Debt - Basics of Debt and Fixed Income

Debt
Borrowers:
Interest is the cost of having access to Funds for his needs – individual or Company or Government.
Lender’s Perspective:
Interest is compensation for Opportunity cost and risk
Invested spent
Interest is based on:
Tenure – Longer the Loan – Higher risk – Opportunity Cost
Risk the borrower – Credit Worthiness – Riskier the borrower Interest will be more
Inflation – higher , interest will be more
How do you raise debt:
Loan through Banks and Financial Institutions
Financial Markets or Debt Markets
 Company or Government issued Securities called Debt
Securities or Bonds
Can issue more than one issue of Debt Securities

Debt
Bond:
A bond is a contract between the issue and the owners
of the bonds (bond holders), that obligates the issuer
to make specified payments over a specific period.
Important Characteristics of Bond
Par value – Principal Value - Face Value
Coupon Rate
Maturity Rate

Debt
Coupon Rate & Coupon Payments:
Coupon Rate: It is the promised interest rate on bond ex: 5% coupon rate
Coupon Payment: Coupon payments are linked to the bonds per value
and bonds coupon rate. Ex: Bonds Coupon rates is 5% and Pay Value is
Rs.100; then Coupon Payment is Rs.5
Most Debt instrument issued by Governments makes coupon payments
as Semi – Annual basis
Rs.2.50 is given – 2 times
In general Debt securities are used with fixed coupon rate and paid
fixed coupon payments; they are referred as fixed – income securities.

Maturity:
Debt Securities – 1 year  Referred as bills
1 year – 10 years Referred as Notes
10 year Bonds
Term bond is used irrespective of its Maturity.
Maturity Date:
The life of the Bond ends on its maturity date and the
issuer is not responsible for any further payments after
that date

Bond Indenture:
Bond is governed by a legal contract between the bond issuer
and the bond holders, which describes the key terms of the debt
obligation. This legal contract is referred as the bond indenture
Covenants:
It describes actions the issuer must perform or is prohibited from
performing.
Ex:
Common covenant requires the issuer to pay interest on timely
basis
To provide Quarterly Financial Statement to bond holder
No additional borrowing or No sale of Assets etc.,
A bond issuer failing to make the promised payments is referred
to as a default.

Secured Debt securities:
When Security is backed by asset or issuer pledges assets as
collateral to bond holders. In the event of default, bond
holders are legally entitled to take the possession of the
assets.
Reduces the risk
So lower coupon
Unsecured Debt Securities:
Not backed by collateral
Higher Risk of default
Higher coupon then secured

Subordinate Debt:
A bond which has a lower priority (specified in
contract) in the event of default. It is unsecured debt
with a lower priority. Bond holders will receive
payment only after higher priority debt claims are
paid.
Priority or Seniority Ranking of Debt Securities :
Secured Debts >> Senior unsecured Debt >> Senior
subordinate debt >> Subordinate Debt >> Junior
subordinate Debt.

Bonds issued by corporate –-> Corporate Bond
Bonds issued by Government - G Secs or
GILTS(India)
Bonds issued by US Government - Treasury
Securities or T- bills

Bond Markets
Primary Market :
Issue of new securities to investors. Investors buy directly from bond
issuer.
Secondary Markets :
Investor later may sell their bonds to other investor in the secondary
market at a market price
Check link : http://primedatabase.com/debtsecurities.asp
“ Price of the bond in Secondary market is reflecting of Credit quality,
interest rate, market conditions
Bond holder (primary purchase or secondary) is entitled to set promised
coupon payments as principal

Categories
Categories :
Bonds are often categorized by their coupon rates :
Fixed – Rate bonds or straight bond
Floating – rate bonds
Zero – Coupon bonds

Fixed Rate Bond or Straight Bond :
It pays a fixed periodic coupon payment over its life
and returns the principal on the maturity date
Coupon rate does not change over the life of the bond
Par value does not change.

