INDEX

Sr. No.

Topic

Page
No.

Introduction

2-5

Types of Bonds

6-10

Term Structure

11-18

Coupon Rate Determinant

19-22

Interest
Management

Risk Associated with Bonds

Difference
between
Market & Stock Market

Bonds on NYSE

Rate

Risk 23-25
26-28

Bond 29-31
32-36

INTRODUCTION
A bond is a security instrument which acknowledges that the
issuer has borrowed money and must repay it to the
bondholder at a specified rate of interest over a predetermined
period of time. These securities are referred to as debt
obligations, contrasted with stocks, which represent ownership
in a corporation. Bonds fall into the three categories of their
issuers: corporations; the U.S. government and its agencies;
and states, municipalities, and other local governments. Each
has features and advantages which should be evaluated when
deciding upon which type of bond best suits your investment
needs.
The interest that a bond pays is called its yield; its expressed
as a percentage of the bonds face value. For example, a
$5,000 bond with an 8% yield would pay $400 in interest per
year. Because the income from a bond doesnt change from
year to year, its known as a fixed-income security. The interest
can be paid out in yearly payments, or coupons; bonds which
do not pay out yearly but pay the principal and all accumulated
interest at maturity are known as zero-coupon bonds.
It is important to be aware of the fundamental relationship
between a bonds yield and its maturity (the predetermined
time for payback). Longer maturities generally translate to
higher yields, because of the increased potential that, Sover
time, a rise in interest rates will lower the bonds price.
Generally, bond prices move in the opposite direction of
interest rates. If rates go up, the price of bonds declines.
Conversely, when interest rates go down, bond prices rise.
Thus a bond is like a loan: the issuer is the borrower (debtor),
the holder is the lender (creditor), and the coupon is the
2

interest. Bonds provide the borrower with external funds to

finance long-term investments, or, in the case of government
bonds, to finance current expenditure. Certificates of deposit
(CDs) or commercial paper are considered to be money market
instruments and not bonds. Bonds must be repaid at fixed
intervals over a period of time.
Bonds and stocks are both securities, but the major difference
between the two is that (capital-) stockholders have an equity
stake in the company (i.e., they are owners), whereas
bondholders have a creditor stake in the company (i.e., they
are lenders). Another difference is that bonds usually have a
defined term, or maturity, after which the bond is redeemed,
whereas stocks may be outstanding indefinitely. An exception is
a consol bond, which is a perpetuity (i.e., bond with no
maturity).
Issuing Bonds
Bonds are issued by public authorities, credit institutions,
companies and supranational institutions in the primary
markets. The most common process of issuing bonds is through
underwriting. In underwriting, one or more securities firms or
banks, forming a syndicate, buy an entire issue of bonds from
an issuer and re-sell them to investors. The security firm takes
the risk of being unable to sell on the issue to end investors.
Primary issuance is arranged by bookrunners who arrange the
bond issue, have the direct contact with investors and act as
advisors to the bond issuer in terms of timing and price of the
bond issue. The bookrunners' willingness to underwrite must be
discussed prior to opening books on a bond issue as there may
be limited appetite to do so.
In the case of Government Bonds, these are usually issued by
auctions, where both members of the public and banks may bid
for bond. Since the coupon is fixed, but the price is not, the
percent return is a function both of the price paid as well as the
coupon.
3

Features of Bonds
The most important features of a bond are:
Nominal, Principal Or Face Amount: The amount on which
the issuer pays interest, and which, most commonly, has to be
repaid at the end of the term. Some structured bonds can have
a redemption amount which is different from the face amount
and can be linked to performance of particular assets such as a
stock or commodity index, foreign exchange rate or a fund. This
can result in an investor receiving less or more than his original
investment at maturity.
Issue Price : The price at which investors buy the bonds when
they are first issued, which will typically be approximately equal
to the nominal amount. The net proceeds that the issuer
receives are thus the issue price, less issuance fees.
Maturity Date : The date on which the issuer has to repay the
nominal amount. As long as all payments have been made, the
issuer has no more obligation to the bond holders after the
maturity date. The length of time until the maturity date is
often referred to as the term or tenor or maturity of a bond. The
maturity can be any length of time, although debt securities
with a term of less than one year are generally designated
money market instruments rather than bonds. Most bonds have
a term of up to thirty years. Some bonds have been issued with
maturities of up to one hundred years, and some even do not
mature at all. In early 2005, a market developed in euros for
bonds with a maturity of fifty years.
In the market for U.S. Treasury securities, there are three
groups of bond maturities:
short term (bills): maturities up to one year;
medium term (notes): maturities between one and ten
years;
4

 long term (bonds): maturities greater than ten years.

