Strategies to maximize returns in Fixed Income Market characterised by increasing interest rates
Department Fixed Income Market Treasury, Bank of Baroda
Under the Guidance of : Manish Kaura Chief Manager, Bank of Baroda
Submitted by : Nitin Agrawal MMS 2010-12 Welingkar Institute of Management Development and Research, Mumbai.
Acknowledgement
I owe a great many thanks to a people who helped and supported me during the writing of this project.
My deepest thanks to Mr. Manish Kaura, Chief Manager, Bank of Baroda, the Guide of the project for guiding and correcting various documents of mine with due attention and care. He has been very helpful trough out the project and makes necessary correction as and when needed.
I express my thanks to the A.G.M. Treasury, Bank of Baroda Mr. D.Jhalmalwala for extending his valuable support.
My deep sense of gratitude to Himanshu Chopra, Aditi Mishra, support and guidance. Thanks and appreciation to the helpful people at treasury, Bank of Baroda Mumbai for their support.
I would also thank my Institution and my faculty members without whom this project would have been a distant reality.
Table Of Contents
Chronological testing of linkage of forex with consolidated market: .......................................... Error! Book
Recommendation: ........................................................................................................................ Error! Book
References: ................................................................................................................................. Error! Book
Executive Summary The project is titled “Strategies to maximize returns in Fixed Income Market characterised by increasing interest rates”. The primary objective of this project is to understand Fixed Income market, mainly Government Security, its relationship with interest rates, future prospects and its relation with various other segments of the market like inflation, repo rates, and crude oil prices. Various strategies that a banking institute undertakes via its Treasury to maintain or enhance returns on its Fixed Income Market related transactions keeping in view the various guidelines laid down by RBI and meeting them. For this, a dummy portfolio has been taken, studied and analysed accordingly.
The project also covers understanding of role played by treasury in bank. What are the various markets for investment available with it and how are they interlinked. A detailed study of Indian Government securities market is covered and instruments which are available and traded in this market are emphasized. In India the Fixed Income market is still in its initial phase but the growth trends are very strong. With the advent of various new innovative trading instruments as well as ease of trading through electronic platforms, Fixed Income market has gained a lot in terms of size and volume of transaction across the world.
The analysis helped us in understanding the major factors to consider while developing a view on the Fixed Income market, mainly G-secs. Finally, the analysis helped us in framing few recommendations which may prove valuable for the bank in long run.
Introduction
Need for Study
The debt market is much more popular than the equity markets in most parts of the world. In India, the reverse has been true. Nevertheless, the Indian debt market has transformed itself into a much more vibrant trading field for debt instruments from the rudimentary market about a decade ago. This project aims at enhancing the G Secs yield vis-a-vis increasing interest rate scenario.
India needs a huge amount of money to fund its developmental programmes. Most of the fund is expected to come from bond routes. Banks, in order to meet its mandatory requirements of SLR invests major portion in G Secs. In return it provides a steady return of interest on coupon. To maintain banks NIM in current increasing rates scenario, its income from interest should increase. Therefore it is now advisory for the banks to diverse its portfolio and innovate its investment portfolio product. Given current market fluctuation in equity market and mounting inflation, it is wise to invest in bond market. There lies a huge market for debt instruments. Also Government?s fiscal deficit will definitely open new gateways for bond market. Thus it is high time to invest in bonds to maximize returns for the company.
Methodology
The operations of fixed income department are observed at the treasury department. The suitable data collected for analysis of linkage of bond (G Secs) price and yield. Suitable data has been obtained from the Bank of Baroda Fixed Income department, internet, books et al. This data is recorded by the bank over the years on a daily basis. The data, thus collected, has been analyzed and strategy to be adopted is advised.
Introduction to Fixed income Market Fixed income refers to any type of investment which is not equity that obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable. Governments issue government bonds in their own currency and sovereign bonds in foreign currencies. Local governments issue municipal bonds to finance themselves. Debt issued by government-backed agencies is called an agency bond. Companies can issue a corporate bond or get money from a bank through a corporate loan ("preferred stock" can be "fixed income" in some contexts). Securitized bank lending (e.g. credit card debt, car loans or mortgages) can be structured into other types of fixed income products such as ABS – asset-backed securities which can be traded on exchanges just like corporate and government bonds. The term fixed income is also applied to a person's income that does not vary with each period. The term "fixed income" can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large expenditures. Fixed-income securities can be contrasted with equity securities that create no obligation to pay dividends, such as stocks. In order for a company to grow as a business, it often must raise money; to finance an acquisition, buy equipment or land or invest in new product development. Investors will give money to the company only if they believe that they will be given something in return commensurate with the risk profile of the company. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond, bank loan, or preferred stock). The term "fixed" in "fixed income" refers only to the schedule of obligatory payments, not the amount. "Fixed income securities" include inflation linked bonds, variable-interest rate notes, and the like. If an issuer misses a payment on a fixed income security, the issuer is in default, and the payees can force the issuer into bankruptcy. In contrast, if a company misses a quarterly dividend to stock (non-fixed-income) shareholders, there is no violation of any payment covenant, and no default.
While a bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed-income industry:
? ? ? ? ? ? ?
The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest. The principal of a bond – also known as maturity value, face value, par value – is the amount that the issuer borrows which must be repaid to the lender.[1] The coupon (of a bond) is the interest that the issuer must pay. The maturity is the end of the bond, the date that the issuer must return the principal. The issue is another term for the bond itself. The indenture is the contract that states all of the terms of the bond. Investors
Investors in fixed-income securities are typically looking for a constant and secure return on their investment. In buying a bond, one is in effect buying a set of cash flows, which are discounted according to the buyer?s perception of how interest and exchange rates will move over its life. Supply and demand affect prices, especially in the case of market participants which are constrained in the set of investments they make. Insurance companies often have long term liabilities that they wish to hedge, which requires low risk, predictable cash flows, such as long dated government bonds. Fixed income derivatives include interest rate derivatives and credit derivatives. Often inflation derivatives are also included into this definition. There is a wide gamut of fixed income derivative products: options, swaps, futures contracts as well as forward contracts. The most widely traded kinds are Credit default swaps A swap designed to transfer the credit exposure of fixed income products between parties Credit Default Swap (CDS) The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.
For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.
Interest rate swaps
An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap Forward rate agreements An over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract. Also known as a "future rate agreement".
Risks of Fixed Income Investing Despite the generally conservative nature of many fixed income investments, such as investment grade-quality bond funds and money market funds, and the tendency of fixed income investments to be more predictable than stocks, investors should be aware that bond funds and individual bonds do carry some degree of risk. Bond funds achieve diversification by holding many securities, so are generally less risky than individual bonds in that regard. However, there are some risks that may apply to both investments, as noted below.
? ? ? ? ? ?
Interest Rate Risk Credit Risk Inflation Risk Call Risk Prepayment Risk Reinvestment Risk Interest Rate Risk If interest rates rise, bond prices usually decline. If interest rates decline, bond prices usually increase. This risk exists because new bonds are likely to be issued with higher yields as interest rates increase, making the old or outstanding bonds less attractive. The longer a bond fund's maturity, the greater the impact a change in interest rates can have on its price. If you don't hold your bond until maturity you may experience a gain or loss when you sell your bond.
Credit Risk Bonds carry the risk of default, which means that the issuer is unable to make further income and principal payments. Many individual bonds are rated by a third party source such as Moody?s or Standard & Poor?s to help describe the creditworthiness of the issuer. U.S. Treasury bonds have backing from the U.S. Government and thus no default risk. Although they are not directly backed by the full faith and credit of the U.S. Government, government agency bonds, such as those issued by Fannie Mae and Freddie Mac, are considered to be high credit quality. Since a bond fund is made up of many individual bonds, diversification can help mitigate the credit risk of a downgrade, which would affect bond prices, or a default. Bonds are typically classified as investment grade-quality (medium - highest credit quality) or below investment grade-quality (commonly referred to as high-yield bonds), as are bond funds. Credit risk is a greater concern for high-yield bonds and bond funds that invest in lower-quality bonds and bonds of issuers whose ability to pay interest and principal may be considered speculative. Some bond funds may invest in both investment grade-quality and high-yield bonds. It's important to read a fund?s prospectus before investing to make sure you understand the fund?s credit quality guidelines.
Inflation Risk Because a high inflation rate can erode the real value of the income you receive, inflation can jeopardize any fixed income stream on which you may be counting. To combat this risk, you may want to consider a bond or bond fund that has its principal adjusted for increases in the inflation rate, such as U.S. Treasury Inflation-Protected bonds (TIPs) and bond funds that invest in TIPs.
Call Risk A callable bond has a provision that allows the issuer to call, or repay, the bond early. If interest rates drop low enough, the bond's issuer can save money by repaying its callable bonds and issuing new bonds at lower coupon rates. If this happens, the bond holder's interest payments cease and they receive their principal early. If the bond holder then reinvests the principal in bonds, he or she will likely have to accept a lower coupon rate, one that is more consistent with prevailing interest rates. This will lower monthly interest payments.
Prepayment Risk Some classes of individual bonds, including mortgage-backed bonds, are subject to prepayment risk. Similar to call risk, prepayment risk is the risk that the issuer of a security will repay principal prior to the bond’s maturity date, thereby changing the expected payment schedule of the bonds. This is especially prevalent in the mortgage-backed bond market, where a drop in mortgage rates can initiate a refinancing wave. When homeowners refinance their mortgages, the investor in the underlying pool of mortgage-backed bonds receives his or her principal back sooner than expected, and must reinvest at lower, prevailing rates.
Reinvestment Risk During periods of declining interest rates, you may be forced to buy new bonds at lower, prevailing interest rates as your existing investments reach maturity. Since bond funds are professionally managed, the fund's manager does this for you, searching for the most attractive bonds in any interest rate environment. In addition to the risks associated with fixed income investments described above, you should keep some other factors in mind before making an investment decision. Price Fluctuations Most importantly, investors should be aware that with either a bond fund or an individual bond, prices may fluctuate, as the securities are affected by economic and other factors. As a result, the value of your investment may increase or decrease. Bonds held to maturity will return the full principal amount to the bondholder upon maturity. However, those sold prior to maturity are subject to gain or loss depending on the market price at the time of sale.
The price of a bond fund may vary daily as the underlying bond prices change. Upon selling shares in the fund, the shareholder will realize a gain or loss depending on the NAV of the fund at the time of sale. Income Fluctuations As bond funds buy and sell bonds of different coupon rates, the income derived from these bonds, and passed on to shareholders, may vary. Balancing Risk vs. Reward As with any type of investment, there is a trade-off between the risk you are willing to assume and the potential return you could receive. The higher the potential reward or return, the greater the risk inherent in a bond fund or individual bond. For example:
?
Government bond funds and securities offer the lowest level of risk but they also typically offer lower yields
?
Bond funds and bonds with shorter maturities or duration will likely have less price volatility, but may have lower yields
?
Because bond funds are diversified across securities and professionally managed, they may be a better choice for many investors
Role of a Treasury Department in a Bank The primary functions of a treasury department at a bank involve asset/liability management. A substantial amount of time is invested by the department in forecasting net interest income (NII) and measuring the bank's interest rate risk (IRR) or sensitivity to changes in prevailing interest rates. The statistics generated by the department are typically fed to the bank's Asset and Liability Committee (ALCO), the group which is responsible for establishing guidelines for risk taking and balance sheet funding. The treasury department generally performs other related functions, such as managing the bank's reserve and risk capital requirements, funding the bank's balance sheet through a number of creative strategies (this is typically done in conjunction with the bank's corporate investments unit), and managing the institution's insurance requirements - property and casualty, directors and officers, and BOLL (Bank Owned Life Insurance). The core function of a treasury department at any bank is the measuring, monitoring, and controlling of interest rate risk (IRR). IRR is the risk that changes in prevailing interest rates will adversely impact the value of the bank's assets and liabilities.
