest.

!$$&*

Bond markets today are more complex than they were just a few years ago. In
selecting a mutual fund company for your bond fund investments, make sure the
company is committed to providing the research and analysis that bond fund
management now requires.


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Ê  
Ê


· Auction Market-Bid/Ask/Spread - Bonds like stocks trade on an auction market

thus, they have a bid, the highest price offered to buy a bond, and an ask, the
lowest price a seller hopes to get for their bonds. Most trades take place
somewhere between these two prices.
· Quantity - The prices quoted are usually for trades of $20,000 (20 Bonds) or
higher. When buying bonds in smaller quantities an investor will commonly have
to pay a higher price than the ask price. The reverse is true when selling a bond in
the secondary market; the price you receive may be lower.
· Identifying a Bond - When requesting a quote or placing an order for a bond be
sure to carefully identify the bond completely by using: issuer, coupon rate,
maturity date and, as an added precaution, the CUSIP number. Also include the
number of bonds you want to buy or sell. Remember, 10 bonds represents $10,000
face value of securities.
· Exchange Traded Bonds - Exchange traded bonds are much easier to buy and sell
than OTC or unlisted issues. Most full service and discount brokerage firms will be
able to place an exchange order. Make sure you tell the broker that it is an
exchange- traded bond, they often won't know this. B e f o re you place an order
ask for a quote. Identify the bond by: issuer, coupon rate, maturity date and as an
added precaution the CUSIP number. Include the number of bonds you want to
buy or sell. Agreeing to the ask price quoted should ensure your buy, however, you
can also place a bid at a lower price. When selling a bond you can offer it at the bid
price or enter a new ask price. When submitting new bids be reasonable and make
it near the market price. Have patience, the more liquid a bond is the better chance

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for an early execution. Many investors place Good Till Cancelled order for bonds,
but don't forget that you have placed the order.
· Not Listed (OTC) Bonds - OTC bonds are difficult to buy and sell in small
quantity. Most discount brokers will not shop for a specific bond. Thus, if it is not
in their inventory, chances are an investor will not be able to execute an order. The
sell side is also difficult for small quantities. Full service firms look beyond their
own inventory however this does not guarantee an execution. Price quotes are very
important and if it is possible multiple quotes should be obtained before placing
and order. Be careful, don't chase a bond and watch for big spreads. It is best to
specify a bid when buying and an offering or ask price when selling.
· Accrued Interest - The amount of interest accumulated but not paid between the
most recent payment and the sale of a bond. When purchasing bonds on the
secondary market, this is the interest the former owner earned but has not been
paid. It will be added to the buy price of a bond and be paid to the seller. The new
buyer will receive the full semiannual interest payment on the next pay date.





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As with any investment vehicle, the higher the potential for return, the higher the
risk.

Bond yields reflect the issuer's credit quality as well as the fund's maturity. Lower-
quality investments generally offer higher yields than higher-quality issues but
may be more volatile. The higher yield compensates the investor for lending
money to a company or municipality that is considered more likely to default ± that
is, not make timely interest or principal payments. This is called credit risk.

The possibility that interest rates will rise after you purchase a fixed-income
security is called %


%, which is another risk factor and is explained in
detail below.

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When interest rates rise, the value of existing bonds and bond fund shares
generally will decline. Conversely, when interest rates fall, the value of bond and
bond fund shares generally will rise. Since it is difficult to predict whether interest
rates will go up or down, T. Rowe Price believes you should create a broadly
diversified bond portfolio that is appropriate for your investment goals.

We do not recommend changing your bond portfolio mix in anticipation of rising

or falling rates. However, investing in several bond funds with different investment
strategies can help cushion the effects of interest rate risk and credit risk on your
overall portfolio. For example, investing in both shorter and longer maturities can
help your strategy stay on track during both high and low interest rate climates.

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To understand how bond funds earn money amid changing market conditions,
we've illustrated some key principles below.

A bond's coupon rate is the bond's fixed rate of interest expressed as a percentage
of its face value (also known as par value) which is normally $1,000. Longer-term
and lower-quality bonds generally have higher coupon rates than shorter-term and
higher-quality issues. Among taxable investments, U.S. Treasury securities carry
the lowest coupon rates because the federal government is the nation's most
creditworthy borrower. Since most bonds pay interest semiannually, a bond with a
face value of $1,000 and an 8% coupon rate pays $40 twice a year, for a total of
$80 per year.

While the coupon rate of a bond is fixed, its current yield can fluctuate with rising
and falling interest rates that are dictated by market conditions. This is how interest
rate risk can affect a bond¶s total return.

You can figure out the current yield by dividing the interest paid each year by the
current price of the bond.

A bond paying $80 interest per year yields 8% at par value. But if interest rates rise
in the market, causing the bond¶s price to fall to $900, the current yield rises to

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8.9% ($80/$900 = 8.9%). If the value of the bond rises to a premium over par, say
to $1,100, the current yield drops to 7.3% ($80/$1,100 = 7.3%).

If you hold a bond until it matures, the bond¶s compound annual rate of return is
made up of two components: interest income and capital gain or loss. An 8% bond
bought at a price of $900 and held until it matures in 10 years generates income of
$800 and a capital gain of $100. Your average annual return, assuming all interest
payments are reinvested at the same rate, is called the àield to maturità.















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Rating services (such as Moody's or Standard & Poor's) evaluate how likely a bond
issuer is to repay the debt and interest on time. A bond rated AAA/Aaa is the most
creditworthy, while a bond rated BB/Ba or below is much riskier.

An established, reputable company might have bonds carrying an investment-grade

rating such as AA (with a low yield but a lower risk of default), while bonds issued
by a company with a high debt level or other financial vulnerability might have a
low rating. These lower-grade, high-yield bonds have a higher return potential but
also a higher risk of default.

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Highest quality AAA Aaa
High quality AA Aa
Upper-medium quality A A
Medium grade BBB Baa
Somewhat speculative BB Ba
Low grade speculative B B
Low grade (default possible) CCC Caa
Low grade (partial recovery
CC Ca
possible)
Default (recovery unlikely) C C


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# %
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The art and science of making decisions about investment mix and policy,
matching investments to objectives, asset allocation for individuals and
institutions, and balancing risk against. performance.

Portfolio management is all about strengths, weaknesses, opportunities and threats

in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and
many other tradeoffs encountered in the attempt to maximize return at a given
appetite for risk.

# %
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In the case of mutual and exchange-traded funds (ETFs), there are two forms of
portfolio management: passive and active. Passive management simply tracks a
market index, commonly referred to as indexing or index investing. Active
management involves a single manager, co-managers, or a team of managers who
attempt to beat the market return by actively managing a fund's portfolio through
investment decisions based on research and decisions on individual holdings.
Closed-end funds are generally actively managed.


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Ê
    



BANKS IN INDIA, generally invest in bonds issued by both the Central and State
Government and their agencies. Investment in corporate debt is also increasingly
becoming popular. Banks may invest in all types of bonds and of varying
maturities and are expected to manage the interest rate risk arising from this
investment by adopting suitable assets ± liability management policies. Further,
certain privately placed Non- SLR Bonds will be treated at par with Advances and
be subjected to all prudential norms relating to advances. A typical bank¶s
investment portfolio would consist of all types of bonds and possibly equity shares
also.

