Part-07 An Introduction to Fixed Income Securities
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Basics
What is debt?
It is a financial claim.
Who issues is?
The borrower of funds
For whom it is a liability
Who holds it?
The lender of funds
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For whom it is an asset 2
Basics (Cont…)
What is the difference between debt and equity?
Debt does not confer ownership rights on the holder. It is merely an IOU
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A promise to pay interest at periodic intervals and to repay the principal itself at a prespecified maturity date.
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Basics (Cont…)
It usually has a finite life span The interest payments are contractual obligations
Borrowers are required to make payments irrespective of their financial performance Interest payments have to be made before any dividends can be paid to equity holders. In the event of liquidation
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The claims of debt holders must be settled first Only then can equity holders be paid.
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Plain Vanilla & Bells and Whistles
The most basic form of a bond is called the Plain Vanilla version. This is true for all securities, not just for bonds. More complicated versions are said to have `Bells and Whistles’ attached.
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Face Value
It is the principal value underlying the bond. It is the amount payable by the borrower to the lender at maturity. It is the amount on which the periodic interest payments are calculated.
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Term to Maturity
It is the time remaining in the life of the bond. It represents the length of time for which interest has to be paid as promised. It represents the length of time after which the face value will be repaid.
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Coupon
The coupon payment is the periodic interest payment that has to be made by the borrower. The coupon rate when multiplied by the face value gives the dollar value of the coupon. Most bonds pays coupons on a semi-annual basis.
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Example of Coupon Calculation
Consider a bond with a face value of $1000. The coupon rate is 8% per annum paid semiannually. So the bond holder will receive 1000 x 0.08 ___ = $40 every six months. 2
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Yield to Maturity (YTM)
Yield to maturity is the rate of return that an investor will get if he buys the bond at the prevailing market price and holds it till maturity. In order to get the YTM, two conditions must be satisfied. The bond must be held till maturity. All coupon payments received before maturity must be reinvested at the YTM.
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Value of a Bond
A bond holder gets a stream of contractually promised payments. The value of the bond is the value of this stream of cash flows. However you cannot simply add up cash flows which are arising at different points in time. Such cash flows have to be discounted before being added.
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Price versus Yield
Price versus yield is a chicken and egg story, that is, we cannot say which comes first. If we know the yield that is required by us, we can quote a price accordingly. Similarly, once we acquire the asset at a certain price, we can work out the corresponding yield.
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Bond Valuation
A bond is an instrument that will pay identical coupon payments every period, usually every six months, for a number of years, and will then repay the face value at maturity. The periodic cash flows obviously constitute an annuity. The terminal face value is a lump sum payment.
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Bond Valuation (Cont…)
Consider a bond that pays a semi-annual coupon of $C/2, and which has a face value of $M. Assume that there are N coupons left, and that we are standing on a coupon payment date. That is, we are assuming that the next coupon is exactly six months away. The required annual yield is y, which implies that the semi-annual yield is y/2.
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Bond Valuation (Cont…)
The present value of the coupon stream is:
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Bond Valuation (Cont…)
The present value of the face value is:
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Bond Valuation (Cont…)
So the price of the bond is:
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Illustration
IBM has issued a bond with a face value of $1,000. The coupon is 8% per year to be paid on a semi-annual basis, on July 15 and January 15 every year. Assume that today is 15 July 2002 and that the bond matures on 15 January 2022. The required yield is 10% per annum.
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Illustration (Cont…)
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Par, Discount & Premium Bonds
In the above example, the price of the bond is less than the face value of $1,000. Such a bond is called a Discount Bond, since it is trading at a discount from the face value. The reason why it is trading for less than the face value is because the required yield of 10% is greater than the rate of 8% that the bond is paying by way of interest.
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Par, Discount & Premium Bonds (Cont…)
If the required yield were to equal the coupon rate, the bond would sell for $1,000. Such bonds are said to be trading at Par. If the required yield were to be less than the coupon rate the price will exceed the face value. Such bonds are called Premium Bonds, since they are trading at a premium over the face value.