The actual level of involvement of a treasury department in interest rate risk management varies by institution, but generally speaking, the department would forecast net interest income (NII) and measure the sensitivity of NII to changes in rates. Typically the department would employ a variety of standard and proprietary models to measure this risk. The output of this analysis would be supplied to the institution's ALCO (Asset/Liability Management Committee). ALCO is responsible for overseeing a variety of asset and liability (ALM) activities including the establishment of guidelines for the bank's risk tolerance levels. The treasury department may further be tasked with ensuring IRR stays within guidelines set by ALCO by entering into a variety of financial transactions, such as interest rate swaps, futures contracts, and so on. There are other functions often housed within the treasury department, including a process known as funds transfer pricing (FTP). At a high-level, the FTP process centrally manages the funding requirements of the entire bank in lieu of having each division fund its own balance sheet. Additionally, the department may assume responsibility for monitoring the institution's risk capital levels including the rules set forth in Basel II. Loans and advances are specific contractual agreements between the Bank and its borrowers and do not form part of treasury assets, although they are obligations to the Bank. (They can, however, be securitized and sold in the market). But an investment in G-Secs can be sold (or bought) in the market. It is, therefore, a treasury asset. An illustrative list of (domestic) treasury assets and liabilities is as follow: Assets • • • • • • Liabilities • Call / Notice / Term Money G-Secs, T-bills, State Government securities Commercial Paper Certificates of Deposit Non-SLR Bonds/Debenture Pass-through Certificates Equity Shares
• • • •
Certificates of Deposit Refinance from SIDBI/NHB/NABARD etc. Refinance from RBI Tier II Capital Bonds (if issued by the Bank)
Treasury income Sources • Investments, where the Bank earns a higher yield than its cost of funds. Example Buy corporate bond maturing in 3 years @9% Fund the amount from deposits maturing in similar period (3 years) @8.5% Profit = 0.5% coupon for 3 years • Spreads between yields on money market assets and money market funding. Example – The Bank may, for instance, borrow short-term for 4% and deploy in commercial paper returning 6%. When call rate is more than CBLO interest rate, buy CBLO and use the proceeds as call money • Arbitrage. – When there is possibility of profit without taking extra risk, there is a chance of arbitrage. Arbitrage exists in market because of market inefficiency. Example – Let?s say existing interest rate in India for 1 Yr loan fixed rate = 8%. 1 yr forward LIBOR 9% Step 1 - Bank took 1 Million Rupees Loan. Interest payment = 8000 Rupees Step 2 – Swap in Forex market. Buy a forward rate, with maturity 1yr @ LIBOR rate 9% Profit will be 1% spread – Forward premium. (Present value should be calculated to find out the exact present profit)
•
Relative Value. This is a form of arbitrage in which the Bank exploits anomalies in market prices. The Bank may have an „AAA? bond, which yields only 9%, compared to another with the same rating and maturity, but of a different issuer, which offers 9.5%. It is worth selling the first bond and investing in the second to improve the yield by 0.5% without any incremental risk, as both bonds have the same credit quality. It?s similar to arbitrage.
•
Proprietary Trading. The focus of proprietary trading is entirely short-term/medium, as compared to investment. The aim is to earn trading profits from inter day (or even intraday) movements in security and forex prices. They are mostly directional trades. Treasury may buy (say) 8.08%% Government of India security 2022 at Rs.99.44 at a yield of 8.15% in anticipation of the yield falling to 7.90%, on fundamental (or technical) grounds. If this happens, the bond appreciates and the Bank exits the position with a profit. Forex trading is also directional, involving, for example, buying dollar/yen in the expectation that the dollar will appreciate or selling euro/dollar hoping that the euro will decline.
•
Customer Services. Bank Treasuries offer their products and services to (generally) non-bank customers. The income to banks in these activities comprises fees for and / or margins on trade execution. Profits would be higher on structured (i.e., nonstandard) transactions compared to plain vanilla (e.g. a straightforward buy sell USD/INR) deals. Treasuries are also involved in investment banking where their responsibility covers trade execution on behalf of the Bank?s clients in the cash or derivatives markets. These may generate good margins, depending on the complexity and skills required to design and put through customized structures in the market.
Bank of Baroda treasury Operations Bank of Baroda has set up dedicated desks at the SITB, headed by experienced professionals, for undertaking various types of treasury activities in different financial markets. Apart from activities pertaining to management of funds and liquidity, the domestic treasury also handles financial instruments like:
? ? ? ? ? ?
Commercial Papers (CP) Certificate of Deposits (CD) Government Securities Treasury Bills (TB) Bonds and Debentures Equities and various other derivatives.
The products and services offered by SITB cater to the inter-bank market as well as to the corporate customers of the bank. The Bank is an active participant both in the inter-bank market and the corporate for all the products. The Bank offers its customers, including firms, companies, corporate bodies, institutions, provident funds trusts, Regional Rural Banks, Urban Cooperative Banks and Non-Banking Financial Companies opportunities to invest in Government Securities as allowed by Reserve Bank of India for non-competitive bidding. Segment wise result for year ending March 2011 results are as follows:
Bond Basics
Bond is a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity).
Some bonds do not pay interest, but all bonds require a repayment of principal. When an investor buys a bond, he/she becomes a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities. These are considered to be default risk free instruments. Payments in a Bond – 1. Principal Payment 2. Interest Payment 3. Interest on interest
Issuers – Central Government, State Government, corporations, and many other types of institutions
Types of Bonds
Classification on the basis of Variability of Coupon I. Zero Coupon Bonds Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders and hence, there are no cash inflows in zero coupon bonds. The difference between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders. The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the maturity period lesser would be the issue price and vice-versa. These types of bonds are also known as Deep Discount Bonds. II. Treasury Strips Treasury strips are more popular in the United States and not yet available in India. Also known as Separate Trading of Registered Interest and Principal Securities, government dealer firms in the United States buy coupon paying treasury bonds and use these cash flows to further create zero coupon bonds. Dealer firms then sell these zero coupon bonds, each one having a different maturity period, in the secondary market. III. Floating Rate Bonds In some bonds, fixed coupon rate to be provided to the holders is not specified. Instead, the coupon rate keeps fluctuating from time to time, with reference to a benchmark rate. Such types of bonds are referred to as Floating Rate Bonds. For better understanding let us consider an example of one such bond from BoB in 2010. The maturity period of this floating rate bond from BOB was 5 years. The coupon for this bond used to be reset half-yearly on a 50 basis point mark-up, with reference to the 10 year yield on Central Government securities (as the benchmark). Coupon rate in some of above mentioned bonds also have floors and caps. For example, this feature was present in the same case of BOB half-yearly floating
rate bond wherein there was a floor of 13.50% (which ensured that bond holders received a minimum of 13.50% irrespective of the benchmark rate). On the other hand, a cap (or a ceiling) feature signifies the maximum coupon that the bonds issuer will pay (irrespective of the benchmark rate). These bonds are also known as Range Notes. More frequently used in the housing loan markets where coupon rates are reset at longer time intervals (after one year or more), these are well known as Variable Rate Bonds and Adjustable Rate Bonds. Coupon rates of some bonds may even move in an opposite direction to benchmark rates. These bonds are known as Inverse Floaters and are common in developed markets.
Classification on the Basis of Variability of Maturity I. Callable Bonds The issuer of a callable bond has the right (but not the obligation) to change the tenor of a bond (call option). The issuer may redeem a bond fully or partly before the actual maturity date. These options are present in the bond from the time of original bond issue and are known as embedded options. A call option is either a European option or an American option. Under a European option, the issuer can exercise the call option on a bond only on the specified date, whereas under an American option, option can be exercised anytime before the specified date. This embedded option helps issuer to reduce the costs when interest rates are falling, and when the interest rates are rising it is helpful for the holders. II. Puttable Bonds The holder of a puttable bond has the right (but not an obligation) to seek redemption (sell) from the issuer at any time before the maturity date. The holder may exercise put option in part or in full. In riding interest rate scenario, the bond holder may sell a bond with low coupon rate and switch over to a bond that offers higher coupon rate. Consequently, the issuer will have to resell these bonds at lower prices to investors. Therefore, an increase in the interest rates poses additional risk to the issuer of bonds with put option (which are redeemed at par) as he will have to lower the re-issue price of the bond to attract investors. III. Convertible Bonds The holder of a convertible bond has the option to convert the bond into equity (in the same value as of the bond) of the issuing firm (borrowing firm) on pre-
specified terms. This results in an automatic redemption of the bond before the maturity date. The conversion ratio (number of equity of shares in lieu of a convertible bond) and the conversion price (determined at the time of conversion) are pre-specified at the time of bonds issue. Convertible bonds may be fully or partly convertible. For the part of the convertible bond which is redeemed, the investor receives equity shares and the non-converted part remains as a bond. Classification on the basis of Principal Repayment I. Amortizing Bonds Amortizing Bonds are those types of bonds in which the borrower (issuer) repays the principal along with the coupon over the life of the bond. The amortizing schedule (repayment of principal) is prepared in such a manner that whole of the principle is repaid by the maturity date of the bond and the last payment is done on the maturity date. For example - auto loans, home loans, consumer loans, etc. II. Bonds with Sinking Fund Provisions Bonds with Sinking Fund Provisions have a provision as per which the issuer is required to retire some amount of outstanding bonds every year. The issuer has following options for doing so: i. ii. issuer Since the outstanding bonds in the market are continuously retired by the issuer every year by creating a separate fund (more commonly used option), these types of bonds are named as bonds with sinking fund provisions. These bonds also allow the borrowers to repay the principal over the bond life. By buying from the market By creating a separate fund which calls the bonds on behalf of the
Risks involved in Bond Investment There is a myriad of fixed-income instruments available to the income-oriented investor. The type of investment bought can and does determine the risks and rewards. One of the most common types of debt available to an income investor is sovereign debt; the debt of a country?s treasury. Government sovereign debt, States, provinces, municipalities is
another type of local governmental debt. Another type of common debt obligations is corporate debt. Credit Risk in Bonds Any country?s sovereign debt is backed by the full faith and credit of that county?s treasury. Political subdivision?s credit is measured by that entity's ability to tax and their general credit worthiness. Corporate debt is issued either as debentures, which is unsecured debt or as debt secured by an asset, such as first mortgage bonds. Corporate and often political subdivisions carry ratings by a combination of three credit rating agencies. If a credit rating is lowered, the value of the bond decreases. The opposite is true should the credit rating be upgraded. All debt trades at a concession to sovereign debt. This concession, measured in basis points, is called the "spread over the curve." The "curve" means the yield curve. Maturity Risk in Bonds The risk to the individual investor is the interest rate to reinvest at once a bond matures. This is particularly important to people that depend on that income. The fixed-income market ranges anywhere from over-night to thirty years plus. If an investor buys a Government security of 10 year at 8% and interest rates are higher five years hence, the investor is that much better off. The opposite is true if interest rates are lower in five years. The investor would have less income. Option Risk in Corporate Bonds People think of "puts" and "calls" in terms of equity options. Many corporate bonds have options as well. A "callable" bond means that the corporation issuing the bond can "call" them back as of a certain date. The corporation would do this in order to refinance that debt at a lower interest rate. The investor has no choice but to give up the bonds. Some corporate bonds have "puts" attached. This means the investor can "put" the bonds or notes back to the corporation as of a certain date, such as a ten year note with a three year "put." The reason for this is so a financial institution can account for this note as a three year asset which helps them manage their asset / liability "gap" better.
Yield Curve Risk The "yield curve" is what interest rates are from very short term to quite long term. A normal curve is called "positive" where the longer the maturity, the larger the interest rate. An "Inverted" curve is where short term interest rates are more than longer term rate are. Often, the curve is "flat;" very little difference between short term and long term interest rates as in the current scenario i.e. first week of June 2011 indicating slowdown in economy ahead. Absent any external influence such as central bank intervention, the curve reflects an economic condition. Where an investor chooses to place their money along the yield curve is very akin to maturity risk plus certain economic assumptions added. Income investors should carefully weigh the various risks before committing their funds.
Duration The duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows is received. Duration also measures the price sensitivity to yield, the percentage change in price for a parallel shift in yields.