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$ is entrusted with the regulation of transactions in
Government securities, money market Securities, gold related securities and repo
in all instruments. In particular, aspects relating to Government Securities are
covered under the Public debt Act and Rules and Notification under the Public debt
Act, issued by both Central and State Governments. As regardes Corporate bonds,
provision contained in Securities contracts (Regulation) Act , Depositories Act ,
Stock Exchange Bye laws and the terms and conditions of issues of the individual
bonds are relevant .

Investment and trading activities of bank in bond should conform with the
regulations issued by RBI on classification and valuation in addition to under legal
provision mainly contain in Securities Contracts (Regulation) Act. The RBI
Regulationare mainly prudential. Accordingly banks are required to categories the
investment in to three, viz,´Held To Maturity´ (HTM), ³Held for Trading´(HFT)
and ³Available For Sale´(AFS). HTM not to exceed 25% of the investments. HFT
should be subjectt to the discipline and controls required for trading. AFS ciontains
investments which are in neither HTM nor HFT categories. Categorisation is based
on the jintensinon if the bank at the time of purchase of the security and shifting
between categories is permissible only exceptionally. There are striggent rules for
shifting between categories. Banks are not excepted to take any unrrealised gain to
income account, but provide for all losses on a mark-to-market basis. While HTM
investments need not be marked to market, HFT and AFS should be marked to
market. RBI also has stipulated that banks should maintain an ³Investment

ccc c

 

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Fluctuation Reseerve´ and build up adequate reserves out of realised gains every
year.

While the above are some of the salient features of the RBI instructions,
Investments jmangagers in banks hsould be fully conversant with the instructions
issued by RBI from time to time regarding the procedural and regulatory aspects
relating to investments.

In addition, it is necessary to take into consideration the management perspectives

on returns and risk management. The organisational structure for treasury
management also has an important bearing on the conduct of bond portfolio
management on safe and sound lines.

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Ê$2
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&Ê2

The Investment policy is the document approved by the top management of a bank
articulating the investment objectives, risk management aspects etc. Banks can
adopt both passive or active approaches to management of their portfolios and the
bank¶s investment policy should specify the bank¶s approach. The passive
approach is usually identified with buy-and-hold strategy. Active bond portfolio
management involves switching and swapping bonds as circumstances change in
the market.

Investments are categorised on the basis of the bank¶s intent at the time of
acquistion of securities. i.e. whether it is meant to be held till maturity (Held To
Maturity) or sold. A further differentiation is possible is respect of the securities
acquired for safe: whehter they are intended to be available for sale at an
appropriate time depending on the bank¶s liquidity needs (Available for Sale) or
whether they are intended for operations (purchase and sale of securities with a
view to take advantage of the expected movement in their market prices). Those
securities purchased with the intension of trading have tdo be classified as ³Held
for Trading´ and are subject to regulatory prescriptions regarding holding period,
stop-loss etc. The aggregation of such securities held for trading forms the
³Trading Book´ of the bank. A bank which decides to maintain a trading book is
expected to have in place proper risk management, trading policies, delegation of
powers, skills, dealing infrastructure etc. Basel Committee¶s capital adequacy
norms prescribe maintenance of capital to cover market risk in the Trading Book.
Securities, other than those in the trading book, are classified as belonging to the
³Banking Book´. In the case of ³Banking Book´ the securities are treated on par
with the other assets as far as balance sheet risks are concerned.

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(

Stock market investors will choose a particular risk level on the SML and invest at
this point, choosing only those securities that lie on the SML (or above it). Stock
investors have different levels of risk/return requirements Bond investors will do
the same thing. A young, aggressive bond investor may choose a high risk bond &
is willing to risk his principal investment. A retiree may not be willing to take a
risky bond investment and may, instead invest in conservative bonds.

Individual investors choose to invest in bonds. Also, pension plans, banks,

insurance companies and other institutions invest in bonds. At any rate, all
investors are interested in a bond investment strategy. There are three major types
of strategies:

1.V passive portfolio management strategies

2.V active portfolio management strategies
3.V matched-funding strategies

In the 1950s the bond market was considered a safe, conservative investment. At
that time a buy-and-hold strategy was sufficient. However, times changed, in the
1960s inflation increased, and interest rates became more volatile. Thus, with more
volatile interest rates, there was a great amount of profit potential with bonds.
Also, in the 1970s the Macauley duration measure was re-discovered.

Not all investors viewed the rise in interest rate volatility as a good thing. The
pension fund and insurance companies that invest in bond found their job much
more difficult. Thus, strategies based on duration were developed to aid pension
fund managers to match their liabilities with properly constructed bond portfolios.

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There are two major passive strategies:

àV buy-and-hold
àV indexing

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This strategy simply involves buying a bond and holding it until maturity. Bond
investors would examine such factors as quality ratings, coupon levels, terms to
maturity, call features and sinking funds. These investors do not trade actively to
earn returns, rather they look for bonds with maturities or durations that match
their investment horizon.

There is also a modified buy-and-hold strategy in which investors buy bonds with
the intention of holding them until maturity, but they still actively look for
opportunities to trade into more desirable positions. [However, if you modify this
too much it turns into an active strategy.]

While the buy-and-hold strategy is a passive strategy, it still involves a great deal
of work. Agency issues typically provide high quality bonds at a higher return than
Treasury securities, callability affects the attractiveness of an issue, etc. Plus, you
may want to develop a portfolio in which coupon payments are structured (and
principal repayments).

'5
6!(75
'%($((: Only default-free or very high quality securities
should be held. Also, those securities that are callable by firm (allows the issuer to
buy back the bond at a particular price and time) or putable by holder (allows
bondholder to sell the bond to issuer at a specified price and time) will introduce
ccc c
 

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alterations in the firm's cash flows, and probably should not be included in the buy-
and-hold strategy. Also, those investors seeking to lock in a rate of return may
choose a zero-coupon bond--good strategy for college tuition or retirement. The
buy-and-hold strategy minimizes transaction costs and, if implemented astutely,
can be highly productive. For example, if interest rates are currently high and are
expected to remain so for an extended period of time, the buy-and-hold strategy
will do well.

.
&

Indexing involves attempting to build a portfolio that will match the performance
of a selected bond portfolio index, such as the Shearson Lehman Hutton
Government/Corporate Bond Index, Merrill Lynch Index, etc. This portfolio
manager is judged on his ability to track the index.

'5
6!(75
'%($((: The fixed income market is broader (in terms of
security types) than the equity market. Also, even though the Shearson Lehman
Hutton Corporate Bond Index has over 4,000 securities, it only represents high
quality corporate bond issues. Thus, a compromise must be made when selected
among different indexes. Also, the strategy of buying every bond in a market index
according to its weight in the index is not a practical one. However, a relevant
subset is possible. We may choose to emulate a narrower bond index.

%#$
)5
'%(: We may choose to randomly select bonds from the universe
of bonds, or, we may choose the stratified approach (segmenting the index into
components from which individual securities are chosen). When choosing the
indexing option, bond portfolio management cannot be considered entirely passive.
Also, there will be transaction costs associated with (1) purchasing the issues used

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to construct the index; and (2) reinvesting cash payments from coupon and
principal repayments; and (3) rebalancing of portfolio if the composition of your
target index changes. Whereas full replication of the target index would work best,
this is impractical. If you choose the stratified method, your performance will
probably not mirror your target index.

