slide1 n.
Skip this Video
Download Presentation
Presentation on Indian Debt Market

Loading in 2 Seconds...

play fullscreen
1 / 57

Presentation on Indian Debt Market - PowerPoint PPT Presentation

  • Uploaded on

Presentation on Indian Debt Market. Overview of Financial Markets. The Basic Premise of Financial Markets- As we know, a market is where buyers and sellers meet to exchange goods, services, money, or anything of value. In a financial market,

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
Download Presentation

PowerPoint Slideshow about 'Presentation on Indian Debt Market' - seda

Download Now An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
The Basic Premise of Financial Markets-
  • As we know, a market is where buyers and sellers meet to exchange

goods, services, money, or anything of value. In a financial market,

the buyers are investors, or lenders: the sellers are issuers, or

borrowers. An investor / lender is an individual, company, government,

or any entity that owns more funds than it can use.

An issuer / borrower is an entity that has a need for capital. Each

investor and issuer is active in a market that meets its needs. Needs

are based on many factors, including a time horizon (short- or longterm),

a cost / return preference, and type of capital (debt or equity).

  • The third group of participants in the marketplace includes financial

intermediaries called brokers and dealers. Brokers facilitate the

buying and selling process by matching investors and issuers

according to their needs. Dealers purchase securities from issuers and

sell them to investors. Brokers and dealers may be referred to as

investment bankers. Investment banking firms specialize in the

financial markets.

What is a Security?
  • Security is a generic term that refers to a debt or equity IOU issued by

a borrower or issuer.

- Debt security or bond – an IOU promising periodic payments

of interest and/or principal from a claim on the issuer's


- Equity or stock – an IOU promising a share in the ownership

and profits of the issuer

Types of Financial Markets
  • There are two general classifications of financial markets:
  • · Money markets
  • · Capital markets
  • Money Markets
    • Money markets trade short-term, marketable, liquid, low-risk

debt securities. These securities are often called "cash equivalents"

because of their safety and liquidity. The liquidity of a market refers to

the ease with which an investor can sell securities and receive cash. A

market with many active investors and few ownership regulations

usually is a liquid market; a market with relatively few investors, only a

few securities, and many regulations concerning security ownership is

probably less liquid.

Capital Markets
  • Capital markets trade in longer-term, more risky securities. There

are three general subsets of capital markets: bond (or debt) markets,

equity markets, and derivative markets. Today, we will discuss

debt markets in more detail and will have a cursory glance at equity markets and

derivative markets

  • Debt markets specialize in the buying and selling of debt securities. To

illustrate how debt markets look, we will analyze a short example.


  • Suppose that HT Manufacturing Company needs new equipment for its

operations. Most companies try to match assets and liabilities

according to maturity (time left before the item is no longer useful).

The company expects the new equipment to have a useful life of about 10 years

and, therefore, after consulting with its financial advisors, HT Manufacturing

decides to issue 10-year bonds to pay for the equipment. HT Manufacturing

consults with investment bankers to find out what types of bonds investors are

buying and to decide what interest rate the bonds will pay. The object is to make

them attractive to investors, yet cost-efficient for HT Manufacturing.

After completing all of the details, HT Manufacturing issues the

bonds to investors using two methods.

1) The investment banks use their brokers to find buyers for the

bonds, and HT Manufacturing sells the bonds directly to the


2) The investment banks also act as dealers by buying some of the

bonds themselves, then selling them to investors.

The original issue of bonds (or bills, or any other debt security) is

called the primary market issue. A secondary market also exists

where debt securities are bought and sold by investors. For example,

suppose an investor who bought HT Manufacturing bonds one year ago

has a change in investment plans and no longer needs 10-year bonds.

S/he can sell the bonds in the secondary market (usually with the

assistance of a broker) to another investor who wants 10-year bonds.

Because this transaction has no effect on HT Manufacturing's finances

or operations, it is considered a secondary market transaction.

Equity markets, also called stock markets, specialize in the buying and

selling of equity securities (stocks) of companies. As in the debt

markets, the equity markets have a primary and secondary market.