Coupon : The interest rate that the issuer pays to the bond
holders. Usually this rate is fixed throughout the life of the
bond. It can also vary with a money market index, such as
LIBOR, or it can be even more exotic. The name coupon
originates from the fact that in the past, physical bonds were
issued which had coupons attached to them. On coupon dates
the bond holder would give the coupon to a bank in exchange
for the interest payment.
The "quality" of the issue refers to the probability that the
bondholders will receive the amounts promised at the due
dates. This will depend on a wide range of factors.
Indentures and Covenants An indenture is a formal debt
agreement that establishes the terms of a bond issue, while
covenants are the clauses of such an agreement. Covenants
specify the rights of bondholders and the duties of issuers, such
as actions that the issuer is obligated to perform or is
prohibited from performing. In the U.S., federal and state
securities and commercial laws apply to the enforcement of
these agreements, which are construed by courts as contracts
between issuers and bondholders. The terms may be changed
only with great difficulty while the bonds are outstanding, with
amendments to the governing document generally requiring
approval by a majority (or super-majority) vote of the
bondholders.
High yield bonds are bonds that are rated below investment
grade by the credit rating agencies. As these bonds are more
risky than investment grade bonds, investors expect to earn a
higher yield. These bonds are also called junk bonds.
Coupon Dates the dates on which the issuer pays the
coupon to the bond holders. In the U.S. and also in the U.K. and
Europe, most bonds are semi-annual, which means that they
pay a coupon every six months.
5

Optionality: Occasionally a bond may contain an embedded

option; that is, it grants option-like features to the holder or the
issuer:
Callability Some bonds give the issuer the right to
repay the bond before the maturity date on the call dates;
see call option. These bonds are referred to as callable
bonds. Most callable bonds allow the issuer to repay the
bond at par. With some bonds, the issuer has to pay a
premium, the so called call premium. This is mainly the
case for high-yield bonds. These have very strict
covenants, restricting the issuer in its operations. To be
free from these covenants, the issuer can repay the bonds
early, but only at a high cost.

Putability Some bonds give the holder the right to

force the issuer to repay the bond before the maturity
date on the put dates; see put option. (Note: "Putable"
denotes an embedded put option; "Puttable" denotes that
it may be put.)
Call Dates And Put Datesthe dates on which callable and
putable bonds can be redeemed early. There are four main
categories.
I

A Bermudan callable has several call dates, usually

coinciding with coupon dates.

II

A European callable has only one call date. This is a

special case of a Bermudan callable.

III

An American callable can be called at any time until

the maturity date.

IV

A death put is an optional redemption feature on a

debt instrument allowing the beneficiary of the
estate of the deceased to put (sell) the bond (back to
6

the issuer) in the event of the beneficiary's death or

legal incapacitation. Also known as a "survivor's
option".
Sinking Fund provision of the corporate bond indenture
requires a certain portion of the issue to be retired periodically.
The entire bond issue can be liquidated by the maturity date. If
that is not the case, then the remainder is called balloon
maturity. Issuers may either pay to trustees, which in turn call
randomly selected bonds in the issue, or, alternatively,
purchase bonds in open market, then return them to trustees.
Bonds can be classified into following types depending
on the type of issuer.
Domestic Bonds: Domestic bonds are bonds which are issued
within the domestic market and are denominated in the
domestic currency. These are issued by a local borrower. For
instance, State bank of India issuing bonds to Indian residents.
Foreign Bonds: These types of bonds are again denominated
in domestic currency and in the local market, only difference
being a foreign borrower. Examples are:
Yankee bonds: Issued in US by a foreign borrower and are
denominated in US
Samurai bonds: Issued in Japan by a foreign borrower and are
denominated in Japanese Yen
Eurobonds: Eurobonds are bonds which are denominated in
foreign currency and are issued by a foreign firm and sold to
the home country residents. For instance, A US denominated
bond issued by a US firm in UK is a euro bond.
Global bonds: These bonds are sold to many other markets as
well as Euromarkets. Global bonds can be issued in same
currency as the country of issuance, which is not the case with
euro bonds,
7

Floating Rate bonds: Floating rate bonds are popularly

known as floaters and are bonds interest rates of which
depends on some reference rate. For example, coupon rates
based on LIBOR can be LIBOR+ Quoted margin. These interest
rates are then reset periodically. In other words, coupon rates
are based on the rate calculated on the reset date.
Floaters can have special features like caps, floors and collars.
Caps: It specifies the maximum coupon rate of the floater. This
is attractive for the issuer as it restricts his liability and is
therefore not so attractive for the investor.
Floors: Similar to caps, floors specify the minimum rate of
coupon and is therefore attractive for the investor.
Collars: These are combinations of caps and floors.
There are also floaters known as Inverse Floaters. They are
different from regular floaters in that they have coupon rates
which are based on opposite direction of reference rate. They
can be represented as (some fixed percentage)-reference rate.
There can also be Dual Indexed floaters which are based on
more than one reference rates.
Some more types of bond are as follows.
Convertible Bond lets a bondholder exchange a bond to a
number of shares of the issuer's common stock.
Exchangeable Bond allows for exchange to shares of a
corporation other than the issuer.
The following descriptions are not mutually exclusive, and more
than one of them may apply to a particular bond.
Fixed Rate Bonds have a coupon that remains constant
throughout the life of the bond.
8