How many securities should you have in your portfolio if you use the random
sampling approach? McEnally and Boardman (1979) have found that, once an
index is selected, close replication is possible with perhaps 40 bonds (for the long
term).

#$

 ""#$'5: Consists of analyzing the index to determine various
stratification levels (what portion of securities that make up index are Treasury,
Aaa Industrial, Baa Financial, of X years to maturity, of X% coupon rate, etc.).
The next step is to select the securities for your portfolio. Typically, at selection
and at the rebalancing period (usually once a month) one security is chosen from
each category (there could be 40 categories). There's no requirement as to which
security is selected from each class.

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These strategies require major adjustments to portfolios, trading to take advantage

of interest rate fluctuations, etc. There are four major active bond portfolio
management strategies:
ccc c
 

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1.V Interest rate anticipation

2.V Valuation analysis
3.V Credit analysis
4.V Yield spread analysis

In each strategy, the manager hops to outperform the buy-and-hold policy by using
acumen, skill, etc.

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This is the riskiest strategy because the investor must act on uncertain forecasts of
future interest rates. The strategy is designed to preserve capital (lose as little as
possible) when interest rates rise (and bond prices drop) and to receive as much
capital appreciation as possible when interest rates drop (and bond prices rise).

These objectives can be obtained by altering the maturity or duration of their

portfolios. Longer maturity, or longer duration, portfolios will benefit the most
from an interest rate decrease and vice versa. Thus, if a manager expects an
increase in interest rates, they would structure portfolio to have the lowest possible
duration.

The problem faced with this type of strategy is the risk of mis-estimating interest
rate movements. It is difficult (EXTREMELY) to predict (with accuracy) interest
rate movements.

However, if this is your strategy, you should be concerned with:

àV direction of the change in interest rates

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àV the magnitude of the change across maturities, and

àV the timing of the change.

How your bond will be affected by changes in interest rates can usually be directly
related to the security's duration. Thus, if you expect IR to drop, you should shift to
high duration securities. Also, the timing as to when you expect the interest rate
shift is important. You don't want to shift too early, because you may compromise
some return. Obviously, you don't want to wait too late.

'$#
$%0(
(: Say, "what if" interest rates rise/fall by this much over the next
month/year/etc. Analyze the individual bonds within your portfolio under each
scenario and see how the returns are affected under each scenario. [See p. 8-30]
The scenario analysis leads us to further analysis.

%$
)!#$%!$%0(
(: We can calculate the overall expected return for
each bond in our scenario (expected return under each interest rate scenario
weighted by the probability of that scenario occurring) and the current duration of
each bond in our portfolio and graph the relationship. Those bonds falling above a
regression line (showing the general relationship) would be doing ok!

#$&
' #
# $%0(
(: We can graph the bonds in our portfolio with the
best case scenario (an interest rate decrease) on the vertical axis and the worst case
scenario on the horizontal axis, as shown below:

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Those securities which fall into Quadrant I represent aggressive securities--if the
best case happens, they will do well; however if the worst case happens they will
be the worst performers. Those securities falling into Quadrant II are superior
securities--they will perform well regardless of which scenario occurs. Quadrant III
represents defensive securities--they will do well under the worst case scenario, but
perform poorly if the best case occurs. Quadrant IV securities are inferior as they
will perform poorly regardless of the scenario. You should sell securities falling
into Quadrant IV. Normally a few securities would fall into Quadrants II and IV,
with most falling into Quadrants I and III.

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The portfolio manager looks for undervalued bonds--those bonds that have a
computed value (according to the portfolio manager) higher than the current
market price). This also translates to those bonds whose expected YTM is lower
than the current YTM. This strategy requires lots of analysis (continuous
evaluations) and lots of trading based on the analysis. Based on your confidence in
your analysis, you would buy undervalued bonds and sell overvalued bonds (or
ignore them if they are not in your portfolio).

Valuation Analysis: We can examine the term structure of pure discount bonds
(zero coupon) and thus determine the value of US Treasuries, thus we can
determine the default free characteristics of any other type of bond. Then we can
attempt to determine the other factors that will affect bond yield by using multiple
factor regression analysis (looking at things such as: quality rating, coupon effect,
sector effect, call provision, sinking fund attributes, etc.) Using this factor analysis,
we can determine the expected yield for the security (if the expected yield <
current YTM then buy). However, there is some subjectivity in factor analysis. For
instance, if there is some "event risk" (something affecting the financial stability of
firm) missing from the analysis, or if there is any anticipation of a market
upgrade...

#
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Credit analysis involves examining bond issuers to determine if any changes in the
firm's default risk can be identified. We try to determine if the bond rating agencies
are going to change the firm's rating. Rating changes are prompted by internal
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changes within the firm as well as external changes. Various factors examined
include financial ratios, GNP, inflation, etc.

Many more downgradings occur during economic contractions [However from

1985-1990 downgradings increased substantially despite an economic expansion.].
To be successful in utilizing bond rating changes, you must accurately predict
when the bond rating change will occur and take action prior to the change. The
market does react to unexpected bond rating changes, however, it reacts quickly.

#
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( 
&5
%!2Ê(8 Junk bonds have a wide spread over
bonds rated BBB and higher. Also, these yield spreads widen over time (during
poor economic times the spread widens). Altman and Nammacher point out that
the net return of junk bonds (average gross return minus losses from bonds that
defaulted) has been superior to higher-rated debt [Of course, they're of higher risk.]
Other points to note: Even though the rating categories have not changed, the
quality of bonds today that fall into, let's say, the A category, has lessened over
time. "Specifically, the average values of the financial ratios that determine
whether bonds are included in the B or CCC rating classes have declined over
time."

Thus, bond portfolio managers will have to involved themselves in detailed credit
analysis to determine those bonds that will not default.

#
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(: The assessment of default risk. Default risk has both systematic
and unsystematic elements. First, individual bond issuers may experience difficulty
in meeting their debt obligations. This could be an isolated incident, and can be
diversified away (or eliminated by effective credit analysis). However, if default
risk is precipitated by adverse general business conditions, then this would require

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more macro-oriented analysis. Many fixed-income investors complement the bond

ratings providing by bond agencies (Fitch's, Moody's, Duff & Phelps, S&P's) with
their own credit analysis, citing reasons such as: more accurate, comprehensive,
and timely analyses and recommendations.


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A portfolio manager would monitor the yield relationships between various types
of bonds and look for abnormalities. If a spread were thought to be abnormally
high, you would trade to take advantage of a return to a normal spread. Thus, you
need to know what the "normal" spread is, and you need the liquidity to make
trades quickly to take advantage of temporary spread abnormalities.

Spread Analysis: Involves anticipating changes in sectoral relationships. For

example, prices and yields on lower investment grade bonds tend to move together
(identifiable classes of securities are referred to as sectors). Changes in relative
yields (or the spread) may occur due to:

àV altered perceptions of the creditworthiness of a sector of the market's

sensitivity to default risk
àV changes in the market's valuation of some attribute or characteristic of
the securities in the sector (such as a zero coupon feature); or
àV changes in supply/demand conditions.

The objective is to invest in the sector or sectors that will display the strongest
relative price movements. Brokerage firms maintain historical records of yield
spreads and are able to conduct specialized analyses for clients, such as
measurement of the historical average, maximum, and minimum spread among
sectors.
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Potential drawbacks of this method include the need to make numerous trades, the
possibility of poor timing (how long will it take for the market to realize the
abnormal spread), and the danger that overall changes in interest rates will dwarf
these efforts.