  • The primary market is where companies originally issue stock in their

companies, a process known as an initial public offering — or "taking

the company public." Investment bankers advise a company on the

process and can also act as brokers and dealers for new stock issues.

  • The secondary market is where investors buy and sell stocks at prices

that reflect the investors' collective view of the future prospects of

each individual firm.

  • Derivative Markets

A derivative instrument is a security that derives its value from an

underlying asset, including financial assets such as stocks and bonds

or other assets such as commodities and precious metals. Derivative

instruments include future and forward contracts and options. These

instruments are bought and sold in the market by investors needing to

hedge risk exposure.

Market Participants In the Debt Market-
  • Central Governments, raising money through bond issuances, to fund budgetary deficits and other short and long term funding requirements.
  • Reserve Bank of India, as investment banker to the government, raises funds for the government through bond and t-bill issues, and also participates in the market through open-market operations, in the course of conduct of monetary policy. The RBI regulates the bank rates and repo rates and uses these rates as tools of its monetary policy. Changes in these benchmark rates directly impact debt markets and all participants in the market.
  • Primary Dealers, who are market intermediaries appointed by the Reserve Bank of India who underwrite and make market in government securities, and have access to the call markets and repo markets for funds.
  • State Governments, municipalities and local bodies, which issue securities in the debt markets to fund their developmental projects, as well as to finance their budgetary deficits.
  • Public Sector Units are large issuers of debt securities, for raising funds to meet the long term and working capital needs. These corporations are also investors in bonds issued in the debt markets.
  • Corporate treasuries issue short and long term paper to meet the financial requirements of the corporate sector. They are also investors in debt securities issued in the debt market.


7. Public Sector Financial Institutions regularly access debt markets with

bonds for funding their financing requirements and working capital

needs. They also invest in bonds issued by other entities in the debt


  • Banks are the largest investors in the debt markets, particularly the

treasury bond and bill markets. They have a statutory requirement to hold

a certain percentage of their deposits (currently the mandatory

requirement is 25% of deposits) in approved securities (all government

bonds qualify) to satisfy the statutory liquidity requirements. Banks are

very large participants in the call money and overnight markets. They are

arrangers of commercial paper issues of corporates. They are also active

in the inter-bank term markets and repo markets for their short term

funding requirements. Banks also issue CDs and bonds in the debt


  • Mutual Funds have emerged as another important player in the debt

markets, owing primarily to the growing number of bond funds that have

mobilised significant amounts from the investors. Most mutual funds also

have specialised bond funds such as gilt funds and liquid funds.


Mutual Funds are not permitted to borrow funds, except for very short-term liquidity

requirements. Therefore, they participate in the debt markets pre-dominantly as

investors, and trade on their portfolios quite regularly.

  • Foreign Institutional Investors FIIs can invest in Government Securities upto

US $ 5 billion and in Coporate Debt upto US $ 15 billion.

  • Provident Funds are large investors in the bond markets, as the prudential

regulations governing the deployment of the funds they mobilise, mandate

investments pre-dominantly in treasury and PSU bonds. They are, however, not

very active traders in their portfolio, as they are not permitted to sell their holdings,

unless they have a funding requirement that cannot be met through regular accruals

and contributions.

  • Charitable Institutions, Trusts and Societies are also large investors in the debt

markets. They are, however, governed by their rules and byelaws with respect to

the kind of bonds they can buy and the manner in which they can trade on their debt



Short term instruments

  • Call/Notice Money (1-14 days)
  • Term Money – FDs (upto 1 year)
  • Repo (1-14 days)- 1 yr
  • CBLO (1 day to 3 months)-(Collateral Borrowing &Lending Obligation)
  • Treasury Bills (91 day, 182 and 365 day)
  • Fixed deposit
  • Certificates of Deposits (upto 1 year)
  • Commercial Paper (upto 1 year)
  • Bills Rediscounting schemes (upto 6 months)


  • Long term instruments
  • Government of India dated securities (GOISECs)
  • Inflation linked bonds
  • Zero coupon bonds
  • State government securities (state loans)
  • Public Sector Undertaking Bonds (PSU Bonds)
  • Corporate debentures
  • Bonds of Public Financial Institutions (PFIs)