Floating rate bonds :
Sometimes referred as variable – rate bonds.
Coupon rate on Floating Rate Bond changes overtime
Coupon rate is linked to a reference rate
Reference rate is a interest rate paid by a highly credit worthy
borrower
LIBOR – London interbank offered rate is widely used
MIBOR – Mumbai interbank offered rate is widely used in India
Floating rate is calculated by making on adjustment to the
reference rate to reflect the riskiness (creditworthiness) of issuer.
Floating Rate= Reference percentage (which reflects Credit
Worthiness and Bond features)
Percentage over Reference rate is called spread and is constant
Any change in Credit worthiness does not reflect at later stage
Percentage is referred in bps or bonus points 1%= 100bps
So it is stated as LIBOR +100 bps (spread is 1%)

Zero Coupon Bonds:
They don’t offer periodic interest payments.
Only cash flow offered by a Zero coupon bond is a single payment
equal to the bonds par value that is paid on the bonds maturity date.
Bonds are issued at a discount to the bonds par value.
The difference between issue price and par value received at maturity is
the return.
Usually Government Securities are issued as Zero coupon securities.
Ex: Book: IDBI issued deep discount bonds at maturity par value is 2 L,
maturity period of 25 years and issued at 5300/-
Use FV=PV(1+r)n
(1+r) 23 = 200000/5300 = (37.73).0434
(1+r) 23= 1.1706= r=.1706 or 17%

Bonds with Embedded provisions
B0nds can have provisions which give the issuer or the
bond holder the right but not the obligation to take
certain actions .
Callable Bonds
Putable Bonds
Convertible Bonds

Callable Bonds
Provides the issuer with the right to buy back (retire or call)
the bond from the bond holders prior to maturity at are
specified price referred to as a call price .
Call Price= par value + Call premium
Call provision is the right of the issuer
Issuer is of advantage over bond holder
To compensate the risk of bond retired early , callable
bonds have higher coupon than coupon of comparable
bond with our call option .
This risk is called call risk

Callable Bonds
Issuer calls for the provision when interest rate are coming down , and he has
option to raise capital at lower coupon .
Ex : Let’s look again at that nice, safe Aaa-rated corporate bond that pays 4% a
year. Imagine that Federal Reserve Bank begins cutting interest rates. Suddenly,
the going rate for a 15-year, Aaa-rated bond falls to 2%. The issuer of your bond
looks at the market and decides it’s in its best interest to pay off those old
bonds and borrow again at 2%.
You the investor will get back the original principal of the bond -- $1,000. But
you won’t be able to reinvest that principal and match the return you were
getting. Now you’ll have to either buy a lower-rated bond to get a 4% return or
buy another Aaa-rated bond and accept at 2% return.

Putable Bonds
A putable bond provides the bondholders with the right to sell (put back )
their bonds to the issuer prior to the maturity date a at pre-specified price
referred to as the put price .
Put provision is the right of the bond holder
Coupon rate of putable bond is generally lower than coupon of comparable
bond .
It will help the bond holders from down side price protection in case of interest
rates increase.
When a bind holder exercises the put provision , the pre specified put price at
which binds are sold back t o the issuer is typically the binds par value .

Convertible Bonds
It has characteristics of both debt and equity
It gives the bond holder to right tot convert the bind in to a pre
specified number of common shares of the issuing company at some
point prior to bonds maturity date .
Conversion value is the value of the bond if it converted to stock .
Conversion ratio is the number of shares that the bond holder would
receive from converting the bond to stock .
Conversion value is equal to the conversion ratio times the share price .
Coupon is lower than comparable bonds as additional feature of
conversion is given .

Let’s look at an example. Acme Company
issues a 5-year convertible bond with a
$1,000 par value and a coupon of 5%. The
“conversion ratio” – or the number of
shares that the investor receives if he or
she exercises the conversion – option is
25. The effective conversion price is
therefore $40 per share, or $1000 divided
by 25. The investor holds on to the
convertible bond for three years and
receives $50 in income each year. At that
point, the stock has risen well above the
conversion price and is trading at $60.
The investor converts the bond and
receives 25 shares of stock at $60 per
share, a total value of $1,500. In this way,
the convertible bond offered both
income and a chance to participate in the
upside of the underlying stock.
On the other hand, let’s say that Acme’s
stock weakens during the life of the
security – rather than rising to $60, it
falls to $25. In this case, the investor
wouldn’t convert – since the stock prices
is less than the conversion price – and
would hold on to the security until
maturity as though it were a straight
corporate bond. In this example, the
investor receives $250 in income over the
five year period, and then receives his or
her $1000 back upon the bond’s
maturity.