#'(


The main difference between passive and active management is the assumption
that the portfolio manager, whether it be a large institution or an individual, has the
ability to either predict the direction of interest rates or exploit mispriced securities.
While the manager does not have to be correct 100% of the time, he/she must be
successful enough to provide returns in excess of a passively managed portfolio,
minus transaction costs, taxes and management fees.

$'5!
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6!(

The matched-funding technique incorporates the passive buy-and-hold strategy and

active management strategies. The manager tries to match specific liability
obligations due at specific times to a portfolio of bonds in a way that minimizes the
portfolio's exposure to interest rate risk (the uncertainty of returns due to possible
changes in interest rates over time). These techniques are meant to avoid or offset
risk, and they typically require constant monitoring and many transactions to
achieve the intended goal.

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Many of these techniques were developed in the 1980s (due to highly volatile
interest rates) for pension funds (known obligations), individual retirement
planning, college education, etc. These investors needed $x at x date. With interest
rates that were highly volatile, at the needed date, bond prices could be down
(substantially below the needed amount). Thus, many investors wanted techniques
that would help them match future liability streams with bond portfolios that would
provide the required funds without having to worry about where interest rates
would be at the time.


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Pure Cash-matched dedicated portfolio: most conservative method. Construct a

bond portfolio with a stream of payments, sinking funds, and maturing principal
payments to exactly match specific liability schedule. This requires estimating your
future obligations (pension fund payouts, college tuition, etc.) You could choose
zero-coupon bonds that had maturity dates exactly when you needed the funds.
This is an entirely passive portfolio that requires no reinvestment (zero coupon
bonds pay no cash coupon payment and matures the day you need the funds, so as
soon as you receive your maturity payment, you would payout your pension
money). Technically it is difficult to determine exactly WHEN your cash flow
payouts will be due, so it is best to apply a somewhat conservative approach.

Dedicated Cash-matched portfolio with reinvestment: Assumes that cash flows

don't always come when needed (may come earlier) and will be reinvested.
Therefore, will require smaller sums of initial funds to meet future goals.

Portfolio Immunization

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Attempts to enable one to "lock-in" going interest rates and not have to worry
about interest rate shifts. Developed by Fisher and Weil in 1971.

Components of Interest Rate Risk: One of the major problems faced by bond
portfolio managers is having the needed amount of funds at a specific date (the
ending wealth requirement) -- your investment horizon. If interest rates never
changed during your investment horizon, you could reinvest your coupon
payments at the stable interest rate and earn the promised YTM. However, in
reality, the yield curve is not flat and interest rates do change. Consequently,
investors face interest rate risk. There are two components of interest rate risk:

I.V #
'#
(2: if interest rates change before the end of your investment horizon
and the bond is sold prior to maturity (you would "win" with an interest rate
decrease and "lose" with an interest rate increase.
II.V !"#
)(*#
(2: The promised YTM assumes that all coupon
payments are reinvested at the promised YTM. If interest rates change, this
cannot be accomplished. You will "win" with an increase in IR and vice
versa.

Immunization and Interest Rate Risk: Note that the "win" situation under price risk
is exactly opposite the "win" situation under coupon reinvestment risk. Bond
portfolio managers would like to eliminate these two interest rate risks. Fisher and
Weil (because of the opposing effects of IR on price and coupon reinvestment risk)
developed a precise immunization process to eliminate IR risk. Fisher and Weil
argue that a portfolio has been immunized if its value at the end of the period is the
same (or higher) than what it would have been if interest rates had not changed
during the investment horizon. They assume that IR changes will affect all rates by
the same amount (i.e. all rates will rise by .005 or fall by .005--long term bonds

ccc c

 

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won't rise by .007 and short term by .005, both will rise by .005). If this is the case,
then portfolio immunization can be achieved by holding a portfolio of bonds with a
modified duration equal to the remaining investment horizon. "To obtain a given
portfolio duration, you set the value-weighted average modified duration of the
portfolio at the investment horizon and keep it equal to the remaining horizon
value over time."

Example of Immunization. Compare the results of choosing a bond with a maturity

equal to the investment horizon vs. a modified duration equal to the investment
horizon. Assumptions: investment horizon is 8 years, current YTM is 8% on 8 year
bonds. If there is no change in yields, the expected ending-wealth would be $1000
* 1.08^8 = $1,850.90. This should also be the expected ending-wealth for a fully
immunized portfolio.

There are two strategies for portfolio immunization:

1.V the maturity strategy (term to maturity equal to investment horizon);

and
2.V the duration strategy (set modified duration equal to investment
horizon).

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Under the maturity strategy simply choose a bond with 8 years to maturity. Under
the duration strategy, find a bond with a modified duration that equal 8 (or as close
to 8 as possible). Now we'll work through the example assuming that interest rates

Results with Maturity Strategy Results with Duration Strategy

Year Cash Reinv. Ending Cash Reinv. Ending

Flow
Rate Value Flow Rate Value

1 80 .08 80 80 .08 80

2 80 .08 166.40 80 .08 166.40

3 80 .08 259.71 80 .08 259.71

4 80 .08 360.49 80 .08 360.49

5 80 .06 462.12 80 .06 462.12

6 80 .06 596.85 80 .06 596.85

7 80 .06 684.04 80 .06 684.04

8 1080 .06 1805.08 1120.64 .06 1845.75

decrease from 8% to 6% in year 4 and again from 8% to 12% in year 4.

From 8% to 6%:

From 8% to 12%

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Results with Maturity Strategy Results with Duration Strategy

Year Cash Reinv. Ending Cash Reinv. Ending

Flow
Rate Value Flow Rate Value

1 80 .08 80 80 .08 80

2 80 .08 166.40 80 .08 166.40

3 80 .08 259.71 80 .08 259.71

4 80 .08 360.49 80 .08 360.49

5 80 .12 483.75 80 .12 483.75

6 80 .12 621.80 80 .12 621.80

7 80 .12 776.42 80 .12 776.42

8 1080 .12 1949.59 1012.4 .12 1881.99

Notice that under the maturity strategy you would lose (from an expected value of
$1,850.90 to an actual value of $1,805.08); whereas under the duration strategy
you would still have an expected value of $1,850.90 and you would achieve
$1,845.72 or $1,881.99 (depending on whether interest rates fell or rose). While we
would have preferred the ending wealth achieved under the rise in IR scenario
using the maturity strategy, due to the uncertainty of IR changes, it's impossible to
know, before the fact, where interest rates will actually be. The duration strategy
actually achieved the ending wealth closest to the expected wealth under both
scenarios.

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Implementing Immunization. While on the surface the immunization strategy may

seem simple, even passive, in reality it is not (except zero coupon bonds face no
coupon reinvestment risk or price risk--as its duration is its term to maturity). Most
portfolios (non-zero-coupon portfolios) require frequent rebalancing to maintain
the modified duration/investment horizon matching. You cannot initially set them
equal and then ignore them after that. Duration is positively affected by term to
maturity, so, as time passes as your investment horizon shortens, so does the
duration of the bond portfolio (assuming nothing else has changed). However,
duration changes at a slower pace than term to maturity. Also, duration is affected
by changes in interest rates, etc. So, it takes constant rebalancing to keep track of
duration matching immunization strategy

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Ê *$$&* (#$&

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8

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A sector rotation strategy for bonds involves varying the weights of different types
of bonds held within a portfolio. An investment manager will form an opinion on
the valuation of a specific sector of the bond market, based on the credit
fundamental factors for that sector and relative valuations compared to historical
norms and technical factors, such as supply and demand, within that sector. A
manager will usually compare her portfolio to the weightings of the benchmark
index that she is being compared to on a performance basis.

