Fixed Income Securities -1

Dr Meena Sharma
Contents

• Bond Characteristics
• Bond Types
• Coupon types
• Computation of different yields and bond price
• Relationship between yield and price
• Floaters and Inverse floaters
Why Investment is Important ?

• Every individual needs to put some part of his income into something which
would benefit him in the long run.
• Investment is essential as unavoidable circumstances can arise anytime and
anywhere.
• One needs to invest money into something which would guarantee maximum
returns with minimum risks in future.
• Money saved now will help you overcome tough times in the best possible way.
What is Equity?
• Equity investments refer to buying stocks and stock related mutual funds.
• When an investor invests in a stock they own a share of the firm’s assets and
revenues.
• They are convinced of the firm’s growth story and believe their investments can
grow as the firm grows.
• However, it also comes with a risk that the company might go southwards, and all
their investments will be gone. For example, if a company had a credit event and
had to file for bankruptcy then investors lose all the money.
• Equity can further be categorized into two types- Common stocks and preferred
stocks.
• Common stocks grant the investors the right to vote in shareholders’ meetings in
addition to a claim on profits. Preferential stock owners do get a claim on
dividends (In fact their claim is more than common stock owners) but they do not
have any right to vote.
What is Fixed Income?

• Fixed income, on the other hand, is the securities that provide a fixed guaranteed
result and hence the name “FIXED INCOME”.
• The cash flows are paid out for a fixed amount on regular intervals and the
principal at maturity. The returns might not be that great but do provide a secured
one.
• Fixed Income can be bonds – zero coupon or coupon, corporate deposits and may
be issued by a corporation or a sovereign entity – government or municipality.
• The maturity for these can range from 3 months to several decades.
• Investment grade bonds are considered to be the safest and give low returns while
junk bonds give better returns but also have a low credit rating and a greater
chance of default.
Criteria for Equity Equity Fixed Income
vs Fixed Income

Status Equity owners have shared owners of the Bond owners are creditors that can only claim the
company which allow them to claim profits. loaned amount and interest earned on it.

Issuers Equity is mainly issued by corporates. Government institutions, financial institutions or

Corporates issue bonds Corporate deposits are
issued by firms.

Risk Highly risky as it depends on the performance of Low risk as they are promised a fixed interest
the firm and the market conditions. irrespective of the firm’s performance

Claim to assets In case of bankruptcy, they have the last claim to In case of bankruptcy debt holders are prioritized
assets. over stockholders.

Returns High returns to compensate for high risks in the Low but guaranteed interest returns.
form of cost appreciation.

Dividends Dividends are cash flow of equity but paid at the No dividends are paid.
discretion of management.

Involvement Since stock owners are the owners of the firm, Bondholders have no say in the company matters
they have voting rights. and voting.
What are Bonds?

• Bonds are issued by organizations generally for a period of more than one
year to raise money by borrowing.
• Organizations in order to raise capital issue bond to investors which is nothing but
a financial contract, where the organization promises to pay the principal amount
and interest (in the form of coupons) to the holder of the bond after a certain date.
(Also called maturity date).
• Some Bonds do not pay interest to the investors, however it is mandatory for the
issuers to pay the principal amount to the investors.
Bond Terminology
• Coupon Interest Rate : The stated annual interest rate on the bond. It is usually
fixed for the life of the bond.
• Current yield: The coupon interest payment divided by the current market price of
the bond.
• Face amount or Par value: the maturity value of the bond. The holder of the bond
will receive the face amount from the issuer when the bond matures.
• Indenture: The contract that accompanies a bond and specifies the terms of the
loan agreement. It includes management restrictions, called covenants.
• Maturity: The number of years or periods until the bond matures and the holder is
paid the face amount.
• Yield to maturity: The yield an investor will earn if the bond is purchased at the
current market price and held until maturity.
Cont.…
• Market rate: The interest rate currently in effect in the market for securities of
like risk and maturity. The market rate is used to value bonds.
• Dividend Yield: is the ratio of per share expected or prospective dividends, gross
of tax, to the current market price of the share.
• Current Yield: In case of a bond, current yield is the ratio of stated (coupon)
interest per year to the current market price of the bond. It does not take into
account the return to be realized by the investor because of the appreciation
(depreciation) in the value of the bond. It is also known as market yield, or
running yield, or income yield.
Characteristics of a Bond