  • Short term instruments
  • Call/Notice Money (1-14 days)
  • Term Money – FDs (upto 1 year)
  • Repo (1-14 days)- 1 yr
  • CBLO (1 day to 3 months)-(Collateral Borrowing &Lending Obligation)
  • Treasury Bills (91 day, 182 and 365 day)
  • Fixed deposit
  • Certificates of Deposits (upto 1 year)
  • Commercial Paper (upto 1 year)
  • Bills Rediscounting schemes (upto 6 months)

Money Market

Call / Notice Money

  • It is an important segment of the Indian money market. In this market, banks and primary dealers borrow and lend funds to each other on unsecured basis.
  • If the period is more than 1 day and up to 14 days it is called “notice money”.
  • Money lent for 15 days to 1 year is called “term money”.
  • No brokers. Settlement is done between the participants through the current accounts maintained with the RBI.
  • In general, the call money rate, referred to as the overnightMIBOR.


  • Repurchase agreements are contracts for the sale and future repurchase of a financial asset, most often sovereign securities.
  • On the termination date, the seller repurchases the asset at the price agreed at inception of the repo.
  • The difference between the sale and repurchase prices represents interest for the use of the funds.
  • A repo is essentially a short term interest bearing loan against collateral.
  • A repo transaction for the borrower is a “reverse repo” transaction for the lender.

Collateralized Borrowing and Lending Obligation (CBLO)

  • As an alternative to the call money market, CCIL has developed CBLO, a money market instrument recognized by RBI.
  • An instrument issued at a discount and in electronic book entry form, for initial maturities ranging from one day to one year.
  • CBLO rates are generally comparable to market repo rates, both being secured transactions.

Treasury Bills

  • Promissory notes of the central government and therefore qualify as being free of credit risks.
  • Issued to meet short term funding requirements of the government account with Reserve Bank.
  • Sale is by auction. Any individual, corporate, bank, primary dealer or other entity is free to buy T-Bill.
  • Denominations of 91, 182 and 364 days.

Commercial Paper (CP)

  • Promissory notes issued by the corporate sector for raising short term funds.
  • Sold at a discount to face value.
  • Maturity can range between a minimum of 7 days and a maximum of 1 year.
  • CPs are required to be rated and the minimum rating eligibility is P2.
  • Every CP issue has an Issuing and Paying Agent (IPA), which has to be a scheduled bank.
  • Stamp duty is currently payable on CP issues, depending on the maturity and who the initial buyer is.

Certificate of Deposit (CD)

  • Similar to CPs except that the issuer is a bank.
  • Minimum amount of a CD can be Rs. 1 lakh and maturity between 7 days and 1 year.
  • Financial Institutions can issue CDs only for maturities between 1 and 3 years.

Bills Rediscounting Scheme

  • The RBI introduced the Bills Market Scheme (BMS) in 1952 which was later modified into the New Bills Market Scheme (NBMS).
  • Under this scheme commercial banks can rediscount the bills which were originally discounted by them with approved institutions (viz., Commercial Banks, Development Financial Institutions, Mutual Funds, Primary Dealers etc.)

Cash Reserve Ratio (CRR)

  • Amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down.
  • RBI uses this method (increase of CRR) to drain out the excessive money from the banks.
  • Currently at 4.00 %.

Repo Rate

  • Rate at which banks borrow from RBI.
  • Currently at 8 %.

Reverse Repo

  • Rate at which RBI borrows from banks.
  • Currently at 7 %.

Statutory Liquidity Ratio (SLR)

  • A percentage of time and demand liabilities banks have to invest in government bonds and other approved securities.
  • Currently at 22.0 %. RBI empowered to increase the ratio up to 40 %.

Derived Instruments

Pass Through Certificate

  • Fixed-income securities that represent an undivided interest in a pool of federally insured mortgages put together by the Government National Mortgage Association.
  • Mortgage-backed certificates are the most common type of pass-through, where homeowners' payments pass from the original bank through a government agency or investment bank to investors.

