Insurance Products Credit Products

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Products

Session 3

Direct Equity Sectoral Equity Funds Diversified Equity Funds Hybrid Funds Gold Long Term Debt Funds Short Term Debt Funds Unsecured Debentures Secured Debentures Fixed Maturity Plans Liquid Funds

Risk

Bank Fixed Deposits

Savings Bank Deposits

Direct Equity

At the end of session 2 we hadFunds Sectoral Equity covered upto here on the spectrum Diversified Equity Funds Balanced Funds of Investment Products.
Gold Long Term Debt Funds Short Term Debt Funds Unsecured Debentures Secured Debentures Fixed Maturity Plans Liquid Funds

Risk

Bank Fixed Deposits

Savings Bank Deposits

Now we move further up on the risk scale.

The next product we take up for study is

Risk

Unsecured Unsecured Debentures Debentures // Bonds Bonds

Secured Secured Debentures Debentures // Bonds Bonds

Bonds or debentures are debt instruments yielding a fixed rate of return over a definite period of time and which can be traded in the market. Unsecured Unsecured Debentures Debentures // Bonds Bonds Secured Secured Debentures Debentures // Bonds Bonds

Risk

A bond / debenture is basically a loan from the investor to the issuer of the instrument.

Unsecured Debentures / Bonds Secured Debentures / Bonds

Risk

Bonds usually refer to debt securities issued by government, semi-government bodies and public sector financial institutions and companies. Debentures usually refer to the debt securities issued by private sector companies. But the term bonds is more commonly used and is often used to refer to long term (more than one year) debt instruments in general.

Face value

The face value or the par value or the principal is the amount of money a holder will get back once a bond matures.

Coupon rate

The coupon rate is the interest rate that the issuer of a bond or other debt security promises to pay during the term of the loan.

Maturity

The maturity is the date in the future on which the investor's principal will be repaid.

Tenor or Residual Maturity or Term to Maturity

The time left for the repayment of the principal.

Market price

Bonds are traded in the market. The price at which they are traded may or may not be equal to the face value. This price is referred to as the market price.

Yield

Yield is a figure that shows the return you get on a bond. In simple terms it is given by (Coupon / Market Price) X 100

Zero Coupon Bonds

or or

Deep Discount Bonds

Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the accumulated interest.

For zero coupon bonds :

Face value = Issue price + Accumulated Interest

Yield To Maturity (ytm)

The rate of return anticipated on a bond if it is held until the maturity date. The calculation of ytm takes into account the current market price, par value, coupon rate and residual maturity. It is also assumed that all coupons are reinvested at the same rate. Sometimes this is simply referred to as "yield" for short.

While calculating the value of the bond, ytm is the rate at which the future flows of income from the bond the coupon and the repayment of principal are discounted to arrive at the Present Value (PV).

Value of a bond

PV of Coupon for year 1 + PV of Coupon for year 2 + PV of Coupon for year 3 + + + PV of Coupon for year n + PV of Principal repayment.

Value Value of of a a bond bond

= = PV PV of of Coupon Coupon for for year year 1 1

+ + PV PV of of Coupon Coupon for for year year 2 2 + + PV PV of of Coupon Coupon for for year year 3 3 + + + + + + PV PV of of Coupon Coupon for for year year n n + + PV PV of of Principal Principal repayment. repayment.
= =
1 (Coupon (Coupon for for year year 1) 1) // (1+ (1+ ytm) ytm)1 2 + + (Coupon (Coupon for for year year 2) 2) // (1+ (1+ ytm) ytm)2 3 + + (Coupon (Coupon for for year year 3) 3) // (1+ (1+ ytm) ytm)3 + + + + n + + (Coupon (Coupon for for year year n) n) // (1+ (1+ ytm) ytm)n n + + (Principal (Principal repayment) repayment) // (1+ (1+ ytm) ytm)n

Here ytm equals the market interest rate the rate which every bond is expected to yield.

If the price of a bond is such that its ytm is less than the market interest rate, its price will fall to make its ytm equal to the market interest rate; similarly if the price of a bond is such that its ytm is more than the market interest rate, its price will rise to make its ytm equal to the market interest rate.

Market Interest Rates and Bond Prices

As seen earlier, the interest rates and bond prices are inversely related. When rates rise, bond prices tend to fall, and when rates fall, bond prices tend to rise. If interest rates rise, newly issued bonds will pay higher interest than the older bonds. Typically, the older bonds will be worth less; so the demand for them will decrease and their market price will fall.

If, however, interest rates drop, newly issued bonds will pay lower interest than the older bonds. Then the older bonds will be typically worth more, and so the demand for them will increase and their market price will rise.

Interest rate risk in bonds

The possibility of fall in the value of a bond due to a rise in market interest rates.
Fall in Bond price Rise in market interest rate

Bond price
p1 p2

r1

r2

Market interest rate

Bond Price Volatility

By how much the bond price will change for a given change in yield, will depend on its duration.

Longer the duration of a bond, higher will be the bond price volatility therefore higher will be the interest rate risk in a bond.

Similarly, shorter the duration of a bond, lower will be the bond price volatility therefore lower will be the interest rate risk in a bond.

? n ? o i n t o i a rrat u d u s d i t s i a t h W Wha

Duration

Duration is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows (coupon or interest payments).

It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.

For each of the two basic types of bonds the duration is the following :

1. Zero-Coupon Bond Duration is equal to its time to maturity.

2. Straight Bond Duration is less than its time to maturity.

Duration

is the weighted average term to maturity of the cash flows from a bond. The weight of each cash flow is determined by dividing the present value of the cash flow by the price.

Duration Duration of of a a bond bond

= = (PV (PV of of Coupon Coupon for for year year 1 1 // Price Price of of bond) bond) X X1 1 year year + + (PV (PV of of Coupon Coupon for for year year 2 2 // Price Price of of bond) bond) X X2 2 years years + + (PV (PV of of Coupon Coupon for for year year 3 3 // Price Price of of bond) bond) X X3 3 years years + + + + + + (PV (PV of of Coupon Coupon for for year year n n // Price Price of of bond) bond) X Xn n years years + + (PV (PV of of Principal Principal repayment repayment // Price Price of of bond) bond) X Xn n years. years.

Default risk in bonds

The possibility of the principal not beig repaid and / or the interest not being paid.

Default risk can be assessed on the basis of Credit Ratings of the bonds.

Unsecured Unsecured Debentures Debentures // Bonds Bonds

Secured Secured Debentures Debentures // Bonds Bonds

d e r u c e s n U s / v d e r u Sec
Its all about default risk.

A secured debenture / bond is a debt instrument that is secured against specific physical assets of the issuer.

If the issuer defaults to pay the interest or repay the principal, the specified assets can be sold off and the proceeds used to meet the obligations.

As against this, an unsecured debenture / bond is a debt instrument that is not secured against any collateral.

Direct Equity

Sectoral Equity Funds We have covered Diversified Equity Funds the spectrum of Investment Products Balanced Funds upto here Gold Long Term Debt Funds Short Term Debt Funds Unsecured Debentures Secured Debentures Fixed Maturity Plans Liquid Funds

Risk

Bank Fixed Deposits

Savings Bank Deposits