Debt Market

A market for long term securities

 Debt Market
 Debt market is a place where fixed income securities of various types and
features are issued and traded.
 Instruments issued by central & state GOVT.s., municipal corporations,
Govt. bodies and commercial entities like financial institutions, banks,
public sector units, public ltd.company etc.
Why invest in fixed income securities
 Offer a predictable stream of payments in the form of interest and
repayment of principal at the maturity of instrument
 Investors benefit as the securities preserve and increase their invested
capital
 Ensure receipt of regular interest income
 Investors can neutralize the default risk by investing in govt. securities
 Greater safety and volatility as compared to other financial instruments
 Importance of Debt Market

 Efficient mobilization and allocation of resources in the economy

 Financing the development activities of the government
 Transmitting signals for implementation of the monetary policy
 Reduction in borrowing cost of the government
 Enable mobilization of resources at a reasonable cost
 Provide greater funding avenue to public and private sector projects
 Reduce the pressure on institutional financing
 Types of risks

 Default Risk- the risk an issuer of a bond may be unable to make timely payment of
interest or principal on a debt security
 Interest rate risk-emerging from an adverse change in the interest rate prevalent in the
market
 Reinvestment rate Risk- the probability of a fall in the interest rate resulting in a lack
of options to invest the interest received at regular intervals at higher rates compared
to the market
 Counter Party Risk- the normal risk associated with any transaction and refers to
failure of the opposite party to deliver the promised security or the sale-value at the
time of settlement
 Price Risk-the possibility of not being able to receive the expected price on any order
due to an adverse movement in the prices.
 Liquidity Risk:
Debt Terminology
 Face value/par value
 Coupon (The interest rate)
 Maturity
 Current Yield
 Yield to maturity(YTM)
 Duration
 Callable bond
 Put able bond
 Zero coupon bond
 FCCB
 Floating rate bond( cap and floor rate)
Bond with Maturity
Bond value = Present value of interest + Present value of
maturity value:
n
INTt Bn
B0   
t 1 (1  kd )t (1  kd ) n

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 problem
An investor is considering the purchase of 8 year
,Rs100 par value bond bearing a coupon rate of
interest of 12%. The required rate of return on this
bond is 14%. What is the present value of the bond.
Government is proposing to sell a 5-year bond of Rs
1000 at 8% rate of interest per annum. The bond
amount will amortized equally over its life. If an
investor has a minimum required rate of return of
7%.Wht is the value of bond now?
Yield to Maturity
 The yield-to-maturity (YTM) is the measure of a bond’s rate of return that
considers both the interest income and any capital gain or loss. YTM is bond’s
internal rate of return.
 A perpetual bond’s yield-to-maturity:

n
IN T IN T
B0  
t 1 (1  k d ) t

kd
 If a bond's coupon rate is less than its YTM, then the bond is selling at a
discount
 If a bond's coupon rate is more than its YTM, then the bond is selling at a
premium
 If a bond's coupon rate is equal to its YTM, then the bond is selling at par.
Problem
Market price of Rs 1000 par value bond, carrying a
coupon rate 9%, maturity after 8 years is Rs 800.
Calculate YTM.
A four year bond with the 7% coupon rate and
maturity value of Rs 1000 is currently selling at Rs
905. what is its YTM.
 Current Yield
 Current yield is the annual interest divided by the bond’s current value.
Example: The annual interest is Rs 60 on the current investment of Rs
883.40. Therefore, the current rate of return or the current yield is:
60/883.40 = 6.8 per cent.
Current yield does not account for the capital gain or loss.

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 Bond Values and Changes in Interest Rates
 The value of the bond declines as
the market interest rate (discount
rate) increases.
 The value of a 10-year, 12 per cent 1200.0
Rs 1,000 bond for the market 1000.0
interest rates ranging from 0 % to 800.0

Bond Value
30 %.
600.0

400.0

200.0

0.0
0% 5% 10% 15% 20% 25% 30%
Interest Rate

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Bond Maturity and Interest Rate Risk
 The intensity of interest rate
risk would be higher on bonds
with long maturities than bonds
with short maturities.
Present Value (Rs)
Discount rate (%) 5-Year bond 10-Year bond Perpetual bond
 The differential value response 5
10
1,216
1,000
1,386
1,000
2,000
1,000
to interest rates changes 15
20
832
701
749
581
667
500
between short and long-term 25 597 464 400

bonds will always be true.

Thus, two bonds of same
quality (in terms of the risk of 30 513 382 333
default) would have different
exposure to interest rate risk.

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Bond Maturity and Interest Rate Risk
2000
5-year bond
1750
10-year bond
1500 Perpetual bond
1250
Value (Rs)

1000
750
500
250
0
5 10 15 20 25 30
Discount rate (%)

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Duration
 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. Rising interest rates mean
falling bond prices, while declining interest rates mean rising bond
prices. The bigger the duration number, the greater the interest-rate risk
or reward for bond prices
 Bond Duration and Interest Rate Sensitivity
 The longer the maturity of a bond, the higher will be its sensitivity to
the interest rate changes. Similarly, the price of a bond with low
coupon rate will be more sensitive to the interest rate changes.
 However, the bond’s price sensitivity can be more accurately estimated
by its duration. A bond’s duration is measured as the weighted average
of times to each cash flow (interest payment or repayment of
principal).

