11/28/2017 Fixed Income

Management
Case Solution

Prathamesh Kadam
B17037
Case Background

Fixed investment management (FIM) is Mumbai based firm that advises its clients on
investment decisions. One of its most important client is the Amboli Golf Club (AGC). The board
of trustees of Amboli Golf Club handle the endowment fund of Amboli Golf Club. For Amboli
Golf Club, Fixed investment management handles fixed income portfolio of sum Rs. 50 crores.
Board of trustees of the AGC endowment has several professionals but no one of them is
expert in financial matters. Their standard practice is to gather four time a year, during the
second week of Jan, April, July and Oct, to evaluate the performance of the funds looking
backwards and its perspective looking forward.
Usually trustees of Amboli Golf Club would provide Fixed investment group with some medium
term goals. Then Fixed investment group will get back to them with list of few bonds matching
that criterion. Trustees then will convene to decide which bond or bonds to be bought.
Although FIM provided one recommendation per year, AGC typically held the bonds purchased
for more than a year.
For years, AGC group had mostly held safe and secure bonds that guaranteed return
with overriding emphasis on preservation of capital. However, in recent times cut in target GOI
rate from 7.783% to 6.549% has left AGC with no choice but to go riskier high-yields bonds.
Hence, they have mandated Robert of FIM to ‘find some safe bonds with a high risk yields’.
So now important task lying ahead for FIM is to find bonds for recommending to AGC
that provide high returns at the same time are safe. In meeting convened by Robert for deciding
bonds for recommendation, his analysts have come with 4 bonds for discussion. Robert has to
choose one from them on basis yield, default risk and interest risk of these bonds. Decision
should be taken shiftily as time as less for it and also should be sound so that trustees are not
disappointed with it and chooses to buy it for their portfolio. The bond which would provide the
best combination of yield and risk would become the final recommendation of FIM to the
trustees of AGC.

Financial Problems

1. Expectations for high returns with high risks

The Amboli Gold Club (AGC) is one of the major clients of Fixed Investment management
(FIM). As AGC handles an endowment fund with portfolio of around Rs. 50 crores, it’s a high
priority customer for FIM. However, AGC always had been prudent and cautious in their
investment approach with overriding emphasis on preservation of principal. AGC mostly held
Indian government bonds in its portfolio and as till now, target GOI interest rate has been

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 sufficiently high AGC never had much problems in the past. However, in recent times as target
GOI interest rate fell to 6.549%, AGC trust was having problems keeping up with their targets.
Hence, they had to switch to high yields bonds. But as they were also cautious with their capital
and didn’t want to erode it due one wrong choice, they made a strange request to find some
safe bonds for them with high yields. This goes against the basic principle of finance of ‘high
risks, high rewards’.

2. Yield calculations
Among the 4 bonds chosen for the final recommendation, each one of them were
trading at different prices in market. They also had different coupon rates and credit ratings
issued by credit agency, based on which organization was issuing them. All of them also had
different coupon payment scheduled. Only one similarity was among them was that all had
almost similar time to maturity remaining. At such times when all bonds varied on different
parameters, it become imperative for FIM to compare them on one common basis, i.e., Yield.
Hence, they needed to calculate it for each of those bonds to select one among them.

3. Interest rate risk

Though default risk of bonds is covered through the ratings of credit rating agencies,
none of the analyst had considered interest risk in their calculations. It’s mentioned that Rishab’s
Andra Pradesh State Financial Corporation had low interest risk whereas Ryan’s GOI treasury
note has high interest risk. However, none of them have been quantified hence we could not
compare this bonds on this measure hence calculating measure of interest risk that is modified
duration was important for all the bonds.

4. Default risk
Most of the bonds that were recommended this time to AGC from FIM diverted from
usual path of past. Not many of them from secure government treasuries. They varied in the
form, one was from private company, one was from state finance corporation and one was from
government enterprise. At such times, it becomes imperative to study their default risk as AGC
always had cautious approach to investing with over emphasis on capital preservation. Bonds
which will default can erode away capital of AGC endowment trust hence they need to choose
bonds wisely.