Bonds with Embedded Provisions
Inflation – Linked Bonds
Bonds contain a provision that adjusts the bonds par
value for inflation .
Inflation reduces the purchasing power from bond
cash flows.
For most inflation linked bonds , the par value of the
bond is adjusted at each payment date to reflect
changes in inflation .
Coupon payments get adjusted with this as it equal to
coupon multiplied by the inflation adjusted par value .

In US they are called Treasury inflation protected securities .(TIPS)
In UK – index linked gilts
Hongkong – iBonds
India recently launched a new kind of bond to give individual investors
some protection against inflation, but they don’t make sense for
everyone.
The new bonds, officially called the Inflation Indexed National Savings
Securities, are available for sale to individuals until Dec. 31.
Unlike a traditional bond where the interest rate is fixed, in the
inflation-linked bonds, the government will pay an interest of 1.5% per
year above the rate of inflation as measured by the Consumer Price
Index.
The interest rate will be reset every six months, to reflect any changes
in inflation

Structured Debt Securities
Securitization :
Creation and issuance of new debt securities , called
structured debt securities that are backed by a pool of
other debt securities .
It is pooling of financial assets and issuing debt
securities against this pool .
It creates Liquidity and option to raise money from
illiquid assets .

Securitization :
Securitization turns mortgages into liquid assets. The process works like this: A bank or
other institution gathers hundreds or thousands of mortgages into a "pool." It then
divides that pool into shares and sells those shares as securities. Buyers of these securities
gain the right to collect mortgage payments made by the hundreds or thousands of
homeowners whose mortgages have been pooled, which is why they're called "mortgage-
backed securities.“
Securitization allows banks to convert their mortgages to cash, which they can then use to
lend money to more home buyers. This ensures that there is a steady supply of credit
available to the housing market. And as long as the homeowners whose loans were
pooled make their payments on time, buyers of the securities get a nice return on their
investment.
Disadvantages
Unfortunately, securitization can also encourage lenders to lend money to high-risk
people who are unlikely to pay it back. That's because once a mortgage has been
securitized and sold off to investors, the lender no longer has any money at stake; all the
risk has been passed off to the investors. This is what happened in the housing bubble of
the early to mid-2000s. When homeowners began defaulting on loans in record
numbers, the securities backed by those mortgages lost their value.

Mortgage backed Securities :
Debt Securities are issued against a pool of underlying
residential mortgage loans (home loans) or on a pool of
underlying commercial mortgage loans.
Asset backed Securities :
Similar to Mortgage backed securities except that the types
of loans underlying are debt obligations such as credit card
receivables , auto loans , corporate bonds etc.
Investors who buy structured debt securities receive a
portion of the pooled monthly loan payments .

Risk of Investing in debt Securities
Debt securities is considered less risky , still bind
holders still face a number of risks
Credit Risk
Interest rate Risk
Inflation Risk
Liquidity Risk
Reinvestment Risk
Call Risk

Credit Risk :
It is referred to as default risk , is the risk of bond
issuer failing to make full and timely payments of
interest and principal .
Risk of decline in price of the bond in case of suspect
of default by issuer .

Credit Risk of a bond can be assessed by reviewing credit rating .
Credit ratings agencies assess the credit quality of the bond and assign them ratings .
Highest ratings are assigned to bonds that are considered to have low risk of default
Credit rating is assigned at issue and also reviewed over the time .
Better the credit rating , better the access to capital at lower rate .

Investment grade bonds Non Investment grade binds
High degree of credit
worthiness
Invested by insurance
companies , pension funds
Lower coupon or yield
Less credit worthy
Also referred as Junk bonds
Higher yield -high risk
Invested by hedge funds etc

Interest Rate Risk :
Interest rate changes . Risk resulting due interest rate .
Bond price decrease with increase of interest rate .
Bond prices are inversely proportional to interest rates
It adversely effects fixed rate binds and zero coupon
bonds
Floating rate bonds coupon are set to current market
interest rates at each payment date , so interest rate risk is
minimal when interest rate increase. But when Interest
rates decline bind holders receive less coupon payment as
coupon rate is reset as per market.