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Problem
Calculate the duration for bond A and bond B with 7%
and 8% coupons having maturity period of 4years. The
face value is Rs 1000.Both the bonds are currently
yielding 6%. Also calculate modified duration
Consider a bond which has following feature, face
value Rs100,coupon interest rate 15% payable
annually, years to maturity is 6 yrs, redemption value
Rs100,current market price is Rs89.5, yield to maturity
18%. Calculate duration of the bond.
 Volatility
 The volatility or the interest rate sensitivity of a bond is given by its
duration and YTM. A bond’s volatility, referred to as its modified
duration, is given as follows:

D uration
V olatility of a bond 
(1  Y T M )

 The volatilities of the 8.5 per cent and 11.5 per cent bonds are as
follows:
4.252
Volatility of 8.5% bond   3.87
(1.100)
4.086
Volatility of 11.5% bond   3.69
(1.106)
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Immunization
 Immunization is technique to safeguard a bond portfolio from interest
rate risk and price risk.
 In immunization ,the coupon rate risk and the price risk can be made to
offset each other.
 Whenever there is an increase in interest rate, price of bond fall, at the
same time the newly issued bond offer high interest rate.
 So coupon from one bond can be reinvested in the bond offering high
interest rate and losses that occur due to price fall can be offset and the
portfolio is immunized.
problem
Abhishek has Rs 50,000 to make one time investment.
His son has entered the higher secondary school and
he needs his money after two years for his son’s
educational expenses. As abhishek’s outflow is one
time outflow, duration is simply two years. Now he has
a choices of two type of bonds.
a) Bond A has coupon rate of 7% and maturity period of
four years with a current yield of 10%.Current price is
Rs 904.90
b)Bond B has coupon rate of 6%,maturity period of one
year and current yield of 10%. Current price is
Rs963.64.
 Convexity
 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.
Explanation
 In the example above, Bond A has a higher convexity than Bond B,
which means that all else being equal, Bond A will always have a
higher price than Bond B as interest rates rise or fall.

As convexity increases, the systemic risk to which the portfolio is

exposed increases. As convexity decreases, the exposure to market
interest rates decreases and the bond portfolio can be considered
hedged. In general, the higher the coupon rate, the lower the convexity
(or market risk) of a bond. This is because market rates would have to
increase greatly to surpass the coupon on the bond, meaning there is
less risk to the investor.
Structure of Interest Rates
 Different factors determine the rate of interest:
Time
Default Risk
Marketability and Liquidity
Tax Status
Call Risk
Current and Expected Inflation
Existence of Transactions Costs
Estimating the appropriate Yield
Y=R +DP+LP+TA+CallP+Con D

Where Y= yield of a debt security

R= Risk free rate of return
DP=default premium
LP= liquidity premium
TA= adjustment due to difference in tax status
Call P=call feature premium to compensate for the possibility that
security will be called
con D= convertibility discount
 The Term Structure of Interest Rates
 Yield curve shows the relationship between the yields to maturity of
bonds and their maturities. It is also called the term structure of
interest rates.
 Yield Curve (Government of India Bonds)

Yield (%)
7.5%
7 .18 %
7.0%

6.5%

6.0%
5 .90 %
5.5%
M aturity
5.0% (Years )
0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 >10

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 The Term Structure of Interest Rates
 The upward sloping yield curve implies that the long-term yields are
higher than the short-term yields. This is the normal shape of the yield
curve, which is generally verified by historical evidence.
 However, many economies in high-inflation periods have witnessed the
short-term yields being higher than the long-term yields. The inverted
yield curves result when the short-term rates are higher than the long-
term rates.

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 The Expectation Theory
 The expectation theory supports the upward sloping yield
curve since investors always expect the short-term rates to
increase in the future.
 This implies that the long-term rates will be higher than the
short-term rates.
 But in the present value terms, the return from investing in
a long-term security will equal to the return from investing
in a series of a short-term security.

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 The Expectation Theory
 The expectation theory assumes
 capital markets are efficient
 there are no transaction costs and
 investors’ sole purpose is to maximize their returns
 The long-term rates are geometric average of current and
expected short-term rates.
 A significant implication of the expectation theory is that
given their investment horizon, investors will earn the same
average expected returns on all maturity combinations.
 Hence, a firm will not be able to lower its interest cost in
the long-run by the maturity structure of its debt.

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 The Liquidity Premium Theory
 Long-term bonds are more sensitive than the prices of the
short-term bonds to the changes in the market rates of
interest.
 Hence, investors prefer short-term bonds to the long-term
bonds.
 The investors will be compensated for this risk by offering
higher returns on long-term bonds.
 This extra return, which is called liquidity premium, gives
the yield curve its upward bias.

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 The Segmented Markets Theory
 The segmented markets theory assumes that the debt market is divided
into several segments based on the maturity of debt.
 In each segment, the yield of debt depends on the demand and supply.
 Investors’ preferences of each segment arise because they want to
match the maturities of assets and liabilities to reduce the susceptibility
to interest rate changes.
 The segmented markets theory approach assumes investors do not shift
from one maturity to another in their borrowing—lending activities and
therefore, the shift in yields are caused by changes in the demand and
supply for bonds of different maturities.

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Significance of term structure
Term structure can be used to
 Forecast interest rates
 Forecast recessions
 Make investment decision
 Financing decision
Impact of Debt management on Term structure
 Debt management involves the treasury’s decision to finance the deficit
 It involves use of a composition of short-term& long-term as sources of
finance.
 The composition can affect the level of investment and therefore
aggregate demand.