SECURITY ANALYSIS

TOPIC:TOPIC:BASIC BOND ANALYSISBASIC BOND ANALYSIS

INTRODUCTION

1.1. It is the long-term debt instruments issued It is the long-term debt instruments issued by the organization's or Government to by the organization's or Government to raise funds.raise funds.

2.2. Interest bearing note.Interest bearing note.3.3. It is also known as acknowledgement to It is also known as acknowledgement to

debt.debt.

TYPES OF BONDS

1.1. Mortgage-Bonds.Mortgage-Bonds.(security must deposit)(security must deposit)

2.2. Debenture Bonds.Debenture Bonds.(security not required)(security not required)

PRICING A BOND

1.1. Maximum price that one is willing to pay Maximum price that one is willing to pay is known as price of bonds.is known as price of bonds.

2.2. The price of a bond is the present value of The price of a bond is the present value of its expected cash flow.its expected cash flow.

SINGLE CASH FLOW

1.1. A lump-sum amount expected some future A lump-sum amount expected some future date.date.

DISCOUNT RATE

1.1. ‘‘i’ is also referred to as the discount rate.i’ is also referred to as the discount rate.2.2. Using this ‘i’ we find out the value of Using this ‘i’ we find out the value of

future cash flow at present. future cash flow at present.

MULTIPLE CASH FLOW

1.1. Bonds have more than one cash flow.Bonds have more than one cash flow.2.2. Each cash flow is discounted in order to Each cash flow is discounted in order to

find the present value.find the present value.3.3. Common practice is bond markets is to Common practice is bond markets is to

discount using a redemption yield.discount using a redemption yield.4.4. Bongs are issued semi-annually.Bongs are issued semi-annually.

DIRTY & CLEAN PRICES

1.1. DIRTY PRICE = With AccruedDIRTY PRICE = With Accrued2.2. CLEAR PRICE = Without AccruedCLEAR PRICE = Without Accrued3.3. Price in the market are usually on a clean Price in the market are usually on a clean

basis but settled on a dirty basis. basis but settled on a dirty basis.

RELATIONSHIP BETWEEN PRICE AND YIELD

1.1. Direct relationship between the price of Direct relationship between the price of bond and its yield.bond and its yield.

2.2. Inverse relationship between YTM and Inverse relationship between YTM and price.price.

YIELDS AND YIELD CURVES

1.1. The interest rate provided by market is The interest rate provided by market is calculated to find IRR.calculated to find IRR.

MONEY MARKET YIELDS1.1. Money market yields are quoted on a Money market yields are quoted on a

different basis and therefore in order to different basis and therefore in order to compare short-term bonds and money compare short-term bonds and money market instruments it is necessary to look market instruments it is necessary to look at them on a comparable basis.at them on a comparable basis.

USES OF YIELDS CURVES AND YIELD CURVES THEORIES

1.1. To analyzed money market yield curves To analyzed money market yield curves are utilized.are utilized.

2.2. Money market yield curves defines Money market yield curves defines graphically structure of yields.graphically structure of yields.

3.3. It is helpful for Government use.It is helpful for Government use.4.4. It shows that to increase investment, yield It shows that to increase investment, yield

and risk increase.and risk increase.

FLAT YIELD

1.1. It does not take into account accrued It does not take into account accrued interest; nor does it take into account interest; nor does it take into account capital gain/ loss (i.e. it assumes prices capital gain/ loss (i.e. it assumes prices will no change over the holding period); will no change over the holding period); nor does it recognize the time value of nor does it recognize the time value of money.money.

SIMPLE YIELD

1.1. This is slightly more sophisticated This is slightly more sophisticated measure of return than flat yield, which measure of return than flat yield, which takes into account capital gain, it grows on takes into account capital gain, it grows on linear fashion.linear fashion.

(YTM)REDEMPTION YIELD

1.1. It is utilized to find out that either coupon It is utilized to find out that either coupon interest provided by the market is in favor interest provided by the market is in favor of the organization who is investing or not. of the organization who is investing or not.

SPOT RATE AND ZERO COUPON CURVE

1.1. Spot rate is the current rate of market.Spot rate is the current rate of market.2.2. Zero coupon curve means, bonds in which Zero coupon curve means, bonds in which

no interest, like price bond etc.no interest, like price bond etc.

FORWARD ZERO COUPON YIELD (Implied forward rate)

1.1. Forward spot yields indicate the expected Forward spot yields indicate the expected spot yield at some date in the future.spot yield at some date in the future.

REAL IMPLIED FORWARD RATES

1.1. Real implied forward rates can understand by Real implied forward rates can understand by using this formula.using this formula.

(1 + nominal forward) = (1 + nominal forward) = (1 + real forward)(1 + real forward) (1 + inflation (1 + inflation

forward)forward)

PAR YIELD1.1. It is the coupon that a bond would have in It is the coupon that a bond would have in

order to be priced at par, using the zero order to be priced at par, using the zero coupon rates in the discount function.coupon rates in the discount function.

