Topic: Fixed Income

Index

Sr. No. Title Page No.

1 Primary and Secondary Debt market 2

2 Types of fixed income securities 2

3 Types of return 4

4 Terms related to Bond 6

5 Types of bonds 8

6 What are Credit spreads? 9

7 Term structure of interest rates 10

8 Duration 13
9 Convexity 14

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Primary and Secondary Debt Markets

Primary Market

The primary markets deal with the trading of newly issued securities. Entities in Primary market:

 Issuer/borrower: Governments and companies that issue securities when they want to
raise money
 Investors/lenders: Buyers (retail or qualified) who purchase the bonds

In the primary market, newly issued securities can be sold to public through a public offering or
sold only to qualified investors through a private placement.

Secondary Market

The secondary market refers to the trading of previously issued bonds. The bonds issued in
primary markets are then traded in the secondary market. Bond trades are cleared through a
clearing system, just as equity trades are. Settlement for government bonds is either the day of
trade or next business day (T+1). Corporate bonds typically settle on T+2 or T+3.

Types of Fixed Income Securities

Bonds

The most common type of fixed income securities are bonds. The borrower, or issuer of bond,
promises to pay interest, called the coupon, on an annual or semi-annual basis until a set date.
The issuer returns the principal amount, also called the face or par value, to the investor on
the maturity date. Bonds may be issued at par, premium and discount depending on its coupon
and YTM.

Government Securities

G-Sec is a tradeable instrument issued by the Central Government or the State Governments.
Such securities are short term (usually called treasury bills, with original maturities of less than
one year) or long term (usually called Government bonds or dated securities with original

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maturity of one year or more). It is a way in which the government raises funds through its
banker i.e. RBI. G-Secs are issued through auctions conducted by RBI. Commercial Banks,
Insurance Companies, Mutual Funds, Provident Funds, etc can buy G-Sec from the auction.

Treasury Bills

Treasury bills (T-bills) are money market instruments, i.e., short-term debt instruments issued by
the Government of India, and are issued in three tenors—91 days, 182 days, and 364 days. The
T-bills are zero coupon securities and pay no interest. They are issued at a discount and are
redeemed at face value on maturity. New issues of T-Bills can be purchased at auctions through
a bidding process held by the government. Previously issued ones can be bought on the
secondary market.

Certificate of Deposit

It is a negotiable money market instrument that can be issued by scheduled commercial banks
and some other financial institutions (as permitted by RBI) against funds deposited by investors
for a specified time period. CDs can be issued to individuals, corporations, companies (including
banks), trusts, funds, associations, etc. The minimum deposit that could be accepted from a
single subscriber should not be less than Rs.1 lakh, and in multiples of Rs. 1 lakh thereafter. The
maturity period of CDs issued by banks should be 7 days to 1 year.

Commercial Paper

Commercial paper is an unsecured, short-term debt instrument issued by a corporation. Firms use
commercial paper to fund working capital and as a temporary source of fund prior to issuing
longer term debt. Only those companies that fulfill Net worth and Credit rating requirement
prescribed by RBI are eligible to issue CPs. CPs can be issued for maturities between a minimum
of 7 days and maximum of 1 year and in denominations of Rs.5 lakh or multiples thereof.
Individuals, banking companies, other corporate bodies, Non-Resident Indians (NRIs) and
Foreign Institutional Investors (FIIs) etc. can invest in CPs.

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Types of return
1. Holding Period Return (HPR)

Holding period return is the total return received from holding an asset or portfolio of assets over
a period of time, generally expressed as a percentage. It takes into account both current return
(eg. Interest or coupon payment) and capital return (capital appreciation) on an investment. It is
particularly useful for comparing returns between investments held for different periods of time.

HPR = Coupon + (Maturity Value – Purchase Price)

Purchase Price

Example: A bond with a face value of Rs. 1000 is issued at Rs. 900. Coupon payable on the bond
is 5%.

HPR = 50+ (1000-900)/900 = 16.66%

2. Simple Annualized Returns

This measure helps to annualize the return when holding period is less than a year. Therefore, it
helps in comparing the returns on investments with different maturities.
Here’s how to calculate it:

((1+ HPR)^(365/no. of days))-1

Example: An investment of Rs. 1000 has grown to Rs. 1250 in 210 days. The HPR in this case is
25% over 210 days.
Simple Annualized return = ((1+0.25)^(365/210))-1 = 47.38%

3. CAGR

The compound annual growth rate (CAGR) is the mean annual growth rate of an investment over
a specified period of time longer than one year. CAGR takes into account the effect of
compounding of returns.