• A bond is generally a form of debt which the investors pay to the issuers for a
defined time frame. In a layman’s language, bond holders offer credit to the
company issuing the bond.
• Bonds generally have a fixed maturity date.
• All bonds repay the principal amount after the maturity date; however some bonds
do pay the interest along with the principal to the bond holders.
The Different Types of Bond Market In India

• Corporate Bond Market

• Municipal Bond Market
• Government and Agency Bond Market
• Funding Bond Market
• Mortgage Backed and Collateral Debt Obligation Bond Market
Types of Bonds
Following are the types of bonds:
• Fixed Rate Bonds
In Fixed Rate Bonds, the interest remains fixed through out the tenure of the
bond. Owing to a constant interest rate, fixed rate bonds are resistant to changes and
fluctuations in the market.
• Floating Rate Bonds
Floating rate bonds have a fluctuating interest rate (coupons) as per the current
market reference rate.
• Zero Interest Rate Bonds
Zero Interest Rate Bonds do not pay any regular interest to the investors. In such
types of bonds, issuers only pay the principal amount to the bond holders.
• Inflation Linked Bonds
Bonds linked to inflation are called inflation linked bonds. The interest rate of
Inflation linked bonds is generally lower than fixed rate bonds.
Cont..
• Perpetual Bonds
Bonds with no maturity dates are called perpetual bonds. Holders of perpetual
bonds enjoy interest throughout.
• Subordinated Bonds
Bonds which are given less priority as compared to other bonds of the company in
cases of a close down are called subordinated bonds. In cases of liquidation,
subordinated bonds are given less importance as compared to senior bonds which
are paid first.
• Bearer Bonds
Bearer Bonds do not carry the name of the bond holder and anyone who possesses
the bond certificate can claim the amount. If the bond certificate gets stolen or
misplaced by the bond holder, anyone else with the paper can claim the bond
amount.
Cont..

• War Bonds
War Bonds are issued by any government to raise funds in cases of
war.
• Serial Bonds
Bonds maturing over a period of time in instalments are called serial
bonds.
• Climate Bonds
Climate Bonds are issued by any government to raise funds when the
country concerned faces any adverse changes in climatic conditions.
General categorisation

Based on coupon interest rates, bonds can be classified into:

• Fixed rate bonds

• Floating rate bonds
• Zero-coupon bonds
Cont..

• Fixed rate bonds have a coupon that remains constant throughout the life of the
bond.
• A variation is a stepped-coupon bonds, whose coupon increases during the life of
the bond.
• Floating rate notes (FRNs, floaters) have a variable coupon that is linked to a
reference rate of interest, such as LIBOR or Euribor.
• For example the coupon may be defined as three month USD LIBOR + 0.20%.
The coupon rate is recalculated periodically, typically every one or three months.
Cont..
• Zero-coupon bonds pay no regular interest.
• They are issued at a substantial discount to par value, so that the interest is
effectively rolled up to maturity (and usually taxed as such).
• The bondholder receives the full principal amount on the redemption date. Zero-
coupon bonds may be created from fixed rate bonds by a financial institution
separating (“stripping off”) the coupons from the principal.
• In other words, the separated coupons and the final principal payment of the bond
may be traded separately.
What is a Coupon Bond?

• A coupon bond is a type of bond that includes attached coupons and pays periodic
(typically annual or semi-annual) interest payments during its lifetime and its par
value at maturity.
• These bonds come with a coupon rate, which refers to the bond’s yield at the date
of issuance.
• Bonds that have higher coupon rates offer investors higher yields on their
investment.
Advantages of Bonds
• The volatility of bonds (especially short and medium dated bonds)
is lower than that of equities (stocks).
• Bonds are generally viewed as safer investments than stocks.
• Bonds are a debt security under which the issuer owes the holders a debt and,
depending on the terms of the bond, is obliged to pay them interest (the coupon)
and or repay the principal at a later date, which is termed the maturity.
• Bonds are often liquid – it is often fairly easy for an institution to sell a large
quantity of bonds without affecting the price much.
• Bondholders also enjoy a measure of legal protection: under the law of most
countries, if a company goes bankrupt, its bondholders will often receive some
money back (the recovery amount).
• There are also a variety of bonds to fit different needs of investors; including
fixed rated bonds, floating rate bonds, zero coupon bonds, convertible bonds, and
inflation linked bonds.
• Bonds are attractive because of the comparative certainty of a fixed interest
payment twice a year and a fixed lump sum at maturity.
Disadvantages of Bonds

• Bonds are subject to risks such as the interest rate risk, prepayment risk, credit
risk, reinvestment risk, and liquidity risk.
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