Determinants of Duration Following factors add to duration factor. 1. Coupon rate (which determines the size of the periodic cash flow) 2. Yield (which determines present value of the periodic cash flow) 3. Time-to-maturity (which weights each cash flow) 4. Frequency of coupon payment (annually, semi-annually)
Relationship of Duration with underlying factors
Holding coupon rate and maturity constant – (effect of YTM) Increases in market yield rates because a decrease in the present value factors of each cash flow. Since Duration is a product of the present value of each cash flow and time, higher yield rates also lower Duration. Therefore Duration varies inversely with yield rates. Holding yield rate and maturity constant – (effect of Coupon rate) Increases in coupon rates raise the present value of each periodic cash flow and therefore the market price. This higher market price lowers Duration. Therefore Duration varies inversely to coupon rate. Holding yield rate and coupon rate constant – (effect of Maturity period) An increase in maturity increases Duration and cause the bond to be more sensitive to changes in market yields. Decreases in maturity decrease Duration and render the bond less sensitive to changes in market yield. Therefore Duration varies directly with timeto-maturity (t) Effect of Frequency of coupon payment It is similar to holding maturity period and YTM constant and varying coupon rate With increase in coupon payment frequency, the duration decreases. Therefore Duration varies inversely to coupon payment frequency.
Effect of interest rate cap and floor – (For floating interest rate)
With addition of a cap the upward movement of the YTM/Interest rate is restricted at the cap. Similarly the downward movement of the interest or YTM is restricted at Floor value. So with the addition of cap or floor (Collar), interest rate risk reduces or Duration decreases. Effect of adding options to security instruments –
Effect of Call/Put Option –
Value of a Bond with call option = Value of option free bond – Value of Call option YTM a Bond with call option = YTM of option free bond + Call Premium
The upward movement of the price of a callable bond is restricted to Call price, because a callable bond has the high probability of being called at Call price. So IRR of a callable bond is less than an option free bond.
Value of a Bond with put option = Value of option free bond + Value of Put option YTM a Bond with put option = YTM of option free bond – put discount
Same is applicable for a Put option, which provides a lower limit to price variance (IR). So IRR of a putable bond is less than an option free bond.
Measurement of Duration
Macaulay Duration – It 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, and is a measure of bond price volatility with respect to interest rates. Macaulay duration =
(Source www.investopedia.com) The metric is named after its creator, Frederick Macaulay. Macaulay duration is frequently used by portfolio managers who use an immunization strategy. Macaulay duration is also used to measure how sensitive a bond or a bond portfolio's price is to changes in interest rates Modified Duration Duration allows market participants to estimate the relative price volatility of different securities:
Modified duration= Macaulay?s duration / (1+y) Using Modified duration we can get the estimation of price volatility %change in price = modified duration x Dy
Duration management strategies
How to take a decision about selecting a bond on the basis of yield and duration – Example –
Two bonds A and B with YTM 7% and 8%. Their durations are 5 and 6 respectively.
Here rate of change of YTM ?Y = ((8 - 7) / 7) %= 14.28% Rate of change of duration ?D =( (6 – 5) / 5 )% = 20% Here there is higher rate of change of risk ( ?D) than increase in rate of change of Yield (?Y) So Bond A is better than bond B
Yield Enhancement
Yield Enhancement is increasing yield of an investment (Bond or portfolio of bonds) at similar risk. They can be classified as Active Bond portfolio management strategies Passive bond portfolio management strategies Matched-funding strategies
There are two basic approaches to investment management:
?
Active asset management is based on a belief that a specific style of management or analysis can produce returns that beat the market. It seeks to take advantage of inefficiencies in the market and is typically accompanied by higher than average costs (for analysts and managers who must spend time to seek out these inefficiencies).
?
Passive asset management is based on the concept that markets are efficient, that market returns cannot be surpassed regularly over time, and that low cost investments held for the long term will provide the best returns.
Passive management concepts to know include the following:
?
Efficient market theory - This theory is based on the idea that information that affects the markets is instantly available and processed by all investors. As a result, this information is always taken into account in market prices. Those who believe in this theory believe there is no way to consistently beat market averages.
?
Indexing - One way to take advantage of the efficient market theory is to use index funds. Since index funds tend to have lower than average transaction costs and expense ratios, they can provide an edge over actively managed funds which tend to have higher costs.
Differences The main difference between passive and active management is the assumption that the portfolio manager, whether it be a large institution or an individual, has the ability to either predict the direction of interest rates or exploit mispriced securities. While the manager does not have to be correct 100% of the time, he/she must be successful enough to provide returns in excess of a passively managed portfolio, minus transaction costs, taxes and management fees. In order to achieve these results, there are at least four active styles to choose from:
? ? ? ? ?
Valuation Interest rate anticipation Yield spread Bond swaps
Each strategy can be deployed across the entire bond universe or specifically to investmentgrade, high-yield, international and municipal bonds for tax-sensitive investors. These strategies can be used independently or simultaneously. Valuation Strategy The basic premise of valuation is based on the portfolio manager's ability to identify and purchase undervalued securities and avoid those that appear to be overvalued. This takes some experience and in-depth knowledge of the bond markets, and can be done on a large scale or across a handful of bonds. That slight deviation can be caused by any number of inefficiencies, up to and including a temporary lack of demand or the intrinsic value of embedded options. These options can have a perceived value or lack of value from one investor to another. The goal here is to exploit those inefficiencies over and over again in a dynamic environment.
Interest Rate Anticipation Interest rate anticipation is one of the most common - and probably riskiest - strategies, since it relies on forecasting.
Since duration is a more accurate metric to measure volatility, it is used to adjust the portfolio. Duration is lengthened in an effort to capture an increase in value when the prediction is that interest rates will fall. Conversely, if interest rates are expected to rise,
the move would be to shorten the duration of the portfolio to preserve capital and potentially reinvest in shorter-term bonds when rates are presumed to be higher. Of course, the risk lies again on the presumption of the future and the success of each adjustment. This strategy can significantly enhance returns with the correct forecasting, but can drive an investment-grade portfolio into the ground if poor bets are made. Yield Spread Strategy Yield spreads are determined by the pricing of bonds in various segments of the market. The unique characteristics of the bonds relate to the varying prices and related yields.
These characteristics can include:
?
Term to maturity - Maturities within a specific segment typically spread across the yield curve if it is not flat. When the yield curve is upward sloping, longer-maturity bonds have higher yields, and the opposite is true in downward-sloping environments.
? ?
Coupon payments - Different coupons across segments can also carry different prices due to their demand and liquidity.
? ?
Sectors - Bonds across different sectors with the same credit ratings may be priced differently for many reasons. An example of that would be AA bonds for a regional bank vs. AA bonds for a pharmaceutical company.
? ?
Credit spreads - Different bond types (i.e. Treasuries vs. corporate) tend to be priced differently, all variables held constant.
? ?
Investors have the opportunity to profit from this strategy by accurately predicting changes in spreads or changes in the term structure of interest rates. It is important to be very familiar with the implied spreads and have the ability and knowledge to move swiftly to take advantage of opportunities. As spreads tend to widen during periods of economic uncertainty, a spread specialist may take long positions in riskier bonds to capture higher yields as others flee to safety. While the coupon spread is the obvious benefit, it is the ability to predict the turning points to a certain degree of accuracy that is the key. This is where the price of a bond moves the most dramatically and most of the value added is found. Bond-Swap Strategies
What is a Bond Swap? A bond swap is a technique whereby an investor chooses to sell a bond and simultaneously purchase another bond with the proceeds from the sale. Fixed-income securities make excellent candidates for swapping because it is often easy to find two bonds with similar features in terms of credit quality, coupon, maturity and price. In a bond swap, you sell one fixed-income holding for another in order to take advantage of current market and/or tax conditions and better meet your current investment objectives or adjust to a change in your investment status. Why You Would Consider Swapping Swapping can be a very effective investment tool to: ? ? ? ? Increase the quality of our portfolio; Increase our total return; Benefit from interest rate changes; and Lower our taxes.
These are just a few reasons why you might find swapping your bond holdings beneficial. Although this booklet contains general information regarding federal tax consequences of swapping, we suggest you consult your own tax advisor for more specific advice regarding your individual tax situation. . Gaining a Greater Yield Investors who want to increase the amount of potential return through their bond investments may choose to swap bonds by:
?
Extending maturity. Investors will often swap a shorter-term bond for a longer-term bond, since longer-term notes typically offer a higher yield. Typically, the longer a maturity on a bond, the greater the yield. When swapping to increase yield, it's important to consider that extending maturities could make your investment more vulnerable to price fluctuations if interest rates change.
?
Lowering credit quality. Because bonds with lower credit ratings typically compensate investors for the greater risk with higher yields, someone may cautiously choose to swap a higher-quality for a lower-quality bond to gain a greater return.
?
Taking advantage of changing conditions. You may want to consider swapping
bonds if you're changing conditions within a specific industry or the overall market is causing issuers to offer higher coupon rates and lower prices for a similar bond (same credit rating, par value, etc.) already in your portfolio.
Dummy Portfolio and Subsequent strategy/s to maximize returns in Government Securities
As and when there is hardening of yields, one tries to manage the bond portfolio through reduction of the duration of the portfolio in order to minimise the impact of rising yields. In a rising interest rate scenario, bond managers typically prune their exposure to longterm bonds that carry higher interest rate risk compared to short- term bonds and move into short-term instruments, like, money market instruments. In the same way, whenever one is of the view that interest rate outlook is going to be soft, they increase the exposure to longterm bonds to maximize their profits and reduce their investments in short-term paper. However, different managers follow different strategies, like: Conservative Strategy: This strategy tries to maintain an appropriate balance between risk and return. In this, portfolio managers try to insulate the portfolio from the vagaries of the market, which are caused by interest rate movements in the economy. Active Strategy: The portfolio managers who try to actively churn their portfolios with a view to maximising their returns depending on the volatility in bond prices come under this Active Strategy. Here, they will try to take a view on the market directions and predict the future course of interest rate movements. Moderate Strategy: A blend of both the above strategies. Here, managers will keep a portion of the total portfolio in various securities of different maturities. The remaining portion will be used for actively churning the portfolio across different time periods and coupons depending on the macro economic scenario, so that the total return from the portfolio remains at a higher level though the latter portion may carry higher risk. Interest Rate Risk: The biggest risk faced by G-Sec holders is interest rate risk. When interest rates go up, GSec prices fall. But, an increase in interest rate allows the bondholder to reinvest the cash flow at a higher rate. Likewise, when interest rates come down, G-Sec prices increase. So, bondholders can make good capital gains from bonds. But, they have to reinvest the sale proceeds at a lower interest rate as interest rates have fallen. For analysis purpose and to give research a hands on approach, we have taken a dummy
portfolio of Rs. 50 crore. Yields of four different Government securities of 1,5,11, and 30 years are being taken. The actual coupon rate, yield, maturity date etc. are as follows:
Factual Coupon Year rate Maturity date Yield as on 31 Dec 2010 Price 99.79431 1 6.85% 05-Apr-11 7.53% 4 98.57999 5 11 7.59% 8.13% 12-Apr-16 21-Sep-22 7.92% 8.03% 1 100.7307 98.59234 30 8.30% 02-Jul-40 8.43% 9 10 15 20 5 Investment (in Rs. cr)
We also gathered actual data of 31 may 2011 for comparison purpose. For yield maximization and balanced portfolio following strategies is advised: Passive Bond portfolio management strategies There are two major passive strategies:
? ?
Buy-and-hold Indexing
Buy-and-hold Strategy This strategy simply involves buying a bond and holding it until maturity. These investors do not trade actively to earn returns, rather they look for bonds with maturities or durations that match their investment horizon. There is also a modified buy-and-hold strategy in which investors buys bonds with the
intention of holding them until maturity, but they still actively look for opportunities to trade into more desirable positions. In our case let us say we are holding all 4 instruments till maturity. And considering higher interest rates ahead. Let us take one by one all the factors which can affect bond yield (remember we are taking January 2011 as our research) Inflation: As per RBI data inflation will remain high in coming months though downslide which will prompt bond yield to remain high. In January 2010 it is around 7.5%. So short term bond maturing will result in higher yields so passive portfolio would not advisable. March 2011 inflation expectation is 5.5%, above from what was stipulated. Liquidity Remains tight in Dec 2010 and Jan 2011 and expected to ease soon as RBI eased SLR by 1% in Nov 2010 monetary policy. Also it unveiled plans to buyback Rs.48000 crore of securities next month. Government Borrowing Programmes The Centre has completed nearly 89% of its Rs 4.47 lakh crore market borrowing for 201011 by mid-January, indicating more funds would be available for corporate in the remaining period of the fiscal. "Nearly 89% of the GOI's gross market borrowing programme for 2010-11 was completed during the year (up to January 19, 2011)," the Reserve Bank today said in its Macroeconomic and Monetary Developments report. Encouraged by buoyancy in tax and non-tax revenue, including receipts under 3G spectrum auctions, the government had scaled down its gross borrowing for the fiscal by Rs 10,000 crore to Rs 4.47 lakh crore. Source:http://articles.timesofindia.indiatimes.com Oil price According to global forecast, oil prices will likely to remain high in 2011. So it may raise WPI inflation in India, which eventually tends to increase yields. Prices are expected to rise as "the world oil market should gradually tighten in 2010 and 2011, provided the global economic recovery continues as projected," the EIA said. Economic growth in developed economies that make up the Organization for Economic Cooperation and Development should increase from 1.2% in 2010 to 2.7% in 2011.