Inflation Risk :
Promised interest payment and principal payment
does not count or change with inflation .
Purchasing power of cash flows comes down.
Inflation linked bonds can protect from inflation.

Liquidity Risk :
Risk of unable to sell a bind prior to the maturity date with
out having to accept a significant discount to market value .
Bonds that don’t trade very frequently face this risk .
Reinvestment Risk :
In falling interest rates scenario , the cash flows on bonds
have to be invested at lower coupon .
Call Risk :
Risk that issuer might buy back the bind prior to maturity
or exercise call option if interest rates are falling . Bind
holders will than have to invest proceeds at a lower interest
rate .

Valuation of Debt Securities
The value of a debt security is estimated using a
discounted cash flow approach.
Value of a bond is the present value of all the future
coupon payments and final principal payment .
Once an estimate of the value of a bond is calculated ,
it is compared with the current price of the bond to
determine whether the bond is over valued ,
undervalued or fairly values .

Bond valuation is only one of the factors investors consider
in determining whether to invest in a particular bond.
Other important considerations are: the issuing company's
creditworthiness, which determines whether a bond is
investment-grade or junk; the bond's price appreciation
potential, as determined by the issuing company's growth
prospects; and prevailing market interest rates and
whether they are projected to go up or down in the future.

Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a coupon rate of 10%, and a
required yield of 12%. In our example we'll assume that coupon payments are made semi-annually to bond holders and
that the next coupon payment is expected in six months. Here are the steps we have to take to calculate the price:
1. Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten
years, we will have a total of 20 coupon payments.
2. Determine the Value of Each Coupon Payment: Because the coupon payments are semi-annual, divide the
coupon rate in half. The coupon rate is the percentage off the bond's par value. As a result, each semi-annual coupon
payment will be $50 ($1,000 X 0.05).
3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be divided by two
because the number of periods used in the calculation has doubled. If we left the required yield at 12%, our bond price
would be very low and inaccurate. Therefore, the required semi-annual yield is 6% (0.12/2).
4. Plug the Amounts Into the Formula:
From the above calculation, we have determined that the bond is selling at a discount; the bond price is less than its
par value because the required yield of the bond is greater than the coupon rate. The bond must sell at a discount to
attract investors, who could find higher interest elsewhere in the prevailing rates. In other words, because investors can
make a larger return in the market, they need an extra incentive to invest in the bonds.

Valuation of debt sec
Discount rate (required rate on the bond given its
riskiness) affects the bonds value relative to the par
value
If bonds coupon rate and discount rate are same the
bonds value is its par value .
If bonds coupon rate is lower than the discount rate
bond value is less than its par value and will trade at a
discount .
If bonds coupon rate is higher than the discount rate
bond value is more than its par value and will trade at
a premium .

Yield to Maturity
The discount rate that equates the present value of a binds
promised cash flows to its market price is the bonds yield to
maturity or yield.
An investor can compare this yield to maturity with the required
rate of return on the bond given its riskiness to decide whether
or not to purchase it .

Yield to Maturity
Yield is a function of its maturity , liquidity and risk
Low risk bonds such as govt bonds trade at relatively
lower yield to maturity , which imply relatively at
higher prices.
High risk bonds , trade at higher yield to maturity
,which imply relatively lower prices.
Bond prices and bond yields to maturity are inversely
related .

Current Yield
A bonds current yield is calculated as the annual
coupon payment divided by current market price .
Current yield provides bond holders with an estimate
of the annualized return from the coupon income only
Ex : Coupon of 4% , and lets the bond is trading at
914.70 .
Current yield = 40(coupon payment)/914.70
= 4.37%

Yield Curve
A line that plots the interest rates, at a set point in time, of bonds having equal credit
quality, but differing maturity dates. The most frequently reported yield curve compares
the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is
used as a benchmark for other debt in the market, such as mortgage rates or bank
lending rates. The curve is also used to predict changes in economic output and growth.
US treasury yield curve
Bond with
comparable
features can be
considered

Credit Spreads
Difference between a risky bonds yield and the yield on a
government bond with same maturity is referred as risky
bond’s credit spread .
Credit Spread tells the investor how much extra yield is
being offered for investing in a bond that has higher
probability of default.

Debt - Basics of Debt and Fixed Income

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