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Zero Coupon Bonds
A Plain Vanilla bond pays coupon interest every period, typically every six months, and repays the face value at maturity. A Zero Coupon Bond on the other hand does not pay any coupon interest. It is issued at a discount from the face value and repays the principal at maturity. The difference between the price and the face value constitutes the interest for the buyer.
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Illustration
Microsoft is issuing zero coupon bonds with 5 years to maturity and a face value of $10,000. If you want a yield of 10% per annum, what price will you pay? The price of the bond is obviously the present value of a single cash flow of $10,000, discounted at 10%.
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Illustration (Cont…)
In practice, we usually discount the face value using a semi-annual rate of y/2, where y in this case is 10%. This is to facilitate comparisons with conventional bonds which pay coupons interest every six months.
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Zero Coupon Bonds (Cont…)
Zero coupon bonds are called zeroes by traders. They are also referred to as Deep Discount Bonds. They should not be confused with Discount Bonds, which are Plain Vanilla bonds which are trading at a discount from the face value.
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Treasury Securities
They are fully backed by the federal government or the central government of the issuing nation. Consequently they are devoid of credit risk or the risk of default. The interest rate on such securities is used as a benchmark for setting rates on other kinds of debt.
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U.S. Treasury Securities
The Treasury issues three categories of marketable securities. T-bills are discount securities
They are issued at a discount from their face values and do not pay interest.
T-notes and T-bonds are sold at face value and pay interest periodically.
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U.S. Treasury Securities (Cont…)
T-bills are issued with a original time to maturity of one year or less.
Consequently they are Money market instruments. They have maturities of either 3, 6, or 12 months at the time of issue.
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US. Treasury Securities (Cont…)
T-notes and T-bonds have a time to maturity exceeding one year at the time of issue.
They are therefore capital market instruments. T-bonds have an original maturity in excess of 10 years, extending up to 30 years.
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U.S. Treasury Securities (Cont…)
T-notes are similar to T-bonds except that their terms to maturity range from one to ten years. Notes and bonds are issued in amounts which range from 8-15 billion USD.
Bonds for which further tranches are issued can reach outstanding amounts of 20 billion USD or more
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U.S. Treasury Securities (Cont…)
The issuance of further tranches is termed as a Re-opening.
For instance, if a 20 year bond with a current time to maturity of 15 years is re-opened then an additional issue of 15 year bonds with the same coupon will be made to add to the outstanding amount in the market.
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U.S. Treasury Securities (Cont…)
The secondary market is liquid and transparent and trades take place through banks and primary dealers. Securities are also listed on the NYSE to accommodate overseas investors who may be permitted by regulations to trade only in listed securities.
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U.S. Treasury Securities (Cont…)
Settlement is arranged through FEDWIRE, which is the Federal Reserve’s wire transfer system
Foreign investors need to arrange for a local custodian with access to FEDWIRE.
Three month and six month bills are issued on a weekly basis. One year bills are issued every month.
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U.S. Treasury Securities (Cont…) Issue of T-notes and Bonds Issue
Frequency
Auction Month
2 Year
Monthly
Every month
3, 10 Year
Quarterly
Feb, May, Aug, Nov
5 Year
Monthly
Every month
30 Year
Semi-annually Feb and Aug
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U.S. Treasury Securities (Cont…)
Interest from these instruments is exempt from state income taxes. Guidelines of Mutual Reciprocity.
Federal bonds are exempt from state taxes Bonds issued by state governments are exempt from federal taxes The exemption applies only to interest income. Capital gains are taxable at normal rates.
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Primary Dealers
Who is a primary dealer?
A PD is a bank or securities broker-dealer that directly deals in U.S. government securities with the Federal Reserve Bank of New York. As of August 2004 there were 22 primary dealers, down from a number of 46 in 1988.
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The most important reason is consolidation. That is many firms have merged or refocused their core lines of business. 36
Primary Dealers (Cont…)
The FED requires primary dealers to participate meaningfully in both open market operations as well as Treasury Auctions. The current list of primary dealers is as follows.