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This can be written as follows:

Example: You invested Rs. 1000 in a fund for 5 years. The end value of investment at the end of
each year is given below

Year Value
1 750
2 1000
3 3000
4 4000
5 4500
Here, CAGR = (4500/1000)^1/5 – 1 = 35.09%

4. Time-Weighted Rate of Return

It eliminates the distorting effects created by inflow and outflow of money caused by interim
investments and redemptions. To compute TWRR for any period, calculate the returns for every
sub-period before any contribution or withdrawal occur and then geometrically link these sub-
period returns together to compute the return over the period.
The time-weighted rate of return of an investment can be calculated using the following formula,
where:

 N = Number of sub-periods
 HPR = (End Value - Initial Value + Cash Flow) / (Initial Value + Cash Flow)
 HPRN = Return for sub-period N

Time-Weighted Rate of Return = [(1 + HPR1) * (1 + HPR2)... * (1 + HPRN)] – 1

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Example: X invested Rs. 1000 on 1st January into a debt fund. Three months later the value of
this investment rises to Rs. 1100. Thereafter he invests another Rs. 1000 in the fund. At the end
of 6 months the value of investment is Rs. 2300.

To calculate TWRR we need to break the calculation into 2 sub periods.

Period 1 = ($1,100-$1,000)/$1,000 = 10%

Period 2 = ($2,300-$2,100)/$2,100 = 9.5%
TWRR = [(1+0.10)(1+0.095)]-1= 20.45%

Terms related to Bond

 Par value or Face Value

Par value is the face value of a bond. Par value is important for a bond or fixed-income
instrument because it determines its maturity value as well as the value of coupon payments.

 Yield

When investors buy bonds, they essentially lend bond issuers money. In return, bond issuers
agree to pay investors interest on bonds throughout their lifetime and to repay the face value
of bonds upon maturity. The money that investors earn is called yield. Investors do not have
to hold bonds to maturity. Instead, they may sell them for a higher or lower price to other
investors, and if an investor makes money on the sale of a bond, that is also part of its yield.

 Coupon

Bonds typically pay interest periodically at the pre specified rate of interest. The annual rate
at which the interest is paid is known as the coupon rate. The dates on which the interest
payments are made are known as the coupon due dates.

 Maturity

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 The maturity of a bond is the length of time until the bond comes due and the bondholder
receives the par value of the bond.
 Accrued interest
This is the interest that has been earned by an investor but not become due for payment to the
investor. Bond buyers pay bond sellers accrued interest whenever a bond is purchased
between its interest payment dates.
 Frequency
The interest in bonds can be paid monthly, quarterly, half-yearly or yearly. This frequency of
interest payments is specified at the time of issue of the debt instrument.
 Dirty price
The price of a bond is calculated by discounting all future cash flows. The concept of "dirty"
price is relevant for bond prices in the secondary market as they are not always traded on the
coupon payment date and hence the seller needs to be compensated for the number of days
he/she has held the bond in between coupon payments. For example, let's consider a bond
pays interest semi-annually and the payment dates are June 30 and December 31; if it gets
sold on, say, March 21, then the seller would have forgone the coupon payment due on June
30. The "dirty" price of the bond includes the interest due but not paid up to March 31.
 Clean Price
Clean price is the price of a coupon bond not including any accrued interest. A clean price is
the discounted future cash flows, not including any interest accruing on the next coupon
payment date. The clean price is calculated as
Clean Price = Dirty Price - Accrued Interest
 Current Yield

It is a measure to calculate yield on bond. But it looks at just one source of return: a bond’s
annual interest income. It does not consider capital gains or losses or reinvestment income.