'!#
0%'
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Security selection for bonds involves fundamental and credit analysis and
quantitative valuation techniques at the individual security level. Fundamental
analysis of a bond considers the nature of the security and the potential cash flows
attached to it. Credit analysis evaluates the likelihood that the payments will be
received as contemplated, or at all. Modern quantitative techniques use statistical
analysis and advanced mathematical techniques to attach values to the cash flows
and assess the probabilities inherent in their nature.

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## %
 5#0

According to Ê '%!# if an investor were to craft the perfect investment,
then he would probably want its attributes to include high returns coupled with
little risk. The reality, of course, is that this kind of investment is next to
impossible to find. Not surprisingly, people spend a lot of time developing
methods and strategies that come close to the "perfect investment". But none is as
popular, or as compelling, as modern portfolio theory (MPT). Here we look at the
basic ideas behind MPT, the pros and cons of the theory, and how MPT affects the
management of your portfolio.

5 5#0

One of the most important and influential economic theories dealing with finance
and investment, MPT was developed by Harry Markowitz and published under the
title "Portfolio Selection" in the 1952 Journal of Finance. MPT says that it is not
enough to look at the expected risk and return of one particular stock. By investing
in more than one stock, an investor can reap the benefits of diversification - chief
among them, a reduction in the riskiness of the portfolio. MPT quantifies the
benefits of diversification, also known as not putting all of your eggs in one basket.

For most investors, the risk they take when they buy a stock is that the return will
be lower than expected. In other words, it is the deviation from the average return.
Each stock has its own standard deviation from the mean, which MPT calls "risk".

The risk in a portfolio of diverse individual stocks will be less than the risk
ccc c
 

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inherent in holding any single one of the individual stocks (provided the risks of
the various stocks are not directly related). Consider a portfolio that holds two
risky stocks: one that pays off when it rains and another that pays off when it
doesn't rain. A portfolio that contains both assets will always pay off, regardless of
whether it rains or shines. Adding one risky asset to another can reduce the overall
risk of an all-weather portfolio.

In other words, Markowitz showed that investment is not just about picking stocks,
but about choosing the right combination of stocks among which to distribute one's
nest eggs.

4
( 
(2


Modern portfolio theory states that the risk for individual stock returns has two
components:
0(*$
'
(2 - These are market risks that cannot be diversified away. Interest
rates, recessions and wars are examples of systematic risks.
(0(*$
' 
(2 - Also known as "specific risk", this risk is specific to
individual stocks and can be diversified away as you increase the number of stocks
in your portfolio (see Figure 1). It represents the component of a stock's return that
is not correlated with general market moves.

For a well-diversified portfolio, the risk - or average deviation from the mean - of
each stock contributes little to portfolio risk. Instead, it is the difference - or
covariance - between individual stocks' levels of risk that determines overall

ccc c

 

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portfolio risk. As a result, investors benefit from holding diversified portfolios

instead of individual stocks.

Figure 1

5
'
#
#


Now that we understand the benefits of diversification, the question of how to
identify the best level of diversification arises.

For every level of return, there is one portfolio that offers the lowest possible risk,
and for every level of risk, there is a portfolio that offers the highest return. These
combinations can be plotted on a graph, and the resulting line is the efficient
frontier. Figure 2 shows the efficient frontier for just two stocks - a high risk/high
return technology stock (Google) and a low risk/low return consumer products
stock (Coca Cola).

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Figure 2

Any portfolio that lies on the upper part of the curve is efficient: it gives the
maximum expected return for a given level of risk. A rational investor will only
ever hold a portfolio that lies somewhere on the efficient frontier. The maximum
level of risk that the investor will take on determines the position of the portfolio
on the line.

Modern portfolio theory takes this idea even further. It suggests that combining a
stock portfolio that sits on the efficient frontier with a risk-free asset, the purchase
of which is funded by borrowing, can actually increase returns beyond the efficient
frontier. In other words, if you were to borrow to acquire a risk-free stock, then the
remaining stock portfolio could have a riskier profile and, therefore, a higher return
than you might otherwise choose
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Modern portfolio theory has had a marked impact on how investors perceive risk,
return and portfolio management. The theory demonstrates that portfolio

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diversification can reduce investment risk. In fact, modern money managers

routinely follow its precepts

That being said, MPT has some shortcomings in the real world. For starters, it
often requires investors to rethink notions of risk. Sometimes it demands that the
investor take on a perceived risky investment (futures, for example) in order to
reduce overall risk. That can be a tough sell to an investor not familiar with the
benefits of sophisticated portfolio management techniques. Furthermore, MPT
assumes that it is possible to select stocks whose individual performance is
independent of other investments in the portfolio. But market historians have
shown that there are no such instruments; in times of market stress, seemingly
independent investments do, in fact, act as though they are related.
Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio
returns, but finding a truly risk-free asset is another matter. Government-backed
bonds are presumed to be risk free, but, in reality, they are not. Securities such
as gilts and U.S. Treasury bonds are free of default risk, but expectations of higher
inflation and interest rate changes can both affect their value.

Then there is the question of the number of stocks required for diversification.
How many is enough? Mutual funds can contain dozens and dozens of stocks.
Investment guru William J. Bernstein says that even 100 stocks is not enough to
diversify away unsystematic risk. By contrast, Edwin J. Elton and Martin J.
Gruber, in their book "Modern Portfolio Theory And Investment Analysis" (1981),
conclude that you would come very close to achieving optimal diversity after
adding the twentieth stock.

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"Effective in presenting the mechanics of bond portfolio management for those who
understand basic bond math worth the price."±±Financial Analysts Journal

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In order to effectively employ portfolio strategies that can control interest rate risk
and/or enhance returns, you must understand the forces that drive bond markets, as well
as the valuation and risk management practices of these complex securities. In 
  

 


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, Frank Fabozzi, Lionel Martellini, and Philippe Priaulet
have brought together more than thirty experienced bond market professionals to help
you do just that.

Divided into six comprehensive parts, )$' Ê # %

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guide you through the state±of±the±art techniques used in the analysis of bonds and
bond portfolio management. Topics covered include:

àV General background information on fixed±income markets and bond portfolio

strategies
àV The design of a strategy benchmark
àV Various aspects of fixed±income modeling that will provide key ingredients in the
implementation of an efficient portfolio and risk management process
àV Interest rate risk and credit risk management

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àV Risk factors involved in the management of an international bond portfolio

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is a valuable resource for anyone involved or interested in this important industry.