5. Contingency at FIM
FIM group had sudden contingency at firms recently. First, already existing client AGC
had come up with changed strange demand of safe bonds with high yields. Hence, FIM was
being challenged to find such investment from vast pool of bond market. Also, as AGC was a
huge client to FIM, it couldn’t say no to them. On the day Robert was supposed to submit the
recommendations to AGC, Rajdeep came into the office. Rajdeep was FIM’s best client and he
had another Rs. 20 Crore that he wanted to invest. But the problem was that needed the
investment to be done within the next two hours. Now Robert had to trust his analysts to
provide good solutions for AGC while he personally tended to Rajdeep’s needs.

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Analysis

We need to compare this bonds on basis of yield, convexity, duration and modified
duration. We also need to consider credit ratings of these bonds issued by credit rating agencies
as clients are very cautious about capital preservation of their funds.
To measure interest rate risk of bonds we are considering convexity and duration. To
measure default risks of these 4 bonds, we are considering credit ratings of these bonds issued
by credit rating agencies as AGC is particular about capital preservation and finally, to calculate
returns, we measure yields of all the bonds.

Bond Yield

A bond yield is the amount of return an investor realizes on a bond. 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.
Because yield to maturity is the interest rate an investor would earn by reinvesting every
coupon payment from the bond at a constant interest rate until the bond’s maturity date, the
present value of all of these future cash flows equals the bond’s market price. The method for
calculating YTM can then be represented with the following formula:

Duration

Duration is a measure of the sensitivity of the price -- the value of principal -- of a fixed-
income investment to a change in interest rates. Duration is expressed as a number of years.
Bond prices are said to have an inverse relationship with interest rates. Therefore, rising interest
rates indicate bond prices are likely to fall, while declining interest rates indicate bond prices are
likely to rise. The bigger the duration, the greater the interest-rate risk or reward for bond
prices.
The duration is also called as Macaulay duration and is calculated as following:

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where:
t = period in which the coupon is received
C = periodic (usually semiannual) coupon payment
y = the periodic yield to maturity or required yield
n = number periods
M = maturity value (in $)
P = market price of bond

Modified Duration

Modified duration is a formula that expresses the measurable change in the value of a security in
response to a change in interest rates. Modified duration follows the concept that interest rates and
bond prices move in opposite directions. This formula is used to determine the effect that a 100-basis-
point (1%) change in interest rates will have on the price of a bond. Modified duration is an extension of
something called Macaulay duration, which allows investors to measure the sensitivity of a bond to
changes in interest rates. Calculated as:

Convexity

Convexity is a measure of the curvature in the relationship between bond prices

and bond yields that demonstrates how the duration of a bond changes as the interest rate
changes. Convexity is used as a risk-management tool, and helps to measure and manage the
amount of market risk to which a portfolio of bonds is exposed.
Convexity is a better measure of interest rate risk, in relation to duration, because the
concept of duration assumes that interest rates and bond prices have a linear relationship.
Duration can be a good measure of how bond prices may be affected due to small and sudden
fluctuations in interest rates. However, the relationship between bond prices and yields is
typically more sloped, or convex. Therefore, convexity is a better measure for assessing the
impact on bond prices when there are large fluctuations in interest rates.

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Default Risk

Default risk is the chance that companies or individuals will be unable to the required
payments on their debt obligations. Lenders and investors are exposed to default risk in virtually
all forms of credit extensions. To mitigate the impact of default risk, lenders often charge rates
of return that correspond the debtor's level of default risk. A higher level of risk leads to a
higher required return.

I have used spreadsheet modelling for the calculation of price, yield, duration and
modified duration of bonds. Functions thus used were as following: -
PRICE: The price of a bond given its yield to maturity.
YLD: The yield to maturity of a bond given its price.
DURATION: The duration of a bond
MDURATION: The modified duration (or volatility) of a bond.