Source:http://www.worldoils.com/oilforum Given all these facts, bond yields are expected to have higher rates and will give higher return in coming months. So it would be appropriate to maintain long term bonds in increasing interest rate scenario. Given below is the actual 31 may 2011 yields for different maturities. As expected bonds yields have increased from Dec 31 2010 rates.
Year 1 5 11 30
Coupon rate 6.85% 7.59% 8.13% 8.30%
Maturity date 05-Apr-11 12-Apr-16 21-Sep-22 02-Jul-40
Yield as on 31 May 2011 8.23% 8.49% 8.51% 8.66%
So keeping in mind the increasing interest rate scenario, we will try to maximize our returns by adopting active portfolio management strategies.
Individual Bond Strategies
Ladders, barbells, and bullets are strategies for timing our bond investments, both when we buy them and when they mature. These strategies can help cushion our investments from interest rate fluctuations.
Ladders: Bonds mature at different times and we continually reinvest them.
Barbells: Sets of bonds mature in the long term and short term, but not the mid term .
Bullets: Bonds, invested at different times, have the same target maturity date.
Ladders Ladders are a popular strategy for staggering the maturity of bond investments and for setting up a schedule for reinvesting them as they mature. A ladder can help you reap the typically higher coupon rates of longer-term investments, while allowing you to reinvest a portion of your funds every few years. Building a Ladder Using Individual Bonds.
Example: Ladder strategy We buy three bonds with different maturity dates: two years, four years, and six years. As each bond matures, we have the option of buying another bond to keep the ladder going. In this example, we buy 10-year bonds. Longer-term bonds typically offer higher interest rates.
Ladders are popular among investors who want bonds as part of a long-term investment objective, such as saving for college tuition, or seeking additional predictable income for retirement planning. The term for each strategy reflects its chief characteristic.
With ladders, we typically reinvest in steps.
Bond Laddering in Dummy Portfolio
Ladders are one of the most common forms of bond investing. This is where the portfolio is divided into equal parts and invested in laddered style maturities over the investor's time horizon. Figure 1 is a actual example of a basic year laddered INR 50 crore bond portfolio with a stated coupons as follows. Here through ladder strategy we divide the principal 50 crore in four equal portion and invested in 1,5,11, and 30 year Government securities having in hand data of Dec 31, 2010.
Year
1
2
3
4
5
6
7
8
9
10
Principal (in Rs.?000) 1 Year coupon (6.85%) 5 year coupon (7.59%) 11 year coupon (8.13%)
1250
1250
1250
1250
1250 1250 1250 1250 1250 1250
85625
94875
94875
94875
94875
9487 5
101,625 101,625 101,625
101,62 101, 101, 101, 101, 101, 101, 5 625 625 625 625 625 625
So we can summarize that by using the ladder strategy we have following advantages:
•
First, by staggering the maturity dates, we won't be locked into one particular bond for a long duration
• •
• •
It provides investors with the ability to adjust cash flows according to their financial situation Higher average yield, consistent return in fluctuating scenario Periodic return of principal provides the investor with additional income beyond the set interest payments Income derived from principal and interest payments can either be directed back into the ladder if interest rates are relatively high or invested elsewhere if they are relatively low
• •
Interest rate volatility is reduced because the investor now determines the best investment option every few years, as each bond matures Can require commitment of assets over time, and return of principal at time of redemption is not guaranteed
Cautions:
?
?
Bond ladder shouldn't be attempted if investors do not have enough money to fully diversify their portfolio by investing in both stocks and bonds Buying small lots of bonds may increase costs
Barbells
Barbells are a strategy for buying short-term and long-term bonds, but not intermediateterm bonds. The long-term end of the barbell allows you to lock into attractive long-term interest rates, while the short-term end insures that you will have the opportunity to invest elsewhere if the bond market takes a downturn.
With barbells, maturing bonds are clustered in short and long term. With bullets, bonds share the same target maturity date.
Example: Barbell strategy We see appealing long-term interest rates, so you buy two long-term bonds. You also buy two short-term bonds. When the short-term bonds mature, we receive the principal and have the opportunity to reinvest it.
Barbell Strategy in Dummy Portfolio
Here we will invest our portfolio in only 1 year and 30 year bonds. The idea behind doing this is to gain in investing short term increasing rate scenario by investing again. Also to protect investor from steady return in investing half of the money in long term bonds as it yields a higher rate of return. Thus investor will get a twofold advantage. Hence from our dummy portfolio of 50 crore, half we will invest in 1 year 6.85% Gsec and rest half in 30 year, 8.30% Gsec.
Potential Advantages: • An investor needs to revise only half of the portfolio depending upon the expectation of changes in interest rates • If interest rates are expected to rise, then he/she should sell the long-term bonds and invest in short term (as we might seen in earlier part of 2011) and do the opposite if the interest rates are expected to fall
Cautions: • One downside to a barbell strategy is its transaction costs due to periodic reinvestment of short term bonds as it is having half of the portfolio
•
In addition, long term bonds are much more sensitive to interest rate changes. Therefore, the long maturity side of the portfolio tends to have greater volatility than
the short maturity side.
Bullets
Bullets are a strategy for having several bonds mature at the same time and minimizing the interest rate risk by staggering when you buy the bonds. This is useful when you know that you will need the proceeds from the bonds at a specific time, such as when a child begins college . Example: Bullet strategy We want all bonds to mature in 10 years, but want to stagger the investment to reduce the interest rate risk. You buy the bonds over four years.
A single maturity of different bonds is the purpose of the bullet strategy. However, the essence is that the maturities of the bonds in the portfolio are concentrating towards one maturity time. One of the advantages of the Bullet Strategy is to focus cash flows to meet expected future expenditures such as meeting some end goal . Zero-coupon bonds could be appropriate in these situations because they eliminate reinvestment risk and provide a known amount of cash at maturity. Another reason to have such a strategy could be to position a portfolio in response to strong anticipated change in interest rates in one direction. Another main benefit of the bullet strategy is that it allows the investor to minimize the impact of fluctuations in the interest rate, while still realizing excellent returns on the investments.
Indexing
Bond Indexing - Bond Indexing involves designing a portfolio consisting of fixed securities, fixed for income, so that a particular bond index benchmark is followed by the securities. Because bonds are considered a lower risk than stocks, it is wise to have many of these within our portfolio so that our portfolio is diversified with less risky investments. A benchmark is a standard that is used to compare. This comparison can then be used to decide which bonds are safe investments with good returns. The adjustment of the weights of assets in an investment portfolio so that its performance matches that of an index. Linking movements of rates to the performance of an index. Indexing is a passive investment strategy. An investor can achieve the same risk and return of an index by investing in an index fund. Examples of rates that could be linked to the performance of an index are wages or tax rates. 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. 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. Source:http://www.fimmda.org/modules/content/?p=1015
Current Inflation scenario is giving a signal of higher rates ahead. Keeping in mind the monetary policies adopted by the RBI and market expectations and economists, there is no sign of inflation easing up. So to protect our investment from inflation erosion, it would be wise to link our portfolio to Inflation Index Bonds i.e. IIB. Shown below is the
Using Derivatives to Mitigate Risk
To protect our portfolio from fluctuation of interest rate, Derivatives will be used. As we are anticipating increase in interest rates in future, this will lead to an increase in yields which will eventually result in decrease in value of the bank assets. So to avoid this we will use the derivative. To mitigate the risk of interest rate fluctuation in future, we will adopt here the Derivative instruments. The most common derivatives which we will use are:
? ? ?
Future, Option and swaps
A derivative is essentially a contract whose payoff depends on the behaviour of some benchmark. We can hedge our Gsec portfolio by using these derivative options.
Hedging using Interest Rate Future
An interest rate future contract rate is "an agreement to buy or sell a package of debt instruments at a specified future date at a price that is fixed today." Here we will mainly use our INR 500 million portfolios in Interest Rate Future first. On December 31, 2010, the yield of 11 year 8.13% Gsec is 8.03%. The price is INR 100.7307. Now let us assume, on 31 May 2011 the 10 year Gsec, notional 9% coupon bond future
contract. 99.4139 will be the price at this yield. We will enter an IRF agreement in exchange with a interest rate of MIBOR+0.5% which is say 9%. So in this, we are hedging our investment in Gsec by getting 9-8.03 i.e. 0.97% till maturity. The actual MIBOR rate was 9.24% on 31 March 2011 which is expected and raised rate is stated above due to short funds available with the banks. So in our portfolio of INR 50 crore, if we had invested about 15 crore in 10 year 8.13% Gsec, we would have gained 15*0.0097 i.e. INR 14, 55,000 Now suppose the yield gone down to 8% as per MIBOR rate, and then the loss will be .03%. Hence it is very much necessary to predict the future rate very well to arrive at IRF agreement. Also he should have knowledge about economy, money situation in country, inflationary expectation et al.
Hedging using Interest rate Swap
Interest rate swaps are an agreement on the payment of cash flow in terms of a fixed interest rate as opposed to the floating and ever changing interest rate. This is an agreement between two parties, which are known as the counterparties. Interest rate swap helps the counterparties avoid the fluctuations in interest rates which can be varied and undesirably liquid, and depends basically on changing position of the market and currency value. Typically, payments made by one counterparty are based on a floating rate of interest, such as the London Inter Bank Offered Rate (LIBOR), while payments made by the other counterparty are based on a fixed rate of interest. Let say given our portfolio of INR 500 million Bank of Baroda and counterparty agree to “plain vanilla” swap starting in January 2010 that calls for a 5-year maturity with the bank paying the swap rate (fixed rate) to the counterparty and the counterparty paying 6-month LIBOR (floating rate) to the issuer. Using the above formula, the Swap Rate can be alculated by using the 6-month LIBOR+0.5% “futures” rate to estimate the present value of the floating component payments. Payments are assumed to be made on an annual basis (i.e., 360-day periods).
Floating Rate - Overnight LIBOR for 5 years Amount (Outstanding at beginning of the year)
Year
Floating LIBOR+ 0.5%
Interest amount
Amount (Outstanding at the end of the year)
1
15,00,00,000
7.00%
1,05,00,000
16,05,00,000
12037500
2 16,05,00,000 7.50%
172537500
172537500
3 7.60%
13112850
185650350
198367399 185650350
4 6.85%
12717049
198367399
5 Total interest accrued 7.65% 7.32%
15175106
213542505
63542505
Assumed LIBOR rate for is given in third column. Total interest accrued on floating rate leg is Rs 63542505 as shown above. Fixed leg interest At say 7% p.a., the interest for 5 year is Rs. 60382760 Thus BoB, which was to receive floating rate of interest will receive Rs 60382760 from counterparty, which was paying floating rate and receiving fixed rate. By looking at the rates as well we can calculate the amount of payout. Bank will receive the difference amount from counterparty. i.e. INR 31,59,745
Hedging using Options
Terminologies
Used in Bond Market Bonds Issuer of Bonds Bond Holder Principal Amount
Meaning in General Terms Loans (in the form of a security) Borrower Lender Amount at which issuer pays interest and which is repaid on the maturity date
Issue Price
Price at which bonds are offered to investors
Maturity Date Coupon
Length of time (More than one year) Rate of interest paid by the issuer on the par/face value of the bond
Coupon Date
The date on which interest is paid to investors
doc_652124241.pdf
Department Fixed Income Market Treasury, Bank of Baroda
Under the Guidance of : Manish Kaura Chief Manager, Bank of Baroda
Submitted by : Nitin Agrawal MMS 2010-12 Welingkar Institute of Management Development and Research, Mumbai.