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In order to effectively employ portfolio strategies that can control interest rate risk
and/or enhance returns, you must understand the forces that drive bond markets, as well
as the valuation and risk management practices of these complex securities. In Advanced
Bond Portfolio Management, Frank Fabozzi, Lionel Martellini, and Philippe Priaulet
have brought together more than thirty experienced bond market professionals to help
you do just that. Divided into six comprehensive parts, Advanced Bond Portfolio
Management will guide you through the state-of-the-art techniques used in the analysis
of bonds and bond portfolio management. Topics covered include: General background
information on fixed-income markets and bond portfolio strategies The design of a
strategy benchmark Various aspects of fixed-income modeling that will provide key
ingredients in the implementation of an efficient portfolio and risk management process
Interest rate risk and credit risk management Risk factors involved in the management of
an international bond portfolio Filled with in-depth insight and expert advice, Advanced
Bond Portfolio Management is a valuable resource for anyone involved or interested in
this important industry.

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The evolution of State Bank of India can be traced back to the first decade of the
19th century. It began with the establishment of the Bank of Calcutta in Calcutta,
on 2 June 1806. The bank was redesigned as the Bank of Bengal, three years later,
on 2 January 1809. It was the first ever joint-stock bank of the British India,
established under the sponsorship of the Government of Bengal. Subsequently, the
Bank of Bombay (established on 15 April 1840) and the Bank of Madras
(established on 1 July 1843) followed the Bank of Bengal. These three banks
dominated the modern banking scenario in India, until when they were
amalgamated to form the Imperial Bank of India, on 27 January 1921.

An important turning point in the history of State Bank of India is the launch of the
first Five Year Plan of independent India, in 1951. The Plan aimed at serving the
Indian economy in general and the rural sector of the country, in particular. Until
the Plan, the commercial banks of the country, including the Imperial Bank of
India, confined their services to the urban sector. Moreover, they were not

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equipped to respond to the growing needs of the economic revival taking shape in
the rural areas of the country. Therefore, in order to serve the economy as a whole
and rural sector in particular, the All India Rural Credit Survey Committee
recommended the formation of a state-partnered and state-sponsored bank.

The All India Rural Credit Survey Committee proposed the take over of the
Imperial Bank of India, and integrating with it, the former state-owned or state-
associate banks. Subsequently, an Act was passed in the Parliament of India in
May 1955. As a result, the State Bank of India (SBI) was established on 1 July
1955. This resulted in making the State Bank of India more powerful, because as
much as a quarter of the resources of the Indian banking system were controlled
directly by the State. Later on, the State Bank of India (Subsidiary Banks) Act was
passed in 1959. The Act enabled the State Bank of India to make the eight
former State-associated banks as its subsidiaries.

The State Bank of India emerged as a pacesetter, with its operations carried out by
the 480 offices comprising branches, sub offices and three Local Head Offices,
inherited from the Imperial Bank. Instead of serving as mere repositories of the
community's savings and lending to creditworthy parties, the State Bank of India
catered to the needs of the customers, by banking purposefully. The bank served
the heterogeneous financial needs of the planned economic development.

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The corporate center of SBI is located in Mumbai. In order to cater to different
functions, there are several other establishments in and outside Mumbai, apart from
the corporate center. The bank boasts of having as many as 14 local head offices
and 57 {onal Offices, located at major cities throughout India. It is recorded that
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SBI has about 10000 branches, well networked to cater to its customers throughout
India

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SBI provides easy access to money to its customers through more than 8500 ATMs
in India. The Bank also facilitates the free transaction of money at the ATMs of
State Bank Group, which includes the ATMs of State Bank of India as well as the
Associate Banks ± State Bank of Bikaner & Jaipur, State Bank of Hyderabad, State
Bank of Indore, etc. You may also transact money through SBI Commercial and
International Bank Ltd by using the State Bank ATM-cum-Debit (Cash Plus) card.

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The State Bank Group includes a network of eight banking subsidiaries and several
non-banking subsidiaries. Through the establishments, it offers various services
including merchant banking services, fund management, factoring services,
primary dealership in government securities, credit cards and insurance.

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àV State Bank of Bikaner and Jaipur (SBBJ)

àV State Bank of Hyderabad (SBH)
àV State Bank of India (SBI)
àV State Bank of Indore (SBIR)
àV State Bank of Mysore (SBM)
àV State Bank of Patiala (SBP)
àV State Bank of Saurashtra (SBS)
àV State Bank of Travancore (SBT)

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àV SBI Term Deposits SBI Loan For Pensioners

àV SBI Recurring Deposits Loan Against Mortgage Of Property
àV SBI Housing Loan Loan Against Shares & Debentures
àV SBI Car Loan Rent Plus Scheme
àV SBI Educational Loan Medi-Plus Scheme

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àV Agriculture/Rural Banking
àV NRI Services
àV ATM Services
àV Demat Services
àV Corporate Banking
àV Internet Banking
àV Mobile Banking
àV International Banking
àV Safe Deposit Locker
àV RBIEFT
àV E-Pay
àV E-Rail
àV SBI Vishwa Yatra Foreign Travel Card
àV Broking Services
àV Gift Cheque
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The country¶s largest lender, State Bank of India , is expected to report a healthier
bottom line in the second quarter, thanks to writeback of provisions on the bond
portfolio.

Based on the current bond prices, SBI is expected to write back Rs 700-800 crore
of provisions. Yields on government bonds have softened in the second quarter.
This is in contrast to the Rs 1,656 crore mark-to-market provisions the bank made
during April-June this year as yields went up 73 basis points at the close of the
quarter. The final write-back figure will depend on how bond prices move over the
next fortnight.

Analysts said that a dip in yields and the consequent write-back of provisions is
one of the major factors that are helping public sector bank stocks rally despite the
global financial crisis.

SBI¶s shares closed 2.14 per cent higher at Rs 1,561.35 on the Bombay Stock
Exchange.

The problem was accentuated for SBI as it had to provide nearly Rs 1,000 crore for
erosion in the value of special bonds it received from the Centre as its share of
subscription for a rights issue in March 2008.

Compared to the yield of 8.66 per cent on June 30, 2008, the yield on 10-year
paper was 8.31 per cent on Thursday. This will help banks report healthier
numbers despite a slower growth in income.

ccc c

 

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On March 31, the yield was 7.93 per cent. During the first quarter, SBI reported a
15 per cent rise in its net profit to Rs 1,640.79 crore.

During the July-September 2008, the profit rose 86 per cent to Rs 2204.56 crore.

SBI has the largest bonds portfolio and is estimated to be around Rs 1,80,000 crore
at present. SBI executives have maintained that by raising lending rates twice in
the second quarter, they have managed to protect the net interest margin, which
was estimated at 3.03 per cent at the end of June 2008. The gain from this is,
however, still unclear as borrowing costs have also gone up, especially on term
deposits.

With banks facing higher delinquency levels due to a rise in interest rates and a
slowdown in economic activity, the provisions for sticky assets may go up,
executives said.

But they appeared confident that the write-back will make up for some of the
additional provisioning.

State Bank of India (SBI), the country¶s largest bank, today launched its Rs 1,000
crore subordinated bond issue to shore up its tier-II capital. The issue has a tenure of
113 months and carries a coupon of 7.45 per cent, payable annually.

Dealers said the tier-II issue will have an unspecified greenshoe option and will
remain open till December 5. This issue is part of the bank¶s plans to raise Rs 3,300
crore through tier-II bonds.

Several other banks are also about to hit the capital market to raise tier-II capital.
These include Uco Bank (Rs 400 crore), Andhra Bank (Rs 400 crore), Union Bank of
India (Rs 800 crore), Bank of India (Rs 750 crore) and Bank of Baroda (Rs 1,500

ccc c

  

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crore).