Certificate of Participation

  • A type of financing where an investor purchases a share of the lease revenues of a program rather than the bond being secured by those revenues.
  • The authority usually uses the proceeds to construct a facility that is leased to the municipality, releasing the municipality from restrictions on the amount of debt that they can incur.

Hedging Mechanism

Interest Rate Swaps

  • A swap is defined as “a financial transaction in which two counterparties agree to exchange streams of payments, or cash flows, overtime” on the basis agreed at the inception of the contract.
  • Interest payment streams of differing character, on an agreed, or notional, principal, are periodically exchanged.

Interest Rate Options

  • An agreement between two parties in which one grants to the other the right to buy (call option) or sell (put option) an asset under specified conditions (price, time) and assumes the obligation, to sell or buy it.
  • The party who has the right, but not the obligation, is the buyer of the option, and pays a fee, or premium, to the writer or seller of the option.
  • The asset could be a currency, bond, interest rate, share, commodity or a futures contract.
  • No Interest Rate options in the INR market at present.

Long term instruments

  • Government of India dated securities (GOISECs)
  • Inflation linked bonds
  • Zero coupon bonds
  • State government securities (state loans)
  • Public Sector Undertaking Bonds (PSU Bonds)
  • Corporate debentures
  • Bonds of Public Financial Institutions (PFIs)
Government of India dated securities (GOISECs):
  • GOISECs are issued by the Reserve Bank of India on behalf of the Government of India. These form a part of the borrowing program approved by Parliament in the Finance Bill each year (Union Budget).
  • They have maturity ranging from 1 year to 30 years.
  • GOISECs are issued through the auction route. The RBI pre specifies an approximate amount of dated securities that it intends to issue through the year
Inflation linked bonds:

These are bonds for which the coupon payment in a particular period is

linked to the inflation rate at that time - the base coupon rate is fixed with the

inflation rate (consumer price index-CPI) being added to it to arrive at the

total coupon rate. Investors are often loath to invest in longer dated securities

due to uncertainty of future interest rates. The idea behind these bonds is to

make them attractive to investors by removing the uncertainty of future

inflation rates, thereby maintaining the real value of their invested capital.

Zero coupon bonds:

These are bonds for which there is no coupon payment. They are issued at a discount to face value with the discount providing the implicit interest payment. In effect, these can be construed as long duration T - Bills or as bonds with cumulative interest payment.

  • State government securities (state loans) :

These are issued by the respective state governments but the RBI coordinates the actual process of selling these securities. Each state is allowed to issue securities up to a certain limit each year. State Government issue such securities to fund their developmental projects and finance their budgetary defictis

Public Sector Undertaking Bonds (PSU Bonds) :

These are long term debt instruments issued by Public Sector Undertakings

(PSUs). The term usually denotes bonds issued by the central PSUs (ie

PSUs funded by and under the administrative control of the Government of

India). The issuance of these bonds began in a big way in the late eighties

when the central government stopped/reduced funding to PSUs through the

general budget. Typically, they have maturities ranging between 5-10 years

and they are issued in denominations (face value) of Rs.1,000 each. Most of

these issues are made on a private placement basis to a targeted investor

base at market determined interest rates.

These PSU bonds are transferable by endorsement and delivery and no tax

is deductible at source on the interest coupons payable to the investor (TDS


Bonds of Public Financial Institutions (PFIs) :

Apart from public sector undertakings, Financial Institutions are also

allowed to issue bonds, that too in much higher quantum. They issue

bonds in 2 ways - through public issues targeted at retail investors and trusts

and also through private placements to large institutional investors. Usually,

transfers of the former type of bonds are exempt from stamp duty while only

part of the bonds issued privately have this facility. On an incremental basis,

bonds of PFIs are second only to GOISECs in value of issuance.

Corporate debentures:

These are long term debt instruments issued by private sector companies.

These are issued in denominations as low as Rs.1,000 and have maturities

ranging between one and ten years. Long maturity debentures are rarely

issued, as investors are not comfortable with such maturities. Generally,

debentures are less liquid as compared to PSU bonds and the liquidity is

inversely proportional to the residual maturity.