Acknowledgement
I owe a great many thanks to a people who helped and supported me during the writing of this project.
My deepest thanks to Mr. Manish Kaura, Chief Manager, Bank of Baroda, the Guide of the project for guiding and correcting various documents of mine with due attention and care. He has been very helpful trough out the project and makes necessary correction as and when needed.
I express my thanks to the A.G.M. Treasury, Bank of Baroda Mr. D.Jhalmalwala for extending his valuable support.
My deep sense of gratitude to Himanshu Chopra, Aditi Mishra, support and guidance. Thanks and appreciation to the helpful people at treasury, Bank of Baroda Mumbai for their support.
I would also thank my Institution and my faculty members without whom this project would have been a distant reality.
Table Of Contents
Chronological testing of linkage of forex with consolidated market: .......................................... Error! Book
Recommendation: ........................................................................................................................ Error! Book
References: ................................................................................................................................. Error! Book
Executive Summary The project is titled “Strategies to maximize returns in Fixed Income Market characterised by increasing interest rates”. The primary objective of this project is to understand Fixed Income market, mainly Government Security, its relationship with interest rates, future prospects and its relation with various other segments of the market like inflation, repo rates, and crude oil prices. Various strategies that a banking institute undertakes via its Treasury to maintain or enhance returns on its Fixed Income Market related transactions keeping in view the various guidelines laid down by RBI and meeting them. For this, a dummy portfolio has been taken, studied and analysed accordingly.
The project also covers understanding of role played by treasury in bank. What are the various markets for investment available with it and how are they interlinked. A detailed study of Indian Government securities market is covered and instruments which are available and traded in this market are emphasized. In India the Fixed Income market is still in its initial phase but the growth trends are very strong. With the advent of various new innovative trading instruments as well as ease of trading through electronic platforms, Fixed Income market has gained a lot in terms of size and volume of transaction across the world.
The analysis helped us in understanding the major factors to consider while developing a view on the Fixed Income market, mainly G-secs. Finally, the analysis helped us in framing few recommendations which may prove valuable for the bank in long run.
Introduction
Need for Study
The debt market is much more popular than the equity markets in most parts of the world. In India, the reverse has been true. Nevertheless, the Indian debt market has transformed itself into a much more vibrant trading field for debt instruments from the rudimentary market about a decade ago. This project aims at enhancing the G Secs yield vis-a-vis increasing interest rate scenario.
India needs a huge amount of money to fund its developmental programmes. Most of the fund is expected to come from bond routes. Banks, in order to meet its mandatory requirements of SLR invests major portion in G Secs. In return it provides a steady return of interest on coupon. To maintain banks NIM in current increasing rates scenario, its income from interest should increase. Therefore it is now advisory for the banks to diverse its portfolio and innovate its investment portfolio product. Given current market fluctuation in equity market and mounting inflation, it is wise to invest in bond market. There lies a huge market for debt instruments. Also Government?s fiscal deficit will definitely open new gateways for bond market. Thus it is high time to invest in bonds to maximize returns for the company.
Methodology
The operations of fixed income department are observed at the treasury department. The suitable data collected for analysis of linkage of bond (G Secs) price and yield. Suitable data has been obtained from the Bank of Baroda Fixed Income department, internet, books et al. This data is recorded by the bank over the years on a daily basis. The data, thus collected, has been analyzed and strategy to be adopted is advised.
Introduction to Fixed income Market Fixed income refers to any type of investment which is not equity that obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable. Governments issue government bonds in their own currency and sovereign bonds in foreign currencies. Local governments issue municipal bonds to finance themselves. Debt issued by government-backed agencies is called an agency bond. Companies can issue a corporate bond or get money from a bank through a corporate loan ("preferred stock" can be "fixed income" in some contexts). Securitized bank lending (e.g. credit card debt, car loans or mortgages) can be structured into other types of fixed income products such as ABS – asset-backed securities which can be traded on exchanges just like corporate and government bonds. The term fixed income is also applied to a person's income that does not vary with each period. The term "fixed income" can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large expenditures. Fixed-income securities can be contrasted with equity securities that create no obligation to pay dividends, such as stocks. In order for a company to grow as a business, it often must raise money; to finance an acquisition, buy equipment or land or invest in new product development. Investors will give money to the company only if they believe that they will be given something in return commensurate with the risk profile of the company. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond, bank loan, or preferred stock). The term "fixed" in "fixed income" refers only to the schedule of obligatory payments, not the amount. "Fixed income securities" include inflation linked bonds, variable-interest rate notes, and the like. If an issuer misses a payment on a fixed income security, the issuer is in default, and the payees can force the issuer into bankruptcy. In contrast, if a company misses a quarterly dividend to stock (non-fixed-income) shareholders, there is no violation of any payment covenant, and no default.
While a bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed-income industry:
? ? ? ? ? ? ?
The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest. The principal of a bond – also known as maturity value, face value, par value – is the amount that the issuer borrows which must be repaid to the lender.[1] The coupon (of a bond) is the interest that the issuer must pay. The maturity is the end of the bond, the date that the issuer must return the principal. The issue is another term for the bond itself. The indenture is the contract that states all of the terms of the bond. Investors
Investors in fixed-income securities are typically looking for a constant and secure return on their investment. In buying a bond, one is in effect buying a set of cash flows, which are discounted according to the buyer?s perception of how interest and exchange rates will move over its life. Supply and demand affect prices, especially in the case of market participants which are constrained in the set of investments they make. Insurance companies often have long term liabilities that they wish to hedge, which requires low risk, predictable cash flows, such as long dated government bonds. Fixed income derivatives include interest rate derivatives and credit derivatives. Often inflation derivatives are also included into this definition. There is a wide gamut of fixed income derivative products: options, swaps, futures contracts as well as forward contracts. The most widely traded kinds are Credit default swaps A swap designed to transfer the credit exposure of fixed income products between parties Credit Default Swap (CDS) The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.
For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.
Interest rate swaps
An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap Forward rate agreements An over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract. Also known as a "future rate agreement".
Risks of Fixed Income Investing Despite the generally conservative nature of many fixed income investments, such as investment grade-quality bond funds and money market funds, and the tendency of fixed income investments to be more predictable than stocks, investors should be aware that bond funds and individual bonds do carry some degree of risk. Bond funds achieve diversification by holding many securities, so are generally less risky than individual bonds in that regard. However, there are some risks that may apply to both investments, as noted below.
? ? ? ? ? ?
Interest Rate Risk Credit Risk Inflation Risk Call Risk Prepayment Risk Reinvestment Risk Interest Rate Risk If interest rates rise, bond prices usually decline. If interest rates decline, bond prices usually increase. This risk exists because new bonds are likely to be issued with higher yields as interest rates increase, making the old or outstanding bonds less attractive. The longer a bond fund's maturity, the greater the impact a change in interest rates can have on its price. If you don't hold your bond until maturity you may experience a gain or loss when you sell your bond.
Credit Risk Bonds carry the risk of default, which means that the issuer is unable to make further income and principal payments. Many individual bonds are rated by a third party source such as Moody?s or Standard & Poor?s to help describe the creditworthiness of the issuer. U.S. Treasury bonds have backing from the U.S. Government and thus no default risk. Although they are not directly backed by the full faith and credit of the U.S. Government, government agency bonds, such as those issued by Fannie Mae and Freddie Mac, are considered to be high credit quality. Since a bond fund is made up of many individual bonds, diversification can help mitigate the credit risk of a downgrade, which would affect bond prices, or a default. Bonds are typically classified as investment grade-quality (medium - highest credit quality) or below investment grade-quality (commonly referred to as high-yield bonds), as are bond funds. Credit risk is a greater concern for high-yield bonds and bond funds that invest in lower-quality bonds and bonds of issuers whose ability to pay interest and principal may be considered speculative. Some bond funds may invest in both investment grade-quality and high-yield bonds. It's important to read a fund?s prospectus before investing to make sure you understand the fund?s credit quality guidelines.
Inflation Risk Because a high inflation rate can erode the real value of the income you receive, inflation can jeopardize any fixed income stream on which you may be counting. To combat this risk, you may want to consider a bond or bond fund that has its principal adjusted for increases in the inflation rate, such as U.S. Treasury Inflation-Protected bonds (TIPs) and bond funds that invest in TIPs.
Call Risk A callable bond has a provision that allows the issuer to call, or repay, the bond early. If interest rates drop low enough, the bond's issuer can save money by repaying its callable bonds and issuing new bonds at lower coupon rates. If this happens, the bond holder's interest payments cease and they receive their principal early. If the bond holder then reinvests the principal in bonds, he or she will likely have to accept a lower coupon rate, one that is more consistent with prevailing interest rates. This will lower monthly interest payments.
Prepayment Risk Some classes of individual bonds, including mortgage-backed bonds, are subject to prepayment risk. Similar to call risk, prepayment risk is the risk that the issuer of a security will repay principal prior to the bond’s maturity date, thereby changing the expected payment schedule of the bonds. This is especially prevalent in the mortgage-backed bond market, where a drop in mortgage rates can initiate a refinancing wave. When homeowners refinance their mortgages, the investor in the underlying pool of mortgage-backed bonds receives his or her principal back sooner than expected, and must reinvest at lower, prevailing rates.
Reinvestment Risk During periods of declining interest rates, you may be forced to buy new bonds at lower, prevailing interest rates as your existing investments reach maturity. Since bond funds are professionally managed, the fund's manager does this for you, searching for the most attractive bonds in any interest rate environment. In addition to the risks associated with fixed income investments described above, you should keep some other factors in mind before making an investment decision. Price Fluctuations Most importantly, investors should be aware that with either a bond fund or an individual bond, prices may fluctuate, as the securities are affected by economic and other factors. As a result, the value of your investment may increase or decrease. Bonds held to maturity will return the full principal amount to the bondholder upon maturity. However, those sold prior to maturity are subject to gain or loss depending on the market price at the time of sale.
The price of a bond fund may vary daily as the underlying bond prices change. Upon selling shares in the fund, the shareholder will realize a gain or loss depending on the NAV of the fund at the time of sale. Income Fluctuations As bond funds buy and sell bonds of different coupon rates, the income derived from these bonds, and passed on to shareholders, may vary. Balancing Risk vs. Reward As with any type of investment, there is a trade-off between the risk you are willing to assume and the potential return you could receive. The higher the potential reward or return, the greater the risk inherent in a bond fund or individual bond. For example:
?
Government bond funds and securities offer the lowest level of risk but they also typically offer lower yields
?
Bond funds and bonds with shorter maturities or duration will likely have less price volatility, but may have lower yields
?
Because bond funds are diversified across securities and professionally managed, they may be a better choice for many investors
Role of a Treasury Department in a Bank The primary functions of a treasury department at a bank involve asset/liability management. A substantial amount of time is invested by the department in forecasting net interest income (NII) and measuring the bank's interest rate risk (IRR) or sensitivity to changes in prevailing interest rates. The statistics generated by the department are typically fed to the bank's Asset and Liability Committee (ALCO), the group which is responsible for establishing guidelines for risk taking and balance sheet funding. The treasury department generally performs other related functions, such as managing the bank's reserve and risk capital requirements, funding the bank's balance sheet through a number of creative strategies (this is typically done in conjunction with the bank's corporate investments unit), and managing the institution's insurance requirements - property and casualty, directors and officers, and BOLL (Bank Owned Life Insurance). The core function of a treasury department at any bank is the measuring, monitoring, and controlling of interest rate risk (IRR). IRR is the risk that changes in prevailing interest rates will adversely impact the value of the bank's assets and liabilities.