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List of Primary Dealers
ABN Amro bank Banc of America Securities Bear, Stearns & Co. Citigroup Global Markets Credit Suisse First Boston Deutsche Bank Securities Goldman Sachs HSBC Securities Lehman Brothers Mizuho Securities Nomura Securities
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BNP Paribas Securities Corp. Barclays Capital CIBC World Markets Countrywide Securities Corp. Daiwa Securities America Dresdner Kleinwert Wasserstein Greenwich Capital Markets J.P. Morgan Securities Merrill Lynch Government Securities Morgan Stanley UBS Securities
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Treasury Auctions
The U.S. Treasury sells bills, notes, and bonds by way of a competitive auction process. Most of the treasury securities are bought by primary dealers. Individual investors who submit non-competitive bids participate on a much smaller scale.
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Treasury Auctions (Cont…)
The auction process begins with a public announcement by the Treasury giving the following information.
Offering amount Description of the offering Strips information
Is the security eligible for stripping
Procedures for submission of bids; minimum bid amount; and payment terms
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Treasury Auctions (Cont…)
Description of the offering includes:
Term and type of security CUSIP number Auction date Issue date Dated date Maturity date Interest payment dates
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Treasury Auctions (Cont…)
Bids may be:
Small investors and individuals generally submit non-competitive bids
Competitive Non-competitive
The bidder merely indicates the quantity sought The price is determined by the auction process
A non-competitive bidder may not bid for more than $1MM worth of securities in a bill auction
Or more than 5 million in a note or bond auction
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Treasury Auctions (Cont…)
Primary dealers who bid for their accounts or on behalf of their clients usually submit large competitive bids
These bids indicate not only the quantity that is sought But also the maximum price that the bidder is prepared to pay if it is a price based auction Or the minimum yield that the bidder is prepared to accept if it is a yield based auction
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Treasury Auctions (Cont…)
Bidders are forbidden from bidding both competitively and noncompetitively for the same account in the same auction. Competitive bidders can submit multiple bids
But no bidder may receive more than 35% of the security being sold.
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Treasury Auctions (Cont…)
Bids are submitted in terms of discount rates for bills
Stated in 3 decimal places In 0.005 percent increments
In note and bond auctions
They are expressed as yields up to 3 decimal places In 0.001 percent increments
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Treasury Auctions (Cont…)
Competitive bids are accepted till 1:00 p.m. EST on the day of the auction The deadline for non-competitive bids is 12:00 EST on the auction date
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Treasury Auctions (Cont…)
Once the bids are received the Treasury will net out the total amount of noncompetitive bids and will begin allocating the balance to competitive bidders. There are two ways in which securities can be allotted
The multiple price/yield auction mechanism The uniform price/yield auction mechanism
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Illustration
Assume that the Treasury is offering 15 billion dollars worth of T-bonds. 2 billion dollars worth of non-competitive bids have been received. So 13 billion dollars worth of bonds are available to be offered to the competitive bidders.
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Illustration (Cont…)
Assume that there are six competitive bidders who have submitted the following yields.
The bids have been arranged in ascending order of yield. Had it been a price based auction the bids would have been arranged in descending order of price.
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Illustration (Cont…) Bidder
Bid Yield
Bid Amount
Aggregate Amount
Alpha
5.370
3.0 bn
3.0 bn
Beta
5.372
3.0 bn
6.0 bn
Gamma
5.373
4.0 bn
10 bn
Delta
5.375
3.0 bn
13 bn
Charlie
5.375
2.0 bn
15 bn
Tango
5.380
2.0 bn
17 bn
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Illustration (Cont…)
The aggregate demand equals the amount on offer at a yield of 5.375. A multiple yield auction will lead to the following allocation.
Alpha will get 3 bn at a yield of 5.370 Beta will get 3 bn at 5.372 Gamma will get 4 bn at 5.373
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Illustration (Cont…)
By the time we reach a yield of 5.375 we have only 3 bn left to allocate. There is a demand of 5 bn at this yield
3 bn from Delta and 2 bn from Charlie.