A key feature that distinguishes debentures from bonds is the stamp duty

payment. Debenture stamp duty is a state subject and the quantum of

incidence varies from state to state. There are two kinds of stamp duties

levied on debentures viz issuance and transfer. Issuance stamp duty is paid

in the state where the principal mortgage deed is registered. Over the years,

issuance stamp duties have been coming down and are reasonably uniform.

Stamp duty on transfer is paid to the state in which the registered office of

the company is located. Transfer stamp duty remains high in many states

and is probably the biggest deterrent for trading in debentures resulting in

lack of liquidity.

Bonds represent loans by investors to a company. In a bond contract, the

investor purchases a certificate from the issuer in exchange for a stream

of interest payments and the return of a principal amount at the end of

the contract. In this section we will discuss the terminology of the bond

market and the methodology for calculating the price (present value) of

a bond.

  • Bond Terminology

There are several terms that are commonly used by investors and

issuers when dealing with bonds.

Coupon The periodic interest payment made by the issuer.

When bonds were first developed, the bond certificate had detachable

coupons that the investor would send to the issuer to receive each

interest payment. The term still applies to payments, even though coupons

are no longer used to redeem them.

Coupon rate The interest rate used to calculate the coupon

amount the bond will pay. This rate is multiplied by the face value of the bond

to arrive at the coupon amount.

Face (par) value The amount printed on the certificate. The face

value represents the principal in the loan agreement, which is

the amount the issuer pays at maturity of the bond.

Maturity date The date the loan contract ends. At this time, the

issuer pays the face value to the investor who

owns the bond.

Bonds are often referred to as fixed income securities because they

have a fixed payout to the investor. Since the coupon rate is set before

the sale of the bond, the investor knows the amount of the interest


Process for Issuing Bonds

A simple example will illustrate the process for issuing bonds.

Example ABC Company needs capital to purchase a new piece of

equipment for its operations. The company meets with financial advisors and

investment bankers to discuss the possibilities of raising the necessary

capital. They decide that a bond issue is the least expensive method for the


The process is as follows:

1. ABC Company sets the maturity date and face value of the bonds.

The bonds will have a maturity date of ten years from the date of

issue and a face value of Rs.1,000. The company will issue as many

bonds as it needs for the equipment purchase – if the equipment

costs Rs.10,000,000 fully installed, then the company will issue

10,000 bonds.

2. Investment bankers set the coupon rate for the bonds.

The investment bankers attempt to gauge the interest rate environment and set the

coupon rate commensurate with other bonds with similar risk and maturity. The

coupon rate dictates whether the bonds will be sold in the secondary market at face

value or at a discount or premium. If the coupon rate is higher than the prevailing

interest rate, the bonds will sell at a premium; if the coupon rate is lower than the

prevailing interest rate, the bonds will sell at a discount.

3. Investment bankers find investors for the bonds and issue them in

the primary market.

The investment bankers use their system of brokers and dealers to find investors to

buy the bonds. When investment bankers complete the sale of the bonds to

investors, they turn over the proceeds of the sale (less the fees for performing their

services) to the company to use for the purchase of equipment. The total face

value of the bonds appears as a liability on the company's balance sheet.

4. The bonds become available in the secondary market.

Once the bonds are sold in the primary market to investors, they

become available for purchase or sale in the secondary market.

hese transactions usually take place between two investors – one

investor who owns bonds that are no longer needed for his/her

investment portfolio and another investor who needs those same


Pricing Bonds
  • Pricing a bond involves finding the present value of the cash flows

from the bond throughout its life. The formula for calculating the

present value of a bond is:

  • V = C[1 / (1+R)]1+ C[1 / (1+R)]2+ ... + C[1 / (1+R)]T+ F[1 / (1+R)]T
  • Where:

V = Present value of the bond

C = Coupon payment (coupon rate multiplied by face value)

R = Discount rate (current prevailing rate)

F = Face value of the bond

T = Number of compounding periods until maturity

  • What is the present value of a bond with a two-year maturity date, a face

value of Rs.1,000, and a coupon rate of 6%? The current prevailing rate for

similar issues is 5%. To apply the formula,

C = Rs.60 (Rs.1,000 x 0.06), R = 0.05, T = 2, and F = Rs.1,000.