The actual level of involvement of a treasury department in interest rate risk management varies by institution, but generally speaking, the department would forecast net interest income (NII) and measure the sensitivity of NII to changes in rates. Typically the department would employ a variety of standard and proprietary models to measure this risk. The output of this analysis would be supplied to the institution's ALCO (Asset/Liability Management Committee). ALCO is responsible for overseeing a variety of asset and liability (ALM) activities including the establishment of guidelines for the bank's risk tolerance levels. The treasury department may further be tasked with ensuring IRR stays within guidelines set by ALCO by entering into a variety of financial transactions, such as interest rate swaps, futures contracts, and so on. There are other functions often housed within the treasury department, including a process known as funds transfer pricing (FTP). At a high-level, the FTP process centrally manages the funding requirements of the entire bank in lieu of having each division fund its own balance sheet. Additionally, the department may assume responsibility for monitoring the institution's risk capital levels including the rules set forth in Basel II. Loans and advances are specific contractual agreements between the Bank and its borrowers and do not form part of treasury assets, although they are obligations to the Bank. (They can, however, be securitized and sold in the market). But an investment in G-Secs can be sold (or bought) in the market. It is, therefore, a treasury asset. An illustrative list of (domestic) treasury assets and liabilities is as follow: Assets • • • • • • Liabilities • Call / Notice / Term Money G-Secs, T-bills, State Government securities Commercial Paper Certificates of Deposit Non-SLR Bonds/Debenture Pass-through Certificates Equity Shares
• • • •
Certificates of Deposit Refinance from SIDBI/NHB/NABARD etc. Refinance from RBI Tier II Capital Bonds (if issued by the Bank)
Treasury income Sources • Investments, where the Bank earns a higher yield than its cost of funds. Example Buy corporate bond maturing in 3 years @9% Fund the amount from deposits maturing in similar period (3 years) @8.5% Profit = 0.5% coupon for 3 years • Spreads between yields on money market assets and money market funding. Example – The Bank may, for instance, borrow short-term for 4% and deploy in commercial paper returning 6%. When call rate is more than CBLO interest rate, buy CBLO and use the proceeds as call money • Arbitrage. – When there is possibility of profit without taking extra risk, there is a chance of arbitrage. Arbitrage exists in market because of market inefficiency. Example – Let?s say existing interest rate in India for 1 Yr loan fixed rate = 8%. 1 yr forward LIBOR 9% Step 1 - Bank took 1 Million Rupees Loan. Interest payment = 8000 Rupees Step 2 – Swap in Forex market. Buy a forward rate, with maturity 1yr @ LIBOR rate 9% Profit will be 1% spread – Forward premium. (Present value should be calculated to find out the exact present profit)
•
Relative Value. This is a form of arbitrage in which the Bank exploits anomalies in market prices. The Bank may have an „AAA? bond, which yields only 9%, compared to another with the same rating and maturity, but of a different issuer, which offers 9.5%. It is worth selling the first bond and investing in the second to improve the yield by 0.5% without any incremental risk, as both bonds have the same credit quality. It?s similar to arbitrage.
•
Proprietary Trading. The focus of proprietary trading is entirely short-term/medium, as compared to investment. The aim is to earn trading profits from inter day (or even intraday) movements in security and forex prices. They are mostly directional trades. Treasury may buy (say) 8.08%% Government of India security 2022 at Rs.99.44 at a yield of 8.15% in anticipation of the yield falling to 7.90%, on fundamental (or technical) grounds. If this happens, the bond appreciates and the Bank exits the position with a profit. Forex trading is also directional, involving, for example, buying dollar/yen in the expectation that the dollar will appreciate or selling euro/dollar hoping that the euro will decline.
•
Customer Services. Bank Treasuries offer their products and services to (generally) non-bank customers. The income to banks in these activities comprises fees for and / or margins on trade execution. Profits would be higher on structured (i.e., nonstandard) transactions compared to plain vanilla (e.g. a straightforward buy sell USD/INR) deals. Treasuries are also involved in investment banking where their responsibility covers trade execution on behalf of the Bank?s clients in the cash or derivatives markets. These may generate good margins, depending on the complexity and skills required to design and put through customized structures in the market.
Bank of Baroda treasury Operations Bank of Baroda has set up dedicated desks at the SITB, headed by experienced professionals, for undertaking various types of treasury activities in different financial markets. Apart from activities pertaining to management of funds and liquidity, the domestic treasury also handles financial instruments like:
? ? ? ? ? ?
Commercial Papers (CP) Certificate of Deposits (CD) Government Securities Treasury Bills (TB) Bonds and Debentures Equities and various other derivatives.
The products and services offered by SITB cater to the inter-bank market as well as to the corporate customers of the bank. The Bank is an active participant both in the inter-bank market and the corporate for all the products. The Bank offers its customers, including firms, companies, corporate bodies, institutions, provident funds trusts, Regional Rural Banks, Urban Cooperative Banks and Non-Banking Financial Companies opportunities to invest in Government Securities as allowed by Reserve Bank of India for non-competitive bidding. Segment wise result for year ending March 2011 results are as follows:
Bond Basics
Bond is a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity).
Some bonds do not pay interest, but all bonds require a repayment of principal. When an investor buys a bond, he/she becomes a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities. These are considered to be default risk free instruments. Payments in a Bond – 1. Principal Payment 2. Interest Payment 3. Interest on interest
Issuers – Central Government, State Government, corporations, and many other types of institutions
Types of Bonds
Classification on the basis of Variability of Coupon I. Zero Coupon Bonds Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders and hence, there are no cash inflows in zero coupon bonds. The difference between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders. The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the maturity period lesser would be the issue price and vice-versa. These types of bonds are also known as Deep Discount Bonds. II. Treasury Strips Treasury strips are more popular in the United States and not yet available in India. Also known as Separate Trading of Registered Interest and Principal Securities, government dealer firms in the United States buy coupon paying treasury bonds and use these cash flows to further create zero coupon bonds. Dealer firms then sell these zero coupon bonds, each one having a different maturity period, in the secondary market. III. Floating Rate Bonds In some bonds, fixed coupon rate to be provided to the holders is not specified. Instead, the coupon rate keeps fluctuating from time to time, with reference to a benchmark rate. Such types of bonds are referred to as Floating Rate Bonds. For better understanding let us consider an example of one such bond from BoB in 2010. The maturity period of this floating rate bond from BOB was 5 years. The coupon for this bond used to be reset half-yearly on a 50 basis point mark-up, with reference to the 10 year yield on Central Government securities (as the benchmark). Coupon rate in some of above mentioned bonds also have floors and caps. For example, this feature was present in the same case of BOB half-yearly floating
rate bond wherein there was a floor of 13.50% (which ensured that bond holders received a minimum of 13.50% irrespective of the benchmark rate). On the other hand, a cap (or a ceiling) feature signifies the maximum coupon that the bonds issuer will pay (irrespective of the benchmark rate). These bonds are also known as Range Notes. More frequently used in the housing loan markets where coupon rates are reset at longer time intervals (after one year or more), these are well known as Variable Rate Bonds and Adjustable Rate Bonds. Coupon rates of some bonds may even move in an opposite direction to benchmark rates. These bonds are known as Inverse Floaters and are common in developed markets.
Classification on the Basis of Variability of Maturity I. Callable Bonds The issuer of a callable bond has the right (but not the obligation) to change the tenor of a bond (call option). The issuer may redeem a bond fully or partly before the actual maturity date. These options are present in the bond from the time of original bond issue and are known as embedded options. A call option is either a European option or an American option. Under a European option, the issuer can exercise the call option on a bond only on the specified date, whereas under an American option, option can be exercised anytime before the specified date. This embedded option helps issuer to reduce the costs when interest rates are falling, and when the interest rates are rising it is helpful for the holders. II. Puttable Bonds The holder of a puttable bond has the right (but not an obligation) to seek redemption (sell) from the issuer at any time before the maturity date. The holder may exercise put option in part or in full. In riding interest rate scenario, the bond holder may sell a bond with low coupon rate and switch over to a bond that offers higher coupon rate. Consequently, the issuer will have to resell these bonds at lower prices to investors. Therefore, an increase in the interest rates poses additional risk to the issuer of bonds with put option (which are redeemed at par) as he will have to lower the re-issue price of the bond to attract investors. III. Convertible Bonds The holder of a convertible bond has the option to convert the bond into equity (in the same value as of the bond) of the issuing firm (borrowing firm) on pre-
specified terms. This results in an automatic redemption of the bond before the maturity date. The conversion ratio (number of equity of shares in lieu of a convertible bond) and the conversion price (determined at the time of conversion) are pre-specified at the time of bonds issue. Convertible bonds may be fully or partly convertible. For the part of the convertible bond which is redeemed, the investor receives equity shares and the non-converted part remains as a bond. Classification on the basis of Principal Repayment I. Amortizing Bonds Amortizing Bonds are those types of bonds in which the borrower (issuer) repays the principal along with the coupon over the life of the bond. The amortizing schedule (repayment of principal) is prepared in such a manner that whole of the principle is repaid by the maturity date of the bond and the last payment is done on the maturity date. For example - auto loans, home loans, consumer loans, etc. II. Bonds with Sinking Fund Provisions Bonds with Sinking Fund Provisions have a provision as per which the issuer is required to retire some amount of outstanding bonds every year. The issuer has following options for doing so: i. ii. issuer Since the outstanding bonds in the market are continuously retired by the issuer every year by creating a separate fund (more commonly used option), these types of bonds are named as bonds with sinking fund provisions. These bonds also allow the borrowers to repay the principal over the bond life. By buying from the market By creating a separate fund which calls the bonds on behalf of the
Risks involved in Bond Investment There is a myriad of fixed-income instruments available to the income-oriented investor. The type of investment bought can and does determine the risks and rewards. One of the most common types of debt available to an income investor is sovereign debt; the debt of a country?s treasury. Government sovereign debt, States, provinces, municipalities is
another type of local governmental debt. Another type of common debt obligations is corporate debt. Credit Risk in Bonds Any country?s sovereign debt is backed by the full faith and credit of that county?s treasury. Political subdivision?s credit is measured by that entity's ability to tax and their general credit worthiness. Corporate debt is issued either as debentures, which is unsecured debt or as debt secured by an asset, such as first mortgage bonds. Corporate and often political subdivisions carry ratings by a combination of three credit rating agencies. If a credit rating is lowered, the value of the bond decreases. The opposite is true should the credit rating be upgraded. All debt trades at a concession to sovereign debt. This concession, measured in basis points, is called the "spread over the curve." The "curve" means the yield curve. Maturity Risk in Bonds The risk to the individual investor is the interest rate to reinvest at once a bond matures. This is particularly important to people that depend on that income. The fixed-income market ranges anywhere from over-night to thirty years plus. If an investor buys a Government security of 10 year at 8% and interest rates are higher five years hence, the investor is that much better off. The opposite is true if interest rates are lower in five years. The investor would have less income. Option Risk in Corporate Bonds People think of "puts" and "calls" in terms of equity options. Many corporate bonds have options as well. A "callable" bond means that the corporation issuing the bond can "call" them back as of a certain date. The corporation would do this in order to refinance that debt at a lower interest rate. The investor has no choice but to give up the bonds. Some corporate bonds have "puts" attached. This means the investor can "put" the bonds or notes back to the corporation as of a certain date, such as a ten year note with a three year "put." The reason for this is so a financial institution can account for this note as a three year asset which helps them manage their asset / liability "gap" better.
Yield Curve Risk The "yield curve" is what interest rates are from very short term to quite long term. A normal curve is called "positive" where the longer the maturity, the larger the interest rate. An "Inverted" curve is where short term interest rates are more than longer term rate are. Often, the curve is "flat;" very little difference between short term and long term interest rates as in the current scenario i.e. first week of June 2011 indicating slowdown in economy ahead. Absent any external influence such as central bank intervention, the curve reflects an economic condition. Where an investor chooses to place their money along the yield curve is very akin to maturity risk plus certain economic assumptions added. Income investors should carefully weigh the various risks before committing their funds.
Duration The duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows is received. Duration also measures the price sensitivity to yield, the percentage change in price for a parallel shift in yields.