So there will be pro-rata allocation
3/5 of 3 bn or 1.8 bn will go to Delta 2/5 of 3 bn or 1.2 bn will go to Charlie
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Illustration (Cont…)
The highest yield that is accepted at the auction is called the Stop Yield
In this case it is 5.375
The ratio of bids received to the amount awarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Illustration (Cont…)
The difference between the average yield of all accepted bids and the stop yield is called the tail of the auction. A multiple price/yield auction is also known as a discriminatory auction
Since each successful bidder is allotted at the price/yield bid by him or her.
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Illustration (Cont…)
The second type of auction is called a uniform price/yield auction. In our case aggregate demand is equal to the supply at a yield of 5.375%. Consequently everyone who bid less will be allotted the quantities sought by them at this yield. The two bidders at 5.375 will also be awarded at this yield but on a pro-rata basis.
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Illustration (Cont…)
Those who bid more than 5.375 will get nothing and are said to be shutout of the auction. Since 1999 the U.S. Treasury has been conducting only uniform yield auctions.
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Treasury Auctions (Cont…)
The auction results are released to the public within two hours of the auction. The following information is made public:
The amount of bids received The total bids accepted The bid to cover ratio High, low and median bids The issue price
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Illustration-I: A Real Treasury Auction
Announcement date: 2 August Offering amount: $ 10 billion Term and type of security:
4 ¾ year note (reopening of a 5 year note) Series: E 2005 CUSIP No.: 912827 6D9 Auction date: 8 August 2000 Issue date: 15 August 2000 Dated date: 15 May 2000 Maturity date: 15 May 2005
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Illustration-I (Cont…)
Interest rate: 6 3/4 % Amount currently outstanding: $15.426 billion Yield: To be determined at the auction Interest payment dates: 15 November and 15 May Minimum bid amounts and multiples: $ 1,000 Premium or discount: To be determined at the auction
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Analysis
This auction is a re-opening of a 5 year note issued on 15 May 2000.
Consequently the securities being issued have 4 ¾ years to maturity.
Although the auction is announced on 2 August the actual auction date is 8 August. The securities will however be issued only on 15 August. The dated date is 15 May which is when the original 5 year security was issued.
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Analysis (Cont…)
The dated date is different from the issue date because the issue is being reopened. The maturity date is 15 May 2005. The interest rate or the coupon is known since the security is already trading in the market. The yield will be determined at the auction.
Consequently the issue price and the premium/discount with respect to the face value will also be determined at the auction.
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Illustration-II
Auction announcement date: 2 August Offering amount: 10 billion Term and type of security: 10 year note Series: C 2010 CUSIP No.: 912827 6J6 Auction date: 9 August 2000 Issue date: 15 August 2000 Dated date: 15 August 2000 Maturity date: 15 August 2010
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Illustration-II (Cont…)
Interest rate: Determined based on the highest accepted competitive bid Amount currently outstanding: Not applicable Yield: Determined at auction Interest payment dates: 15 Feb and 15 August Minimum bid amounts and multiples: $ 1,000 Premium/discount: To be determined at the auction
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Analysis
This auction represents a fresh issue of a 10 year T-note The coupon rate is unknown at the outset since it will be fixed based on the bids received.
Assume that the market clearing yield is 4.920% The coupon will be set after rounding down the winning bid to the nearest multiple of 1/8th which in this case is 4.875%.
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Zero Coupon Treasury Securities
The Treasury per se does not issue zero coupon securities. But there exist two types of treasury based zero coupon securities. The principle behind both forms is the same.
Take a large quantity of a T-note or bond and separate all the coupons from each other and from the principal. Sell the entitlement to each cash flow separately.
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Zero…(Cont…)
Take the case of a two-year T-note. It can be separated into four zero coupon securities maturing after:
6 months 12 months 18 months 24 months
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Zero…(Cont…)
Earlier investment banks used to buy regular coupon bonds from the Treasury and then separate the cash flows themselves. Each cash flow was then sold separately as a zero coupon bond. Such issues are called trademarks.