V = C[1 / (1+R)]1 + C[1 / (1+R)]2 + F[1 / (1+R)]2

V = Rs.60[1 / (1+0.05)] + Rs.60[1 / (1+0.05)]2 + Rs.1,000[1 / (1+0.05)]2

V = Rs.60[0.95238] + Rs.60[0.90703] + Rs.1,000[0.90703]

V = Rs.57.14 + Rs.54.42 + Rs.907.03

V = Rs.1,018.59

The present value of Rs.1,018.59 is the price that the bond will trade for

in the secondary bond market. You will notice that the price is higher

than the face value of Rs.1,000. In the time since these bonds were

issued, interest rates have fallen from 6% to 5%. Investors are willing

to pay more for the Rs.60 interest payments when compared with new

bond issues that are only paying Rs.50 in interest per Rs.1,000 face value.

This inverse relationship is important.

As interest rates fall, bond prices rise;

As interest rates rise, bond prices fall.

  • A bond with a coupon rate that is the same as the market rate sells for

face value. A bond with a coupon rate that is higher than the prevailing

interest rate sells at a premium to par value; a bond with a lower rate

sells at a discount.

bond structure
Bond structure

Serial Number


Name of bond

e.g. GOI 2020

Nominal/Par Value

e.g. Rs.100.00

Coupon rate

12 ¼ % pa.

Redemption date

e.g. Dec 2020




Current Yield, in contrast to the Coupon Yield or Nominal Yield, is a Bond Yield that is determined by dividing the fixed coupon amount (that is paid as a percentage on the face or original value of the specific bond) by the current price value of the particular bond. In other words, Current Bond Yield = Coupon amount / current price of a bond.

For example:

The market price for a 8.24% G-Sec 2018 is Rs.118.85. The current yield on the security will be 0.0824 x 100 / 118.85 = 6.93 percent.

Yield to Maturity is the most popular measure of yield in the Debt Markets. YTM refers

to the percentage rate of return paid on a bond, note or other fixed income security if

the investor buys and holds the security till its maturity date.

The calculation for YTM is based on the coupon rate, the length of time to maturity and

the market price of the bond. YTM is basically the Internal Rate of Return on the bond.

It can be determined by equating the sum of the cash-flows throughout the life of the

bond to zero. One of the major assumptions underlying the YTM is that the coupon

interest paid over the life of the bond is assumed to be reinvested at the same rate.


The concept of Yield to Maturity assumes that the future cash flows are reinvested at the same rate at which the original investment was made.

Market price =

I/2 I/2 I/2 I/2+FV

---- + ---- + ---- ........... ------

(1+r) (1+r)2 (1+r)3 (1+r)n

where I/2 = annual interest rate payable half yearlyr = discount rate or YTMn = number of half years remaining to maturity


The approximate Yield to Maturity (YTM) can be computed as per the formula given below:

where I = Annual interest RateF = Face value of bondM = Market price of the bondN = Number of years to maturity

YTM* I+(F-M)/N

---------- = ---------

*(Approx.) (F+M)/2

Suppose Ramesh buys 12% GOI-2008 at Rs 102 and Suresh buys the same instrument at Rs 104 then the yield to maturity using approximation is For Ramesh,


YTM = --------------- = 11.59%



For Suresh,


YTM = -------------- = 11.20%


relationship between prices yield
Relationship between prices & yield







YTM = 10%

Coupon = 10%

Bond price = Rs100

Flat yield = 10%


YTM  = 12%

Bond price = Rs83

Flat yield = 12 %

YTM = 12%

Coupon = 10%

Bond price = Rs 83

Flat yield = 12%


YTM  = 12%

Bond price = Rs100

Flat yield = 10 %



Price Interest rate relationship:

The price of a government security is inversely related to the market interest rate. As the interest rate increases price decreases and therefore, the yield increases. However, if the interest rates fall the G-Sec become expensive and therefore, the yield falls.