Debt Management ProductTreasury Bills:Treasury Bills:

1.1.T-bills debt instruments with maturities of one year or lessT-bills debt instruments with maturities of one year or less2.2.Treasury bills are low-risk investments with a broad and Treasury bills are low-risk investments with a broad and liquid secondary market.liquid secondary market.3.3.Issued at discount to their face value.Issued at discount to their face value.4.4.T-bills are free of default risk, they generally have lower T-bills are free of default risk, they generally have lower yields yields 5.5.T-bills are purchased by investors at a weekly auction at T-bills are purchased by investors at a weekly auction at less than face value and are redeemed at maturity at face less than face value and are redeemed at maturity at face value. value. 6.6.The difference between the purchase price and the face The difference between the purchase price and the face value of the T-bill is the investor's return.value of the T-bill is the investor's return.

Conventional Bond

Conventional bonds have a fixed coupon and Conventional bonds have a fixed coupon and redemption payment at maturity.redemption payment at maturity.

Coupon are usually paid annually or semi-Coupon are usually paid annually or semi-annually.annually.

This bond can be thought of as offering a This bond can be thought of as offering a nominal nominal yieldyield that takes into account the real yield and that takes into account the real yield and anticipated inflation:anticipated inflation:

Real yield = Real return + Risk premium Real yield = Real return + Risk premium

N = R + PN = R + Pee + RP + RP The risk premium is the amount of market demands The risk premium is the amount of market demands

for unanticipated inflation.for unanticipated inflation.

High inflation = greater risk premiumHigh inflation = greater risk premium

Floating Rate Bonds

1.1. Floating-rate bonds, take away the risk that fixed-Floating-rate bonds, take away the risk that fixed-income bonds bear. As their name implies, floating-income bonds bear. As their name implies, floating-rate bonds pay different rates of interest depending rate bonds pay different rates of interest depending on prevailing rates in the bond market. on prevailing rates in the bond market.

2.2. The bonds generally refer to a benchmark market The bonds generally refer to a benchmark market rate; when that rate rises, so will your interest rate; when that rate rises, so will your interest payments. But if the rate falls, then your interest payments. But if the rate falls, then your interest checks will go down as well.checks will go down as well.

3.3. The price of floater depends on the spread above or The price of floater depends on the spread above or below the prevailing rate below the prevailing rate

Index Linked Bond

A bond in which payment of income on the A bond in which payment of income on the principal is related to a specific price index, principal is related to a specific price index, often the Consumer Price Index. often the Consumer Price Index.

This feature provides protection to investors This feature provides protection to investors by shielding them from changes in the by shielding them from changes in the underlying index. The bond's cash flows are underlying index. The bond's cash flows are adjusted to ensure that the holder of the bond adjusted to ensure that the holder of the bond receives a known real rate of return. receives a known real rate of return.

Convertible Bond A convertible bond is a bond that gives the holder the right to A convertible bond is a bond that gives the holder the right to

"convert" or exchange type of security for another, e.g. short "convert" or exchange type of security for another, e.g. short term to long term, fixed to floating or indexed.term to long term, fixed to floating or indexed.

The exchange feature of a convertible bond gives the right for The exchange feature of a convertible bond gives the right for the holder to convert the par amount of the bond for common the holder to convert the par amount of the bond for common shares a specified price or "conversion ratio".shares a specified price or "conversion ratio".

For example, a conversion ratio might give the holder the right For example, a conversion ratio might give the holder the right to convert $100 par amount of the convertible bonds of to convert $100 par amount of the convertible bonds of Ensolvint Corporation into its common shares at $25 per Ensolvint Corporation into its common shares at $25 per share. This conversion ratio would be said to be " 4:1" or "four share. This conversion ratio would be said to be " 4:1" or "four to one". to one".

The interest paid by a bond is called the coupon or coupon The interest paid by a bond is called the coupon or coupon amount. amount.

Zero coupon bonds do not make regular interest payments to Zero coupon bonds do not make regular interest payments to the bond holders.the bond holders.

Zero coupon bonds, also sometimes known as "Strips," do Zero coupon bonds, also sometimes known as "Strips," do not have regular interest payments.not have regular interest payments.

Zero coupon buyers purchase the bond at a significant Zero coupon buyers purchase the bond at a significant discount to the face value at maturity. The amount of discount to the face value at maturity. The amount of interest to be earned is the difference between the current interest to be earned is the difference between the current price and the face amount. price and the face amount.

zero coupon bonds are issued with long-term zero coupon bonds are issued with long-term maturities--10 years or longer. maturities--10 years or longer.

Zero coupons are useful for planning and Zero coupons are useful for planning and providing money for a future event, such as providing money for a future event, such as paying for paying for college or starting retirement. or starting retirement.