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Zero…(Cont…)
The issue of trademarks has now ceased. This is because investment banks can now create such instruments in concert with the Treasury itself. These zero coupon bonds are known as STRIPS – Separate Trading of Registered Interest and Principal of Securities.
These are not issued or sold by the Treasury The market is made by investment banks. But such issues are considered to be an obligation of the Treasury.
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Trademark Products
Some of the older trademark products which have not yet matured continue to trade. The process of issuing trademarks was begun by Merrill Lynch and Salomon Brothers in 1982. These securities are synthetic zero coupon Treasury receipts.
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Trademarks (Cont…)
The procedure for issuing them is as follows:
The bank concerned would purchase a Treasury coupon bearing security and deposit it in a bank custody account. It would then issue receipts representing an ownership interest in each coupon payment on the underlying asset, as well as a receipt for ownership of the maturity value.
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Trademarks (Cont…)
The process of separating each coupon payment as well as the principal and selling securities backed by them is referred to as Coupon Stripping. The receipts issued in the process are not created by the Treasury. But the underlying asset in the bank custody account is an obligation of the Treasury. Thus the cash flows from the underlying asset are guaranteed.
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Example
Assume that a bank purchases $100 MM worth of a Treasury note with a 10 year maturity and a coupon of 10%.
This note will yield 20 coupon payments of $5 million each and a final principal repayment of $100 million.
This note will be deposited in a custody account.
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Example (Cont…)
21 zero coupon securities will then be issued.
Each will represent a claim on one cash flow from the underlying security. The first 20 such securities will have a face value of $5 million. The last will have a face value of $100 MM. The maturity dates for the receipts will coincide with the coupon payment dates on the underlying.
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Trademarks (Cont…)
Merrill Lynch marketed its Treasury receipts as Treasury Income Growth Receipts – TIGRS for short. Salomon Brothers called its receipts as Certificates of Accrual on Treasury Securities – CATS for short. Lehman Brothers offered Lehman Investment Opportunities Notes or LIONS for short.
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Trademarks (Cont…)
These securities are called trademarks because each is associated with a particular investment banking firm. They are called Animal Products for obvious reasons. This segment of the financial market was also referred to as the Zoo.
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Trademarks (Cont…)
Receipts created by one firm were rarely traded by others.
So the secondary market was illiquid.
What is the motivation for investment banks to create such products? In practice arbitrage is possible when a Treasury coupon security is purchased at a price that is lower than what could be obtained by selling each cash flow separately.
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STRIPS
The Treasury launched this programme in 1985 to facilitate the stripping of designated Treasury securities.
All new T-bonds and notes with a maturity of 10 years or more are eligible. The zeroes created in the process are direct obligations of the U.S. government. They are cleared through the Federal Reserve’s book-entry system.
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STRIPS (Cont…)
On dealer quote sheets and vendor screens, STRIPS are identified as follows. Cash Flow Source Coupon Principal from Tbond
Symbol ci bp
Principal from Tnote
np
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Floating Rate Bonds
In the case of a Plain Vanilla Bond, the coupon rate that is specified at the outset, is valid for the life of the bond. In the case of a Floating Rate bond, the coupon rate is reset at the beginning of every period, and is therefore valid for only the next six months. Thus when you buy such a bond, the coupon will be known only for the first six months. Subsequent coupons will be unknown.
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Floaters
For instance the rate on a floating rate bond, also called a Floater, may be specified as LIBOR + 50b.p. in which case the spread is positive. Or it may be specified as LIBOR – 30b.p., in which case the spread is negative. The rate of interest on a floater will move directly with changes in the benchmark. Thus if LIBOR rises, the rate will increase, whereas if LIBOR falls, the rate will decrease.
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Inverse Floaters
In the case of an inverse floater the coupon varies inversely with the benchmark. For instance the rate on an inverse floater may be specified as 10% - LIBOR. In this case as LIBOR rises, the coupon will decrease, whereas as LIBOR falls, the coupon will increase. In this case a floor has to be specified for the coupon.