Determinants of Duration Following factors add to duration factor. 1. Coupon rate (which determines the size of the periodic cash flow) 2. Yield (which determines present value of the periodic cash flow) 3. Time-to-maturity (which weights each cash flow) 4. Frequency of coupon payment (annually, semi-annually)
Relationship of Duration with underlying factors
Holding coupon rate and maturity constant – (effect of YTM) Increases in market yield rates because a decrease in the present value factors of each cash flow. Since Duration is a product of the present value of each cash flow and time, higher yield rates also lower Duration. Therefore Duration varies inversely with yield rates. Holding yield rate and maturity constant – (effect of Coupon rate) Increases in coupon rates raise the present value of each periodic cash flow and therefore the market price. This higher market price lowers Duration. Therefore Duration varies inversely to coupon rate. Holding yield rate and coupon rate constant – (effect of Maturity period) An increase in maturity increases Duration and cause the bond to be more sensitive to changes in market yields. Decreases in maturity decrease Duration and render the bond less sensitive to changes in market yield. Therefore Duration varies directly with timeto-maturity (t) Effect of Frequency of coupon payment It is similar to holding maturity period and YTM constant and varying coupon rate With increase in coupon payment frequency, the duration decreases. Therefore Duration varies inversely to coupon payment frequency.
Effect of interest rate cap and floor – (For floating interest rate)
With addition of a cap the upward movement of the YTM/Interest rate is restricted at the cap. Similarly the downward movement of the interest or YTM is restricted at Floor value. So with the addition of cap or floor (Collar), interest rate risk reduces or Duration decreases. Effect of adding options to security instruments –
Effect of Call/Put Option –
Value of a Bond with call option = Value of option free bond – Value of Call option YTM a Bond with call option = YTM of option free bond + Call Premium
The upward movement of the price of a callable bond is restricted to Call price, because a callable bond has the high probability of being called at Call price. So IRR of a callable bond is less than an option free bond.
Value of a Bond with put option = Value of option free bond + Value of Put option YTM a Bond with put option = YTM of option free bond – put discount
Same is applicable for a Put option, which provides a lower limit to price variance (IR). So IRR of a putable bond is less than an option free bond.
Measurement of Duration
Macaulay Duration – It 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, and is a measure of bond price volatility with respect to interest rates. Macaulay duration =
(Source www.investopedia.com) The metric is named after its creator, Frederick Macaulay. Macaulay duration is frequently used by portfolio managers who use an immunization strategy. Macaulay duration is also used to measure how sensitive a bond or a bond portfolio's price is to changes in interest rates Modified Duration Duration allows market participants to estimate the relative price volatility of different securities:
Modified duration= Macaulay?s duration / (1+y) Using Modified duration we can get the estimation of price volatility %change in price = modified duration x Dy
Duration management strategies
How to take a decision about selecting a bond on the basis of yield and duration – Example –
Two bonds A and B with YTM 7% and 8%. Their durations are 5 and 6 respectively.
Here rate of change of YTM ?Y = ((8 - 7) / 7) %= 14.28% Rate of change of duration ?D =( (6 – 5) / 5 )% = 20% Here there is higher rate of change of risk ( ?D) than increase in rate of change of Yield (?Y) So Bond A is better than bond B
Yield Enhancement
Yield Enhancement is increasing yield of an investment (Bond or portfolio of bonds) at similar risk. They can be classified as Active Bond portfolio management strategies Passive bond portfolio management strategies Matched-funding strategies
There are two basic approaches to investment management:
?
Active asset management is based on a belief that a specific style of management or analysis can produce returns that beat the market. It seeks to take advantage of inefficiencies in the market and is typically accompanied by higher than average costs (for analysts and managers who must spend time to seek out these inefficiencies).
?
Passive asset management is based on the concept that markets are efficient, that market returns cannot be surpassed regularly over time, and that low cost investments held for the long term will provide the best returns.
Passive management concepts to know include the following:
?
Efficient market theory - This theory is based on the idea that information that affects the markets is instantly available and processed by all investors. As a result, this information is always taken into account in market prices. Those who believe in this theory believe there is no way to consistently beat market averages.
?
Indexing - One way to take advantage of the efficient market theory is to use index funds. Since index funds tend to have lower than average transaction costs and expense ratios, they can provide an edge over actively managed funds which tend to have higher costs.
Differences The main difference between passive and active management is the assumption that the portfolio manager, whether it be a large institution or an individual, has the ability to either predict the direction of interest rates or exploit mispriced securities. While the manager does not have to be correct 100% of the time, he/she must be successful enough to provide returns in excess of a passively managed portfolio, minus transaction costs, taxes and management fees. In order to achieve these results, there are at least four active styles to choose from:
? ? ? ? ?
Valuation Interest rate anticipation Yield spread Bond swaps
Each strategy can be deployed across the entire bond universe or specifically to investmentgrade, high-yield, international and municipal bonds for tax-sensitive investors. These strategies can be used independently or simultaneously. Valuation Strategy The basic premise of valuation is based on the portfolio manager's ability to identify and purchase undervalued securities and avoid those that appear to be overvalued. This takes some experience and in-depth knowledge of the bond markets, and can be done on a large scale or across a handful of bonds. That slight deviation can be caused by any number of inefficiencies, up to and including a temporary lack of demand or the intrinsic value of embedded options. These options can have a perceived value or lack of value from one investor to another. The goal here is to exploit those inefficiencies over and over again in a dynamic environment.
Interest Rate Anticipation Interest rate anticipation is one of the most common - and probably riskiest - strategies, since it relies on forecasting.
Since duration is a more accurate metric to measure volatility, it is used to adjust the portfolio. Duration is lengthened in an effort to capture an increase in value when the prediction is that interest rates will fall. Conversely, if interest rates are expected to rise,
the move would be to shorten the duration of the portfolio to preserve capital and potentially reinvest in shorter-term bonds when rates are presumed to be higher. Of course, the risk lies again on the presumption of the future and the success of each adjustment. This strategy can significantly enhance returns with the correct forecasting, but can drive an investment-grade portfolio into the ground if poor bets are made. Yield Spread Strategy Yield spreads are determined by the pricing of bonds in various segments of the market. The unique characteristics of the bonds relate to the varying prices and related yields.
These characteristics can include:
?
Term to maturity - Maturities within a specific segment typically spread across the yield curve if it is not flat. When the yield curve is upward sloping, longer-maturity bonds have higher yields, and the opposite is true in downward-sloping environments.
? ?
Coupon payments - Different coupons across segments can also carry different prices due to their demand and liquidity.
? ?
Sectors - Bonds across different sectors with the same credit ratings may be priced differently for many reasons. An example of that would be AA bonds for a regional bank vs. AA bonds for a pharmaceutical company.
? ?
Credit spreads - Different bond types (i.e. Treasuries vs. corporate) tend to be priced differently, all variables held constant.
? ?
Investors have the opportunity to profit from this strategy by accurately predicting changes in spreads or changes in the term structure of interest rates. It is important to be very familiar with the implied spreads and have the ability and knowledge to move swiftly to take advantage of opportunities. As spreads tend to widen during periods of economic uncertainty, a spread specialist may take long positions in riskier bonds to capture higher yields as others flee to safety. While the coupon spread is the obvious benefit, it is the ability to predict the turning points to a certain degree of accuracy that is the key. This is where the price of a bond moves the most dramatically and most of the value added is found. Bond-Swap Strategies
What is a Bond Swap? A bond swap is a technique whereby an investor chooses to sell a bond and simultaneously purchase another bond with the proceeds from the sale. Fixed-income securities make excellent candidates for swapping because it is often easy to find two bonds with similar features in terms of credit quality, coupon, maturity and price. In a bond swap, you sell one fixed-income holding for another in order to take advantage of current market and/or tax conditions and better meet your current investment objectives or adjust to a change in your investment status. Why You Would Consider Swapping Swapping can be a very effective investment tool to: ? ? ? ? Increase the quality of our portfolio; Increase our total return; Benefit from interest rate changes; and Lower our taxes.
These are just a few reasons why you might find swapping your bond holdings beneficial. Although this booklet contains general information regarding federal tax consequences of swapping, we suggest you consult your own tax advisor for more specific advice regarding your individual tax situation. . Gaining a Greater Yield Investors who want to increase the amount of potential return through their bond investments may choose to swap bonds by:
?
Extending maturity. Investors will often swap a shorter-term bond for a longer-term bond, since longer-term notes typically offer a higher yield. Typically, the longer a maturity on a bond, the greater the yield. When swapping to increase yield, it's important to consider that extending maturities could make your investment more vulnerable to price fluctuations if interest rates change.
?
Lowering credit quality. Because bonds with lower credit ratings typically compensate investors for the greater risk with higher yields, someone may cautiously choose to swap a higher-quality for a lower-quality bond to gain a greater return.
?
Taking advantage of changing conditions. You may want to consider swapping
bonds if you're changing conditions within a specific industry or the overall market is causing issuers to offer higher coupon rates and lower prices for a similar bond (same credit rating, par value, etc.) already in your portfolio.
Dummy Portfolio and Subsequent strategy/s to maximize returns in Government Securities
As and when there is hardening of yields, one tries to manage the bond portfolio through reduction of the duration of the portfolio in order to minimise the impact of rising yields. In a rising interest rate scenario, bond managers typically prune their exposure to longterm bonds that carry higher interest rate risk compared to short- term bonds and move into short-term instruments, like, money market instruments. In the same way, whenever one is of the view that interest rate outlook is going to be soft, they increase the exposure to longterm bonds to maximize their profits and reduce their investments in short-term paper. However, different managers follow different strategies, like: Conservative Strategy: This strategy tries to maintain an appropriate balance between risk and return. In this, portfolio managers try to insulate the portfolio from the vagaries of the market, which are caused by interest rate movements in the economy. Active Strategy: The portfolio managers who try to actively churn their portfolios with a view to maximising their returns depending on the volatility in bond prices come under this Active Strategy. Here, they will try to take a view on the market directions and predict the future course of interest rate movements. Moderate Strategy: A blend of both the above strategies. Here, managers will keep a portion of the total portfolio in various securities of different maturities. The remaining portion will be used for actively churning the portfolio across different time periods and coupons depending on the macro economic scenario, so that the total return from the portfolio remains at a higher level though the latter portion may carry higher risk. Interest Rate Risk: The biggest risk faced by G-Sec holders is interest rate risk. When interest rates go up, GSec prices fall. But, an increase in interest rate allows the bondholder to reinvest the cash flow at a higher rate. Likewise, when interest rates come down, G-Sec prices increase. So, bondholders can make good capital gains from bonds. But, they have to reinvest the sale proceeds at a lower interest rate as interest rates have fallen. For analysis purpose and to give research a hands on approach, we have taken a dummy
portfolio of Rs. 50 crore. Yields of four different Government securities of 1,5,11, and 30 years are being taken. The actual coupon rate, yield, maturity date etc. are as follows:
Factual Coupon Year rate Maturity date Yield as on 31 Dec 2010 Price 99.79431 1 6.85% 05-Apr-11 7.53% 4 98.57999 5 11 7.59% 8.13% 12-Apr-16 21-Sep-22 7.92% 8.03% 1 100.7307 98.59234 30 8.30% 02-Jul-40 8.43% 9 10 15 20 5 Investment (in Rs. cr)
We also gathered actual data of 31 may 2011 for comparison purpose. For yield maximization and balanced portfolio following strategies is advised: Passive Bond portfolio management strategies There are two major passive strategies:
? ?
Buy-and-hold Indexing
Buy-and-hold Strategy This strategy simply involves buying a bond and holding it until maturity. These investors do not trade actively to earn returns, rather they look for bonds with maturities or durations that match their investment horizon. There is also a modified buy-and-hold strategy in which investors buys bonds with the
intention of holding them until maturity, but they still actively look for opportunities to trade into more desirable positions. In our case let us say we are holding all 4 instruments till maturity. And considering higher interest rates ahead. Let us take one by one all the factors which can affect bond yield (remember we are taking January 2011 as our research) Inflation: As per RBI data inflation will remain high in coming months though downslide which will prompt bond yield to remain high. In January 2010 it is around 7.5%. So short term bond maturing will result in higher yields so passive portfolio would not advisable. March 2011 inflation expectation is 5.5%, above from what was stipulated. Liquidity Remains tight in Dec 2010 and Jan 2011 and expected to ease soon as RBI eased SLR by 1% in Nov 2010 monetary policy. Also it unveiled plans to buyback Rs.48000 crore of securities next month. Government Borrowing Programmes The Centre has completed nearly 89% of its Rs 4.47 lakh crore market borrowing for 201011 by mid-January, indicating more funds would be available for corporate in the remaining period of the fiscal. "Nearly 89% of the GOI's gross market borrowing programme for 2010-11 was completed during the year (up to January 19, 2011)," the Reserve Bank today said in its Macroeconomic and Monetary Developments report. Encouraged by buoyancy in tax and non-tax revenue, including receipts under 3G spectrum auctions, the government had scaled down its gross borrowing for the fiscal by Rs 10,000 crore to Rs 4.47 lakh crore. Source:http://articles.timesofindia.indiatimes.com Oil price According to global forecast, oil prices will likely to remain high in 2011. So it may raise WPI inflation in India, which eventually tends to increase yields. Prices are expected to rise as "the world oil market should gradually tighten in 2010 and 2011, provided the global economic recovery continues as projected," the EIA said. Economic growth in developed economies that make up the Organization for Economic Cooperation and Development should increase from 1.2% in 2010 to 2.7% in 2011.