Convexity Calculations

Convexity = ((P+) + (P-) - (2Po)) / (2 x ((Po)(change in Y)²)))

Where (P+) is the bond price when the interest rate is decremented, (P-) is the bond price when
the interest rate is incremented, (Po) is the current bond price and the change in Y is the change
in interest rate and is represented in decimal form. "Change in Y" can also be described as the
bond's effective duration.

GOI T Bond SBI DSK ltd. AP State

FinCorp

Maturity 2-Aug-22 12-Sep-22 4-Aug-22 20-Mar-23

Redemption 100 100 100 100

coupon 0.0808 0.101 0.1275 0.0915

coupon payment yearly yearly quarterly Semi annually

Frequency 1 1 4 2

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credit rating AAA AAA BBB+ BB+

last traded price (%) 105.55 101.48 73.5 49.15

Settlement Date 1-Jan-17 1-Jan-17 1-Jan-17 1-Jan-17

Yield 0.0683716 0.0972621 0.2088788 0.260783942

8 1 5

Duration 4.60 4.49 3.69 4.01

Modified Duration 4.31 4.09 3.51 3.54

Yield + 25 basis point 0.0708716 0.0997621 0.2113788 0.263283942

8 1 5

Yield - 25 basis point 0.0658716 0.0947621 0.2063788 0.258283942

8 1 5

P+ 104.38567 100.41829 72.841391 48.69479776

4 6 6

P- 105.55000 101.48 73.5 49.15000001

0

P0 105.55 101.48 73.5 49.15

Change in Yield ( 50 0.005 0.005 0.005 0.005

bps)

Convexity -220.62078 -209.24406 -179.21316 -185.2297993

Default Ratings of Bonds

1. GOI Treasury bond

Crisil Rating: AAA
Safety Level: Highest Safety
Interpretation: Instruments with this rating are considered to have the highest degree of
safety regarding timely servicing of financial obligations. Such instruments carry lowest
credit risk.

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 2. State Bank of India
Crisil Rating: AAA
Safety Level: Highest Safety
Interpretation: Instruments with this rating are considered to have the highest degree of
safety regarding timely servicing of financial obligations. Such instruments carry lowest
credit risk.

3. D S Kulkarni Developers Limited

Crisil Rating: BBB+
Safety Level: Moderate Safety
Interpretation: Instruments with this rating are considered to have moderate degree of
safety regarding timely servicing of financial obligations. Such instruments carry
moderate credit risk.

4. Andhra Pradesh State Financial Corporation

Crisil Rating: BB+
Safety Level: Moderate Risk
Interpretation: Instruments with this rating are considered to have moderate risk of
default regarding timely servicing of financial obligations.

Recommendation

GOI T Bond SBI DSK ltd. AP State FinCorp

Maturity 2-Aug-22 12-Sep- 4-Aug- 20-Mar-23
22 22
Yield 6.84% 9.73% 20.89% 26.08%
Duration 4.60 4.49 3.69 4.01
Modified Duration 4.31 4.09 3.51 3.54
Convexity -220.62 -209.24 -179.21 -185.23
coupon 8.08% 10.10% 12.75% 9.15%
coupon payment yearly yearly quarterl Semi annually
y
credit rating AAA AAA BBB+ BB+
last traded price (%) 105.55 101.48 73.5 49.15

Based on all above bond characteristics, the most suitable bond for AGC is SBI bond. It has
attractive risks and returns characteristics that matches the expectations of clients. As AGC had
traditionally been investing in government T bonds, additional returns coming from SBI bonds
are plus for AGC.

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Also risk profile of bond is very low. Bond already has AAA rating hence AGC doesn’t have to
compromise on risk parameter as it is well contained. Also, SBI is a huge successful organization
hence, question of SBI defaulting and thus putting AGC capital to zero is very distant possibility.
Risk is lower even on duration and convexity scale.
Hence, we have recommended SBI for AGC for their portfolio holding.

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