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Inverse Floaters (Cont…)
In the absence of a floor the coupon can become negative in principle. In the above case, if LIBOR were to exceed 10%, then we would be confronted with the spectre of a negative coupon.
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Callable Bonds
In the case of such a bond, the issuer has the right to call back the bond prematurely. That is he can buy it back from the holder before maturity by paying him the face value. In this case the option is with the issuer, and so he has to pay a price for it. This compensation will manifest itself as a lower price for the bond as compared to a Plain Vanilla Bond.
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Callable Bond (Cont…)
Since prices and yields are inversely related a lower price means a higher yield. Thus buyers of callable bonds demand a higher yield from them as compared to buyers of otherwise similar plain vanilla bonds. This is because a buyer of a callable bond is exposed to cash flow uncertainty. That is, he can never be sure as to when a bond will be recalled.
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Callable Bonds (Cont…)
When will a callable bond be recalled? Obviously when interest rates or required yields are falling. Under such conditions, the issuer can call back the bonds and issue fresh bonds with a lower coupon. However this is precisely the scenario when a holder would like to hold on to his bonds, since they are yielding a higher rate of interest.
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Callable Bond (Cont…)
Thus the call provision works in favour of the borrower and against the lender. Hence it is not surprising that callable bonds command a lower price. Freely callable bonds can be called at any time. Thus they offer the lender no protection.
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Callable Bonds (Cont…)
Deferred Callable Bonds on the other hand do offer some protection. This is because they have a Call Protection Period during which they cannot be recalled. For instance if a bond with 20 years to maturity has a call protection period of 10 years, then it cannot be recalled for the first 10 years. After that, it will of course become freely callable.
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Callable Bond (Cont…)
In practice when a bond is recalled, the issuer will pay the lender not just the face value, but usually also one year’s coupon. This additional amount is called the Call Premium. The call premium acts as a sweetener, that is it makes such bonds more attractive to potential investors.
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Callable Bond (Cont…)
One of the risks in a callable bond is therefore reinvestment risk
That is, the bond will be called back when market rates are low and consequently the proceeds will have to be invested at a lower rate of interest.
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Callable Bond (Cont…)
Second, the price appreciation potential for a callable bond in a declining interest rate environment is limited.
This is because the market will increasingly expect the bond to be redeemed at the call price as rates fall. This is referred to as Price Compression.
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Callable Bond (Cont…)
Given the reinvestment risk and price compression why would any investor want to hold such a bond.
If he receives sufficient compensation in the form of a higher yield he may be willing to take the risk.
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Puttable Bonds
Such bonds give the lender or the bondholder, the right to return the bond prematurely, and take back the face value. The option in such cases is with the bondholders or the lenders, and consequently they have to pay an option premium. This will manifest itself as a higher bond price, as compared to that of an otherwise similar plain vanilla bond.
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Puttable Bonds (Cont…)
A higher bond price obviously means a lower yield. When will such a put option be exercised? Obviously when interest rates are rising. Under such conditions holders can return the bonds and buy fresh bonds with a higher coupon rate. This is precisely the scenario when the issuers would prefer that the holders hold on to the bonds.
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Puttable Bonds (Cont…)
Since the put option works in favour of the holder and against the issuer, it is but natural that such bonds are characterized by higher prices or lower yields. The price at which a bond can be sold back by the holder acts as a floor price for the bond when interest rates rise. Since the holders can always return the bonds to the issuer at this price, they will never sell them to anyone else at a lower price.
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Convertible Bonds
A conversion provision, if present in the bond, grants the bondholder the right to convert the bond into a predetermined number of shares of common stock of the issuer.
It is therefore a Plain Vanilla corporate bond with a call option to buy the common stock of the issuer.
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Convertible Bonds (Cont…)
The number of shares of common stock that a bondholder will receive if he converts the bond is called the Conversion Ratio.
The conversion privilege may extend for all or only some portion of the bond’s life. The stated conversion ratio may also decline over time. The conversion ratio is always adjusted proportionately for stock splits and stock dividends.