Current yield = Annual cash coupon payment/Bond Price

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Types of bonds
Municipal bonds
These are issued by states or cities to finance its capital expenditure. Say your city corporation
wants to set up a new Metro rail network. It can issue municipal bonds to fund the project.
Institutional investors as well as the public can buy these bonds. Revenues from the Metro will
then be used to repay the interest and principal on these bonds. Such bonds where the cash flow
from a particular project is used to repay the interest obligation are Revenue bonds. But
Municipal bonds are not so popular in India.
Corporate bonds
These are issued by private and public corporations. Corporate bonds are characterized by
higher yields because there is a higher risk of a company defaulting than a government. The
upside is that they can also be the most rewarding fixed-income investments because of the risk
the investor must take on. The company's credit quality is very important: the higher the quality,
the lower the interest rate the investor receives.
Zero coupon bonds
Zero coupon bonds are issued at deep discount and does not pay any amount before maturity
date. On the maturity date, investors are paid the par value. The difference between the par value
and the price at which the bond is issued is the return of investors.
Callable bond
It gives the issuer the right to redeem all or part of a bond issue at a specific price (call price) if
they choose to. A call option has value to the issuer because it gives the issuer the right to
redeem the bond and issue a new one if the market yield on the bond declines. This could occur
either because interest rates in general have decreased or because the credit quality on the bond
has increased (default risk has decreased).
Putable bond
A put option gives the bondholder the right to sell the bond back to the issuing company at a pre-
specified price, typically at par. Bondholders are likely to exercise such an option when the fair
value of the bond is less than the put price because interest rates have risen or the credit quality
of the issuer has fallen. A putable bond sells at a higher price (lower yield) compared to an
otherwise identical option free bond.
Perpetual bonds

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A perpetual bond is a fixed income security with no maturity date which means that these bonds
are not redeemable. They pay periodic interest forever. Since investors do not get their principal
back, as compensation the coupon on these bonds is higher. Most perpetual bonds have a call
option embedded in it. Example, the perpetual bonds that were issued by the UK government in
1917 to finance WW1 were called back by the government in 2017.
Convertible bond
Convertible bonds, typically issued with maturities of 5-10 years, give bondholders the option to
exchange the bond for a specific number of shares of the issuing company’s common stock.
Because the conversion option is valuable to bondholders, these bonds can be issued with lower
yields compared to otherwise identical straight bonds. Essentially, the owner of this bond has
downside protection (compared to equity) of a bond, but at a reduced yield, and the upside
opportunity of equity shares.

What are Credit spreads?

A Credit spread is the yield spread. It refers to the difference in the interest rates between a
corporate bond and a comparable government bond. The credit spread is a measure to compare
the creditworthiness of different borrowers in the capital markets. Suppose interest rate on a five-
year corporate bond is 6% and that on a similar five-year Government bond is 5%. This means
that the interest on a corporate bond consists of risk-free rate of 5% plus a credit spread of 1%.
Credit spreads narrow as the economy strengthens and investors expect firm’s credit metrics to
improve. Conversely, spreads widen as economy weakens. Yield spreads are useful for analyzing
factors that affect bond yields. If a bond’s yield increases but yield spread remains the same, the
yield on its benchmark must have increased which suggests macro factors caused bond yields to
increase in general. However, if yield spread increases, it suggests increase in bond’s yield was
caused by micro factors such as credit risk or issue’s liquidity.

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Term structure of interest rates
The term structure of interest rates, also called the yield curve, is a graph that plots the yields of
similar-quality bonds against their maturities, from shortest to longest. The yield curve represents
the changes in interest rates associated with a particular security based on length of time until
maturity. It enables investors to quickly compare the yields offered on short-term, medium-term
and long-term bonds.
The term structure of interest rates takes five primary shapes:

1. Normal Yield Curve

If short-term yields are lower than long-term yields, the curve slopes upwards and the curve is
called a positive (or "normal") yield curve. This yield curve is considered "normal" because the
market usually expects more compensation for greater risk.

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 2. Inverted Yield Curve

If short-term yields are higher than long-term yields, the curve slopes downwards and the curve
is called a negative (or "inverted") yield curve. Inverted yield curves present a point where short-
term rates are more favorable than long-term rates.

3. Flat Yield Curve

A flat term structure of interest rates exists when there is little or no variation between short and
long-term rates of bonds with same credit quality. This type of yield curve is often seen during
transitions between normal and inverted curves.

4. Steep Yield curve:

A steep curve indicates that the long-term yields are rising at a faster rate than short-term yields.
Steep yield curves have historically indicated the start of an expansionary economic period. Both
the normal and steep curves are based on the same properties but the only difference is that a
steeper curve has a larger difference between short term and long term return expectations.