Source:http://www.worldoils.com/oilforum Given all these facts, bond yields are expected to have higher rates and will give higher return in coming months. So it would be appropriate to maintain long term bonds in increasing interest rate scenario. Given below is the actual 31 may 2011 yields for different maturities. As expected bonds yields have increased from Dec 31 2010 rates.
Year 1 5 11 30
Coupon rate 6.85% 7.59% 8.13% 8.30%
Maturity date 05-Apr-11 12-Apr-16 21-Sep-22 02-Jul-40
Yield as on 31 May 2011 8.23% 8.49% 8.51% 8.66%
So keeping in mind the increasing interest rate scenario, we will try to maximize our returns by adopting active portfolio management strategies.
Individual Bond Strategies
Ladders, barbells, and bullets are strategies for timing our bond investments, both when we buy them and when they mature. These strategies can help cushion our investments from interest rate fluctuations.
Ladders: Bonds mature at different times and we continually reinvest them.
Barbells: Sets of bonds mature in the long term and short term, but not the mid term .
Bullets: Bonds, invested at different times, have the same target maturity date.
Ladders Ladders are a popular strategy for staggering the maturity of bond investments and for setting up a schedule for reinvesting them as they mature. A ladder can help you reap the typically higher coupon rates of longer-term investments, while allowing you to reinvest a portion of your funds every few years. Building a Ladder Using Individual Bonds.
Example: Ladder strategy We buy three bonds with different maturity dates: two years, four years, and six years. As each bond matures, we have the option of buying another bond to keep the ladder going. In this example, we buy 10-year bonds. Longer-term bonds typically offer higher interest rates.
Ladders are popular among investors who want bonds as part of a long-term investment objective, such as saving for college tuition, or seeking additional predictable income for retirement planning. The term for each strategy reflects its chief characteristic.
With ladders, we typically reinvest in steps.
Bond Laddering in Dummy Portfolio
Ladders are one of the most common forms of bond investing. This is where the portfolio is divided into equal parts and invested in laddered style maturities over the investor's time horizon. Figure 1 is a actual example of a basic year laddered INR 50 crore bond portfolio with a stated coupons as follows. Here through ladder strategy we divide the principal 50 crore in four equal portion and invested in 1,5,11, and 30 year Government securities having in hand data of Dec 31, 2010.
Year
1
2
3
4
5
6
7
8
9
10
Principal (in Rs.?000) 1 Year coupon (6.85%) 5 year coupon (7.59%) 11 year coupon (8.13%)
1250
1250
1250
1250
1250 1250 1250 1250 1250 1250
85625
94875
94875
94875
94875
9487 5
101,625 101,625 101,625
101,62 101, 101, 101, 101, 101, 101, 5 625 625 625 625 625 625
So we can summarize that by using the ladder strategy we have following advantages:
•
First, by staggering the maturity dates, we won't be locked into one particular bond for a long duration
• •
• •
It provides investors with the ability to adjust cash flows according to their financial situation Higher average yield, consistent return in fluctuating scenario Periodic return of principal provides the investor with additional income beyond the set interest payments Income derived from principal and interest payments can either be directed back into the ladder if interest rates are relatively high or invested elsewhere if they are relatively low
• •
Interest rate volatility is reduced because the investor now determines the best investment option every few years, as each bond matures Can require commitment of assets over time, and return of principal at time of redemption is not guaranteed
Cautions:
?
?
Bond ladder shouldn't be attempted if investors do not have enough money to fully diversify their portfolio by investing in both stocks and bonds Buying small lots of bonds may increase costs
Barbells
Barbells are a strategy for buying short-term and long-term bonds, but not intermediateterm bonds. The long-term end of the barbell allows you to lock into attractive long-term interest rates, while the short-term end insures that you will have the opportunity to invest elsewhere if the bond market takes a downturn.
With barbells, maturing bonds are clustered in short and long term. With bullets, bonds share the same target maturity date.
Example: Barbell strategy We see appealing long-term interest rates, so you buy two long-term bonds. You also buy two short-term bonds. When the short-term bonds mature, we receive the principal and have the opportunity to reinvest it.
Barbell Strategy in Dummy Portfolio
Here we will invest our portfolio in only 1 year and 30 year bonds. The idea behind doing this is to gain in investing short term increasing rate scenario by investing again. Also to protect investor from steady return in investing half of the money in long term bonds as it yields a higher rate of return. Thus investor will get a twofold advantage. Hence from our dummy portfolio of 50 crore, half we will invest in 1 year 6.85% Gsec and rest half in 30 year, 8.30% Gsec.
Potential Advantages: • An investor needs to revise only half of the portfolio depending upon the expectation of changes in interest rates • If interest rates are expected to rise, then he/she should sell the long-term bonds and invest in short term (as we might seen in earlier part of 2011) and do the opposite if the interest rates are expected to fall
Cautions: • One downside to a barbell strategy is its transaction costs due to periodic reinvestment of short term bonds as it is having half of the portfolio
•
In addition, long term bonds are much more sensitive to interest rate changes. Therefore, the long maturity side of the portfolio tends to have greater volatility than
the short maturity side.
Bullets
Bullets are a strategy for having several bonds mature at the same time and minimizing the interest rate risk by staggering when you buy the bonds. This is useful when you know that you will need the proceeds from the bonds at a specific time, such as when a child begins college . Example: Bullet strategy We want all bonds to mature in 10 years, but want to stagger the investment to reduce the interest rate risk. You buy the bonds over four years.
A single maturity of different bonds is the purpose of the bullet strategy. However, the essence is that the maturities of the bonds in the portfolio are concentrating towards one maturity time. One of the advantages of the Bullet Strategy is to focus cash flows to meet expected future expenditures such as meeting some end goal . Zero-coupon bonds could be appropriate in these situations because they eliminate reinvestment risk and provide a known amount of cash at maturity. Another reason to have such a strategy could be to position a portfolio in response to strong anticipated change in interest rates in one direction. Another main benefit of the bullet strategy is that it allows the investor to minimize the impact of fluctuations in the interest rate, while still realizing excellent returns on the investments.
Indexing
Bond Indexing - Bond Indexing involves designing a portfolio consisting of fixed securities, fixed for income, so that a particular bond index benchmark is followed by the securities. Because bonds are considered a lower risk than stocks, it is wise to have many of these within our portfolio so that our portfolio is diversified with less risky investments. A benchmark is a standard that is used to compare. This comparison can then be used to decide which bonds are safe investments with good returns. The adjustment of the weights of assets in an investment portfolio so that its performance matches that of an index. Linking movements of rates to the performance of an index. Indexing is a passive investment strategy. An investor can achieve the same risk and return of an index by investing in an index fund. Examples of rates that could be linked to the performance of an index are wages or tax rates. 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. 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. Source:http://www.fimmda.org/modules/content/?p=1015
Current Inflation scenario is giving a signal of higher rates ahead. Keeping in mind the monetary policies adopted by the RBI and market expectations and economists, there is no sign of inflation easing up. So to protect our investment from inflation erosion, it would be wise to link our portfolio to Inflation Index Bonds i.e. IIB. Shown below is the
Using Derivatives to Mitigate Risk
To protect our portfolio from fluctuation of interest rate, Derivatives will be used. As we are anticipating increase in interest rates in future, this will lead to an increase in yields which will eventually result in decrease in value of the bank assets. So to avoid this we will use the derivative. To mitigate the risk of interest rate fluctuation in future, we will adopt here the Derivative instruments. The most common derivatives which we will use are:
? ? ?
Future, Option and swaps
A derivative is essentially a contract whose payoff depends on the behaviour of some benchmark. We can hedge our Gsec portfolio by using these derivative options.
Hedging using Interest Rate Future
An interest rate future contract rate is "an agreement to buy or sell a package of debt instruments at a specified future date at a price that is fixed today." Here we will mainly use our INR 500 million portfolios in Interest Rate Future first. On December 31, 2010, the yield of 11 year 8.13% Gsec is 8.03%. The price is INR 100.7307. Now let us assume, on 31 May 2011 the 10 year Gsec, notional 9% coupon bond future
contract. 99.4139 will be the price at this yield. We will enter an IRF agreement in exchange with a interest rate of MIBOR+0.5% which is say 9%. So in this, we are hedging our investment in Gsec by getting 9-8.03 i.e. 0.97% till maturity. The actual MIBOR rate was 9.24% on 31 March 2011 which is expected and raised rate is stated above due to short funds available with the banks. So in our portfolio of INR 50 crore, if we had invested about 15 crore in 10 year 8.13% Gsec, we would have gained 15*0.0097 i.e. INR 14, 55,000 Now suppose the yield gone down to 8% as per MIBOR rate, and then the loss will be .03%. Hence it is very much necessary to predict the future rate very well to arrive at IRF agreement. Also he should have knowledge about economy, money situation in country, inflationary expectation et al.
Hedging using Interest rate Swap
Interest rate swaps are an agreement on the payment of cash flow in terms of a fixed interest rate as opposed to the floating and ever changing interest rate. This is an agreement between two parties, which are known as the counterparties. Interest rate swap helps the counterparties avoid the fluctuations in interest rates which can be varied and undesirably liquid, and depends basically on changing position of the market and currency value. Typically, payments made by one counterparty are based on a floating rate of interest, such as the London Inter Bank Offered Rate (LIBOR), while payments made by the other counterparty are based on a fixed rate of interest. Let say given our portfolio of INR 500 million Bank of Baroda and counterparty agree to “plain vanilla” swap starting in January 2010 that calls for a 5-year maturity with the bank paying the swap rate (fixed rate) to the counterparty and the counterparty paying 6-month LIBOR (floating rate) to the issuer. Using the above formula, the Swap Rate can be alculated by using the 6-month LIBOR+0.5% “futures” rate to estimate the present value of the floating component payments. Payments are assumed to be made on an annual basis (i.e., 360-day periods).
Floating Rate - Overnight LIBOR for 5 years Amount (Outstanding at beginning of the year)
Year
Floating LIBOR+ 0.5%
Interest amount
Amount (Outstanding at the end of the year)
1
15,00,00,000
7.00%
1,05,00,000
16,05,00,000
12037500
2 16,05,00,000 7.50%
172537500
172537500
3 7.60%
13112850
185650350
198367399 185650350
4 6.85%
12717049
198367399
5 Total interest accrued 7.65% 7.32%
15175106
213542505
63542505
Assumed LIBOR rate for is given in third column. Total interest accrued on floating rate leg is Rs 63542505 as shown above. Fixed leg interest At say 7% p.a., the interest for 5 year is Rs. 60382760 Thus BoB, which was to receive floating rate of interest will receive Rs 60382760 from counterparty, which was paying floating rate and receiving fixed rate. By looking at the rates as well we can calculate the amount of payout. Bank will receive the difference amount from counterparty. i.e. INR 31,59,745
Hedging using Options
Terminologies
Used in Bond Market Bonds Issuer of Bonds Bond Holder Principal Amount
Meaning in General Terms Loans (in the form of a security) Borrower Lender Amount at which issuer pays interest and which is repaid on the maturity date
Issue Price
Price at which bonds are offered to investors
Maturity Date Coupon
Length of time (More than one year) Rate of interest paid by the issuer on the par/face value of the bond
Coupon Date
The date on which interest is paid to investors
doc_652124241.pdf