A few private banks have already raised subordinated debt needed to boost capital
adequacy. ICICI Bank raised Rs 700 crore of tier-II capital, HDFC Bank Rs 1,000
crore and Yes Bank Rs 200 crore.

Tier-I capital includes paid-up capital, statutory reserves and other disclosed reserves.
tier-II capital consists of subordinate debt and revaluation reserves. Tier-II capital can
be equal to tier-I capital, but subordinated debt can only be 50 per cent of tier-I
capital.

With the deadline for compliance to Basel-II nearing, banks are experiencing a rise in
their requirements for regulatory capital. To maintain their capital adequacy ratios
well above the regulatory 9 per cent, banks are taking the tier-II route.

The current industry-wide capital adequacy ratio (CAR) stands at 12.0-12.5 per cent,
which would drop to about 10 per cent, following the implementation of Basel-II.
The Reserve Bank of India (RBI) recently allowed banks to include provisions under
investment fluctuation reserve (IFR) as part of tier-I capital (IFR has been hitherto
been classified as Tier II capital). This change permits considerable headroom for
banks to increase their Tier-II capital.

A study by leading credit rating agency, Crisil, reveals that Indian banks can
potentially borrow an additional Rs 11,100 crore in subordinate bonds, as a result of
the change in the treatment of IFR.

Banks are required to create IFR out of their profits equivalent to 5 per cent of their

ccc c

 

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investment portfolio under held for trading (HFT) and available for sale (AFS)
categories. IFR is meant to cushion interest rate risk on these investments.

Crisil¶s analysis also reveals that, on an overall basis, the banks covered in its study
can grow their risk-weighted assets by up to 32 per cent, and still, from a regulatory
perspective, maintain a comfortable capital adequacy of 11 per cent.

This will happen even without raising any fresh equity, by fully utilising the existing
headroom for raising subordinate debt (this headroom is estimated to be Rs.14,800
crore for the banks covered under the CRISIL study) and by completely availing the
additional subordinate debt window being provided by the RBI notification.


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MUMBAI (Reuters) - State Bank of India, the country's largest lender, plans to
raise 180 billion rupees ($3.8 billion) through bonds by March 2010, the bank said
on Tuesday, a day ahead of its 20-billion-rupee bond issue.

In a note to the stock exchange, SBI said it would offer bonds with a minimum
maturity of more than 60 months, in tranches through structured deals, private
placement or retail participation.

On Monday, SBI set a coupon of 8.90 percent on a 15-year upper Tier-II

subordinated debt issue, to be launched on Wednesday.

ccc c

 

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Several Indian banks have stepped up bond sales over the past month to meet Basel
II requirements, which by March 2009 aim to match capital reserve requirements
to the risks faced by banks.

"Yields are very low and attractive now, but Basel II is also a reason why banks are
issuing bonds," Harihar Krishnamoorthy, treasurer at Development Credit Bank,
said.

India's benchmark 10-year federal bond on Tuesday plunged below 6 percent for
the first time since Sept. 2004. It has eased from a seven-year high of 9.55 percent
touched in early July as falling inflation and slowing growth led the central bank to
lower key interest rates.

The Reserve Bank of India in October reversed a 4-½ year monetary tightening
cycle to cut the repo rate, at which it lends money to banks. In a series of policy
easings since then, it has cut the repo rate by 250 basis points to 6.5 percent now.

In its latest move, the bank on Dec. 6 slashed both the repo and the reverse repo
rate, at which it absorbs funds from banks, by 100 basis points each.

($1 = 47.8 rupees)


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New Delhi, Mar 27 (PTI) The government issued close to Rs 10,000 crore bonds to
State Bank of India to buy around 60 per cent of its rights issue, which is priced at
Rs 1,590 a share.

The 16-year Special Bonds are precisely for Rs 9,996.012 crore and would carry a
coupon rate of 8.35 per cent.

"The special bonds are being issued at par to SBI today as subscription towards
Rights Issue of equity shares of SBI," an official release said.

The investment in special bonds by banks and insurance companies will not be
reckoned as an eligible investment in government securities

SBI to raise Rs 16,736 cr from rights issue

Mumbai, Jan 14 (PTI) -- Country's largest lender SBI today decided to raise Rs
16,736.31 crore from its much-awaited rights issue, which will be priced at Rs
1,590 a share.

According to a decision of the Central Board of the bank here, existing

shareholders would be given a share for every five shares.

The price at which shares would be offered represents about 36 per cent of
discount to State Bank of India's current share price.

This means shareholders would get a share at a premium of Rs 1,580, if face value
of Rs 10 is considered, but at a discount of Rs 889, if today's current price at Rs ...

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SBIA
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 State Bank of India (SBI) is set to raise upto USD one billion from the
international market this month through the issue of five year maturity bonds. This
will fill up the immediate fund-requirement of the banking behemoth to fuel its
expansion plans in key-overseas markets, primarily setting up of around 40
newoffices and expanding the lending book.

The bond issue, a part of SBI's USD five billion Medium Term Notes (MTN)
programme launched in 2004, will target investors including banks, insurance
companies, hedge funds and private equities in the global market, a seniorSBI
official told PTI here.

State Bank of India has designed the bond issue through Reg-S route, which means
it can target only non-US clients through the bond issue to raise a maximum of
USD one billion.

The bank plans to launch international roadshows for the programme in the next
few weeks and has appointed five leading investment banks -- Barclays, JP
Morgan, Citi, HSBC and UBS as lead arrangers, the official said.

However, the official declined to give details of interest rate at which SBI would
issue bonds to global investors. "We will be giving it (bonds) to the arrangers,
who, in turn will distribute among their clients. The issue could be a mix of fixed
and floating rate bonds. We are yet to arrive at the coupon rate," the official said.

SBI has so far raised around USD 2.3 billion through the MTN programme.
Assuming that the lender will successfully raise USD one billion from the current

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issue, it will still have a headroom to raise USD 1.7 billion when required through
the MTN route, the official said.

The banking giant plans to open over 40 new offices globally in the next one year.
Presently the bank has 132 foreign offices including five subsidiaries. Overseas
business currently contributes around 12 per cent of SBIs balancesheet.

SBI's international subsidiaries are Indonesia (6 branches), Mauritius (12

branches), Nepal (32 branches), California (7 branches) and Canada (7 branches).
Other destinations, where the bank plans to open newoffices include Middle East,
Singapore, South Africa, Bangladesh, Saudi Arabia, USA, Srilanka, Nepal and
HongKong.

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Fitch Ratings has today assigned a 'BBB-'rating to State Bank of India's senior
unsecured USD bonds to be issued under the bank's USD5bn Medium-Term Note
programme. The size and pricing of the issue is expected to be finalised today. The
agency has simultaneously affirmed the outstanding ratings of State Bank of India
(SBI) as follows:

1.V Long-term foreign currency Issuer Default rating (IDR) at 'BBB-';

2.V Short-term foreign currency IDR at 'F3';
3.V National Long-term rating at 'AAA(ind)';
4.V Individual at 'C' ;
5.V Support at '2'; and
6.V Support Rating Floor at 'BBB-'.

The Rating Outlook is Stable. The list of outstanding issues rated is attached
below.