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 5. Humped Yield Curve:

A humped yield curve is when medium-term yields are greater than both the short-term yields
and long-term yields. A humped yield curve is rare and typically indicates a slowing of economic
growth. The Humped Yield Curve is quite rare and rarely occurs.

In general, when the term structure of interest rates is positive, this indicates that investors desire
a higher rate of return for taking the increased risk of lending their money for a longer time
period. Many economists also believe that a steep positive curve means that investors expect
strong future economic growth with higher future inflation (and thus higher interest rates), and
that a sharply inverted curve means that investors expect sluggish economic growth with lower
future inflation (and thus lower interest rates). A flat curve generally indicates that investors are
unsure about future economic growth and inflation.

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Duration
Duration is used as a measure of bond’s interest rate risk or sensitivity of a bond’s price change
to a change in its yield. It is calculated as the weighted average of the number of years until each
of the bond’s promised cash flows is to be paid, where the weights are the present values of each
cash flow as a percentage of bond’s full value.
Example: Find the duration of a 6-year bond with FV= Rs. 500, yield = 8% and paying a coupon
of 5% annually.
Period Cash Flows Discount Factor DF x Cash /flows (A) X Period
(DF) (A)
1 25 1/(1.1)^1 = 0.909 22.72 22.73
2 25 1/(1.1)^2 = 0.826 20.65 41.32
3 25 1/(1.1)^3 = 0.751 18.775 56.35
4 25 1/(1.1)^4 = 0.683 17.075 68.3
5 25 1/(1.1)^5 = 0.621 15.525 77.62
6 525 1/(1.1)^6 = 0.5644 296.31 1778.09
Sum = 2044.41
Duration = 2044.41/FV of bond = 2044.41/500
Duration = 4.08 years

Modified Duration
Modified duration provides an approximate % change in a bond’s price for a 1% change in
YTM. It is calculated as
Modified duration = Duration
(1+YTM)
For the above example, modified duration = 4.08/(1+0.08) = 3.78 years

The price change for a given change in YTM can be calculated as:
Approximate % change in bond price = -ModDur x ∆YTM

Based on ModDur of 3.78, the price of bond should fall by approximately 3.78*0.1%=0.378% in
response to 0.1% change in YTM.

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Effective Duration
We can effective duration directly using bond values for an increase in YTM and for a decrease
in YTM of the same size. The calculation is based on a given change in YTM.
Effective Duration = (V_- V+)/(2*Vo*∆YTM)

V_ is price of bond if YTM is decreased by ∆YTM and V+ is price of bond if YTM is increased
by ∆YTM. The formula uses average of the magnitudes of price increase and decrease, which is
why numerator is divided by 2.
Example: For a 3 year, 4% annual pay bond currently trading at par, calculate the effective
duration based on a change in yield of 25 basis points.

Price of bond at yield of 4%+0.25%:

Period Cash Flow Present Value
1 4%*1000 = 40 40/(1+4.25%)^1 = 38.36
2 40 40/(1+4.25%)^2 = 36.805
3 1040 40/(1+4.25%)^3 = 917.92
Sum = 993.09

Similarly, price of bond at yield of 4%-0.25% = Rs. 1006.97

Effective Duration = (1006.97-993.09)/(2*1000*0.25%) = 2.77
Approximate change in price for a 1% change in YTM is 2.77%.

Convexity
Modified duration is a linear estimate of relation between a bond’s price and YTM, whereas the
actual relation is convex, not linear. This means that modified duration provides good estimates
of bond prices for small changes in yield, but increasingly poor estimates for larger changes in
yield as the effect of curvature of price yield curve is more pronounced. Therefore, the duration
based estimates of a bond’s price for a given change in YTM will be different from actual prices.
The price estimates can be improved by using convexity which is a measure of curvature of
price-yield relation. Convexity is increased or decreased by the same bond characteristics that
affect duration. A longer maturity, lower coupon rate, or lower YTM will increase convexity.

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Convexity = (V_+ V+ - 2Vo)/(2*Vo*∆YTM2)

Example: FV = Rs. 2000, Tenure = 40 years, Coupon = 10%, Yield = 10%, %∆YTM = 1%

YTM Price of Bond (actual) Change in price

9% 2215.15 +215.15
10% 2000
11% 1820.98 -179.02

As can be observed 1% change in YTM leads to uneven change in price. This is convexity.
Convexity = [2215.15+1820.98-2*2000]/[2*2000*(0.01)2] = 90.32

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