  • Therefore, if the market price is equal to face value of the government security, then the current yield, coupon yield and Yield to maturity will all be equal to the coupon rate or interest payable on government security.

Coupon rate = Yield to maturity if, Market price = Face value

  • If Market Price is less than the face value of the government security the current yield and yield to maturity will be higher than the coupon yield than the coupon rate.

Coupon rate < Yield to maturity if, Market price < Face value

  • In cases where the market price of the government security/bond is more than its face value the current yield and Yield to maturity will be lower than the coupon rate.

Coupon rate > Yield to maturity if, Market price > Face value


Average Maturity-

Average Maturity is the weighted Average of the maturities of all the instruments in a portfolio.

Duration of a Bond-

  • Duration is the measure we use to estimate the average maturity of

a bond's cash flows. It represents the weighted average life of the

bond, where the weights are based on the present value of the

individual cash flows relative to the present value of the total cash

flows (current price of the bond).

  • Duration measures the sensitivity of a bond’s or portfolio’s, price to changes in interest rates.

- A three year duration portfolio will approximately rise ( fall ) 3% if interest rates fall (rise) by 100 bps (1%)

- A six year duration portfolio will rise (fall) 6% if interest rates fall (rise) by 100 bps (1%)


Relation of Duration with Maturity Date,YTM and Coupon Rate:

  • A bond's duration generally increases with the time to maturity,

holding the coupon rate constant.

  • The duration of a coupon bond is higher when the bond's yield to

maturity is lower.

  • The higher the coupon rate, the lower the duration.

Term Structure of Interest Rates

  • There are three main patterns created by the term structure of interest rates:

Normal Yield Curve: Remember that as general current interest rates increase, the price of a bond will decrease and its yield will increase.

Flat Yield Curve: Sends mixed signalsthat short-term interest rates will rise and other signals that long-term interest rates will fall.

Inverted Yield Curve :The inverted yield curve indicates that the market currently expects interest rates to decline as time moves farther into the future, which in turn means the market expects yields of long-term bonds to decline.

Remember, also, that as interest rates decrease, bond prices increase and yields decline.


The Credit Spread

  • The credit spread, or quality spread, is the additional yield an investor receives for acquiring a corporate bond instead of a similar federal instrument.
  • When inflation rates are increasing (or the economy is contracting) the credit spread between corporate and Treasury securities widens. This is because investors must be offered additional compensation (in the form of a higher coupon rate) for acquiring the higher risk associated with corporate bonds.
  • When interest rates are declining (or the economy is expanding), the credit spread between Federal and corporate fixed-income securities generally narrows. The lower interest rates give companies an opportunity to borrow money at lower rates, which allows them to expand their operations and also their cash flows. When interest rates are declining,

the economy is expanding in the long run, so the risk associated with investing in a long-term corporate bond is also generally lower.


Yield Curve Analysis

  • Yield Curve theory
    • Pure expectations theory

- Argues that yields differ with maturities because of market expectations of future changes in interest rates.

- For example, the 2-year yield is higher than the 1-year yield because the expectations about the 1-year yield 1-year from now, is factored in the 2-year yield is ruling now.

    • Liquidity preference theory

- If YTMs were equal across maturities, investors will prefer shorter maturity bonds because longer the maturity, greater the uncertainties, about the future inflation and interest rates.

- As compensation for the higher uncertainties, investors demand a higher yield (or liquidity premium) to invest in longer term securities.

-Weakness of the theory is that, on first principles, liquidity premium should go up with maturity.

    • Market Segmentation Theory
      • Different investors in different maturity segments, depending on their maturity

preference and asset liability management needs, and the yields are independent of each other.


Risks in Bond Investing

  • Interest rate risk ( price risk )

- Impact on price of a bond due to changes in interest rate changes

  • Credit risk

- Impact due to credit migration or default risk

  • Reinvestment risk

- Coupons get reinvested at different rates, impacting the total return of the portfolio

  • Liquidity risk
  • Event risk
  • Yield curve risk

- Yield curve shifts may not be parallel