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Convertible Bonds (Cont…) Illustration
ABC Corporation has issued the following bond
Maturity = 10 years Coupon rate = 8% Conversion ratio = 40 Face value = $1,000 Current market price = $900 Current share price = $20 Dividends per share = $1
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Convertible Bonds (Cont…)
The conversion price = 1000 ------- = $25 40 The conversion value of a convertible bond is the value if it is converted immediately.
Conversion value = Share price x Conversion Ratio
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Convertible Bond (Cont…)
The minimum price of a convertible bond is the greater of:
Its conversion value or Its value as a bond without the conversion option . This is also called the straight value of the bond.
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Convertible Bond (Cont…)
To estimate the straight value we must determine the required yield on a non-convertible bond with the same credit rating and similar investment characteristics.
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Convertible Bond (Cont…)
In our case the conversion value is
$20 x 40 = $800
To determine the straight value we have to obtain the YTM of a comparable straight bond. Assume it is 10%.
Straight value = 40PVIFA(5,20)+1000PVIF(5,20) = $875.38
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Exchangeable Bonds
These are a category of convertible bonds where the holder gets the shares of a different company when he converts the bonds. For instance if IBM were to issue convertible bonds, the holders would get shares of IBM if they were to convert. On the other hand, if IBM were to issue exchangeable bonds, the holders would get shares of another company, say Hewlett Packard.
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Exchangeable Bonds (Cont…)
Exchangeable bonds may be issued by firms which own blocks of shares of another company and intend to sell them eventually. They may like to defer the sale and issue such bonds, because they may perceive a rise in the value of the shares. It may also be the case that they desire to defer their capital gains tax liability.
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Risks Inherent in Bonds
What is risk? Risk is the possibility of loss arising due to the uncertainty regarding the outcome of a transaction. All bonds are exposed to one or more sources of risk.
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Credit Risk
This risk refers to the possibility of default by the borrower. That is, it refers to the risk that coupon payments and/or principal payments may not be forthcoming as promised. Except for Treasury securities, which are backed by the full faith and credit of the Federal government, all debt securities are exposed to credit risk of varying magnitudes.
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Credit Evaluation
At the time of issue, it is the issuer’s responsibility to provide accurate information about his financial soundness and creditworthiness. This is provided in the Offer Document or the Prospectus. But every potential investor cannot be expected to be able to properly evaluate the creditworthiness of a borrower. Thus in practice we have credit rating agencies.
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Credit Rating Agencies
Such agencies specialize in evaluating the credit quality of a bond at the time of issue. They also monitor the issuing company, throughout the life of the bond, and modify their recommendations if required. The main rating agencies in the U.S. are Moody’s Investors Service, Standard and Poor’s Corporation and Fitch Ratings.
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Rating Criteria
Ratings are based on an in-depth analysis of the issuer’s financial condition and management, and the specific source of revenue that has been specified as collateral for the bond.
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Investment Grade Ratings Credit Risk
Moody’s S&P’s Ratings Ratings
Fitch’s Ratings
Highest Quality High Quality
Aaa
AAA
AAA
Aa
AA
AA
Upper Medium
A
A
A
Medium
Baa
BBB
BBB
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Non Investment Grade Ratings Credit Risk
Moody’s
S&P
Fitch
Somewhat Speculative
Ba
BB
BB
Speculative
B
B
B
Highly Speculative
Caa
CCC
CCC
Most Speculative
Ca
CC
CC
Imminent Default
C
C
C
Default
C
D
D
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Changes in Ratings
Ratings can change over the course of time. If a rating change is being contemplated, the agency will signal its intentions. S&P will place the security on Credit Watch. Moody’s on Under Review. Fitch on Rating Watch.
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Bond Insurance
A company can have its issue insured in order to enhance its credit quality. An insurance premium will have to be paid, but the coupon rate will come down. The insurance company will then guarantee the timely payment of the principal and interest.