SBI's Long-term ratings are driven by its quasi-sovereign risk status and huge
systemic importance, as well as its competitive edge as India's largest domestic
bank with an extensive branch reach, strong deposit franchise, above-average

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capital ratios and better income diversity compared to other government banks.
The Long-term foreign currency IDR is at the Support Rating Floor level.

Funding is mostly through domestic retail deposits sourced from its pan-Indian
branch network (the largest amongst Indian banks), which supports the bank's
liquidity. SBI also has a major share of the banking business of the central
government and the various state governments, which helps boost its share of low
cost current and savings deposits, versus other Indian banks. The bank's reported
Tier 1 capital ratio has been above 8% since FY98; the ratio was at 9.7% at end-
June 2009 and comprised mostly of core capital. Given the statutory minimum
shareholding that the government needs to maintain in the bank, SBI would
ultimately rely on the government for capital; the government subscribed to the
bank's rights issue of common equity in March 2008.

The rapid loan growth in recent years (loans doubled between FY06 and FY09),
together with the economic slowdown leads to asset quality concerns, and the
bank's NPL and stressed accounts could rise in FY10 and FY11. That said, the
sector diversity of SBI's loan portfolio provides some respite against sudden spikes
in the NPL ratios; Fitch notes that the bank's reported gross NPL ratio and
restructured loan portfolio at end-June 2009 were both close to the average for
Indian banks. Fitch's stress test on Indian banks (for more information please refer
to the Special Report titled "Stress Test on Indian Banks: Higher-Rated Banks
Mostly Able to Preserve Equity" dated 1 October 2009) suggests that SBI's credit
costs in the stress scenario can be absorbed by its pre-impairment operating profit,
leaving the capital unimpaired under fairly harsh stress assumptions.

That said, the bank's performance in FY10 could come under pressure on several
fronts. SBI's focus since FY09 on regaining market share in its lending business

ccc c

 

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has affected its net interest margin (NIM), and while NIM can be expected to
recover as deposits are re-priced at rates lower than 2008, it may remain lower than
the targeted 3% (Q1FY10: 2.3%). Credit costs would likely rise during the current
downturn in asset quality; in addition, the bank also plans to raise its currently low
specific loan loss reserves level (FY09: 38%) closer to the system average of 50%
of gross NPL. Profits could also be impacted if interest rates result in mark-to-
market losses on its available-for-sale portfolio of government securities, which
needs to be adjusted through profits under local accounting. The healthy accretion
of fee income from both the banking business provides comfort and helped
maintain ROA close to 1% during Q1FY10.

With over 11,000 branches and 8,500 ATMs, SBI continues to dominate the
banking sector in India.

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àV EUR100m senior bonds: 'BBB-';

àV USD500m senior bonds: 'BBB-';
àV USD300m senior bonds: 'BBB-'; and
àV USD400m perpetual non-cumulative Tier 1 bonds rated: 'BB';

Fitch Ratings currently maintains coverage of approximately 6,000 financial

institutions, including over 3,200 banks and 2,200 insurance companies. Finance &
leasing companies, broker-dealers, asset managers, managed funds, and covered
bonds make up the remainder of Fitch Ratings¶ financial institution coverage
universe.

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Fitch India has Five rating offices located at Mumbai, Delhi, Chennai, Kolkata and
Bangalore. Fitch is recognised by Reserve Bank of India, Securities Exchange
Board of India (SEBI) and National Housing Bank.

V

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The 'AAA' (triple A) rating assigned to the Rs. 1,000 crore bond programme of
State Bank of India has been reaffirmed by the Credit Rating Information Services
of India (Crisil). The P1 plus (P one plus) rating assigned to the certificates of
deposit programme of Bank of India has also been reaffirmed.

The rating reaffirmation reflects the large size and sound capitalisation of the bank,
and its importance to the Indian economy. The rating also takes into account the
strong resources position of SBI arising out of its reach, its dominant market
position and the diversity of its earning streams. The key sensitivities in the rating
of State Bank of India in future would be the asset quality, ability to maintain
market share in deposits at competitive costs and ability to manage interest rate
risk on its investment portfolio.

The bank is the largest institution in the Indian financial sector with assets of more
than Rs. 222,500 crores and deposits of more than Rs. 169,000 crores as at March
31, 1999, having a market share of over 21 per cent in deposits and around 20 per
cent in advances among all scheduled commercial banks.

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Since bond and fixed-income portfolios are held by most institutional investors in
addition to stock portfolios, their relative importance in terms of total portfolio
returns necessitate a closer analyses of bond valuation and bond volatility. The
underlying determinants of bond value are the nominal interest rates (i.e., real
interest rate plus inflation premium) and their term premia. Term premium results
from the hypotheses that investors have different time preferences when trading
bonds with different maturities in different markets. Both nominal interest rate and
term premium combine to form the bond yield thereby determining the market
value of bond. The yield curve - a relationship between the bond yield and its
maturity - represents the term structure of the interest rate. A positively sloping
yield curve implies that the future interest rates will be higher, and vice versa. This
term structure helps the bond investors to form their expectations correctly in order
to maximize their bond portfolio returns.

The change in yield curve affects the bond price through duration (interest rate
risk) and convexity. Duration gives the bond investors how sensitive the bond
prices are to the changes in bond yields or the interest rates. As yield increases,
duration decreases and vice versa. The rate of change in duration is measured by
convexity which is used in bond duration matching. Bond portfolio can be
immunized from the effect of yield fluctuation through the use of both duration and
convexity. We can relate bond price, coupon, yield, duration, and time to maturity

ccc c

 

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by the following conclusions: 1) price is inversely related to yield but directly

related to duration, 2) a decrease in yield raises price more than the same increase
in yield lowers price, and 3) if yield equals coupon, then duration and time to
maturity are directly related.




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The Portfolio Management Services Section (PMS) of State bank of India has been
set up to handle investment and regulatory related concerns of Institutional
investors functioning in the area of Social Security.

The PMS forms part of the Treasury Dept. of State Bank of India, and is based at
Mumbai.

PMS was set up exclusively for management of investments of Social Security

funds and custody of the securities related thereto. In the increasingly complex
regulatory and investment environment of today, even the most sophisticated
investors are finding it difficult to address day to day investment concerns, such as

a.V adherence to stated investment objectives

b.V security selection quality considerations
c.V conformity to policy constraints
d.V investment returns

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The team manning the PMS Section consists of highly experienced officers of
State Bank of India, who have the required depth of knowledge to handle large
investment portfolios and address the concern of large investors. The capabilities
of the team range from Investment Management and Custody to Information
Reporting.

MUMBAI: India¶s largest bank ² State Bank of India ² is foraying into the
international market to raise close to $1 billion, riding on the back of improved
sentiment for Indian paper.

SBI plans to raise between $700 million and $1 billion through this bond issue, the
proceeds of which will be used to fuel the bank¶s growth plans. SBI chairman OP
Bhatt had recently said his bank, which accounts for one-fifth of the total deposits
and credit in the banking sector, hoped to record a credit growth of 20% in 2009-
10, although loan growth has been muted so far during the first few months of the
current fiscal.

MUMBAI (Reuters) - State Bank of India, the country's largest lender, plans to
raise 180 billion rupees ($3.8 billion) through bonds by March 2010, the bank said
on Tuesday, a day ahead of its 20-billion-rupee bond issue.

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