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List of Specialist Insurance Companies American Municipal Bond Assurance Corporation (AMBAC) ACA Financial Guaranty Asset Guaranty Insurance Company AXA Re Finance Capital Guaranty Insurance Company Capital Reinsurance Company Enhance Reinsurance Company Financial Guaranty Insurance Company Financial Security Assurance Municipal Bond Insurance Association 11/27/09
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Insured Bonds
Insured bonds receive the same rating as the insurance company, which is based on the insurer’s capital and claims-paying ability. In the U.S., the buyer of an uninsured bond can separately buy insurance for it on his own.
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Liquidity Risk
This risk refers to the possibility that the market may be illiquid or thin at a time when the asset holder wants to buy or sell the security. A liquid market is characterized by the presence of a sizeable number of buyers and sellers at any point in time.
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Illiquid Markets
In illiquid markets, potential buyers will have to offer a large premium over the fair value of an asset in order to acquire it, whereas potential sellers will have to accept large discounts at the time of sale. Illiquid markets are characterized by large bid-ask spreads, because trades will be few and far between.
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Interest Rate Risk
The interest rate or yield is the key variable of interest in debt markets. The yield is the fundamental variable that drives the market. Interest rate risk refers to the fact that rates may move in an adverse fashion from the standpoint of the holder of the debt instrument.
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Interest Rate Risk
Interest rate risk impacts fixed income securities in two ways. Firstly, all bonds with the exception of zeroes pay coupons, which have to be reinvested. Reinvestment risk is the risk that market rates of interest may decline by the time a coupon is received.
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Interest Rate Risk (Cont…)
If so, the coupon will have to be reinvested at a lower than anticipated rate of interest. Secondly a bond may not be held to maturity. If it is sold prior to maturity, it will have to be at the prevailing market price, which will be inversely related to the prevailing yield.
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Interest Rate Risk (Cont…)
Market Risk or Price Risk, is the risk that interest rates may be higher than anticipated at the time of sale, in which case the bond will have to be sold at a lower than anticipated price. The two risks work in opposite directions. Reinvestment risk arises because rates may fall subsequently, whereas market risk arises because rates may rise subsequently.
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Inflation Risk
Inflation refers to the erosion in the purchasing power of money. Most bonds promise fixed cash flows in dollar terms. Inflation risk is the risk that the purchasing power of money may have eroded by more than what was anticipated, by the time the cash flow from the bond is received.
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Inflation Risk (Cont…)
High inflation will reduce the effective or Real rate of interest. The interest rate in monetary terms is called the Nominal Rate of interest. The Real Rate, on the other hand, is the nominal rate adjusted for changes in the purchasing power.
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Indexed Bonds
These are bonds whose coupons are linked to a price index. Price indices are used as barometers of changes in the purchasing power of a currency. If inflation is high, so will be the index level and vice versa.
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Indexed Bonds (Cont…)
Thus indexed bonds will offer higher cash flows during times of high inflation, and relatively lower cash flows during periods of lower inflation, which will ensure that the cash flow in real terms is kept at a virtually constant level.
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Timing Risk
In the case of Plain Vanilla bonds, there is no uncertainty regarding the times to receipt of the cash flows. However, callable bonds can be recalled at any time. For a callable bond holder there is cash flow uncertainty, since he is unsure as to how many periods he is going to get coupons for, and also as to when the face value will be repaid.
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Timing Risk (Cont…)
Thus holders of callable bonds will demand a premium for bearing this risk. That is why callable bonds trade at a lower price than otherwise comparable plain vanilla bonds.
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Foreign Exchange Risk
This risk arises when the cash flows from a bond are denominated in a foreign currency. If the foreign currency depreciates in value with respect to the home currency of the bondholder, then when the cash flows from the bond are converted into the home currency, the returns will be lower than anticipated.
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Illustration
A bond promises to pay a coupon of $10 every six months. Assume that the rate of exchange is Rs 50 per dollar. So an Indian bondholder will expect to receive Rs 500 every six months. However, what if the exchange rate at the time of the coupon payment is Rs 45. If so, he will receive only Rs 450.
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