Floating Rate Notes (Frns) have a variable coupon that is

linked to a reference rate of interest, such as LIBOR or Euribor.
For example the coupon may be defined as three month USD
LIBOR + 0.20%. The coupon rate is recalculated periodically,
typically every one or three months.
Zero-Coupon Bonds pay no regular interest. They are issued
at a substantial discount to par value, so that the interest is
effectively rolled up to maturity (and usually taxed as such).
The bondholder receives the full principal amount on the
redemption date. An example of zero coupon bonds is Series E
savings bonds issued by the U.S. government. Zero-coupon
bonds may be created from fixed rate bonds by a financial
institution separating ("stripping off") the coupons from the
principal. In other words, the separated coupons and the final
principal payment of the bond may be traded separately. See IO
(Interest Only) and PO (Principal Only).
Other Indexed Bonds, for example equity-linked notes and
bonds indexed on a business indicator (income, added value) or
on a country's GDP.
Asset-Backed Securities are bonds whose interest and
principal payments are backed by underlying cash flows from
other assets. Examples of asset-backed securities are
mortgage-backed securities (MBS's), collateralized mortgage
obligations (CMOs) and collateralized debt obligations (CDOs).
Subordinated Bonds are those that have a lower priority than
other bonds of the issuer in case of liquidation. In case of
bankruptcy, there is a hierarchy of creditors. First the liquidator
is paid, then government taxes, etc. The first bond holders in
line to be paid are those holding what is called senior bonds.
After they have been paid, the subordinated bond holders are
paid. As a result, the risk is higher. Therefore, subordinated
bonds usually have a lower credit rating than senior bonds. The
main examples of subordinated bonds can be found in bonds
issued by banks, and asset-backed securities. The latter are
9

often issued in tranches. The senior tranches get paid back

first, the subordinated tranches later.
Perpetual Bonds are also often called perpetuities or 'Perps'.
They have no maturity date. The most famous of these are the
UK Consols, which are also known as Treasury Annuities or
Undated Treasuries. Some of these were issued back in 1888
and still trade today, although the amounts are now
insignificant. Some ultra-long-term bonds (sometimes a bond
can last centuries: West Shore Railroad issued a bond which
matures in 2361 (i.e. 24th century)) are virtually perpetuities
from a financial point of view, with the current value of principal
near zero.
Bearer Bond is an official certificate issued without a named
holder. In other words, the person who has the paper certificate
can claim the value of the bond. Often they are registered by a
number to prevent counterfeiting, but may be traded like cash.
Bearer bonds are very risky because they can be lost or stolen.
Especially after federal income tax began in the United States,
bearer bonds were seen as an opportunity to conceal income or
assets. U.S. corporations stopped issuing bearer bonds in the
1960s, the U.S. Treasury stopped in 1982, and state and local
tax-exempt bearer bonds were prohibited in 1983.
Registered Bond is a bond whose ownership (and any
subsequent purchaser) is recorded by the issuer, or by a
transfer agent. It is the alternative to a Bearer bond. Interest
payments, and the principal upon maturity, are sent to the
registered owner.
Municipal Bond is a bond issued by a state, city, local
government, or their agencies. Interest income received by
holders of municipal bonds is often exempt from the federal
income tax and from the income tax of the state in which they
are issued, although municipal bonds issued for certain
purposes may not be tax exempt.

10

Book-Entry Bond is a bond that does not have a paper

certificate. As physically processing paper bonds and interest
coupons became more expensive, issuers (and banks that used
to collect coupon interest for depositors) have tried to
discourage their use. Some book-entry bond issues do not offer
the option of a paper certificate, even to investors who prefer
them.
Serial Bond is a bond that matures in installments over a
period of time. In effect, a $100,000, 5-year serial bond would
mature in a $20,000 annuity over a 5-year interval.
Revenue Bond is a special type of municipal bond
distinguished by its guarantee of repayment solely from
revenues generated by a specified revenue-generating entity
associated with the purpose of the bonds. Revenue bonds are
typically "non-recourse," meaning that in the event of default,
the bond holder has no recourse to other governmental assets
or revenues.

11

The term structure of interest rate

The term structure of interest rates, also known as the yield

curve, is a very common bond valuation method. Constructed
by graphing the yield to maturities and the respective maturity
dates of benchmark fixed-income securities, the yield curve is a
measure of the market's expectations of future interest rates
given the current market conditions. Treasuries, issued by the
federal government, are considered risk-free, and as such, their
yields are often used as the benchmarks for fixed-income
securities with the same maturities. The term structure of
interest rates is graphed as though each coupon payment of a
noncallable fixed-income security were a zero-coupon bond that
matures on the coupon payment date. The exact shape of the
curve can be different at any point in time. So if the normal
yield curve changes shape, it tells investors that they may need
to change their outlook on the economy.

There are three main patterns created by the term structure of

interest rates:

1) Normal Yield Curve:

As its name indicates, this is the yield curve shape that
forms during normal market conditions, wherein investors
generally believe that there will be no significant changes in
the economy, such as in inflation rates, and that the
economy will continue to grow at a normal rate. During such
conditions, investors expect higher yields for fixed income
instruments with long-term maturities that occur farther into
the future. In other words, the market expects long-term
fixed income securities to offer higher yields than short-term
fixed income securities. This is a normal expectation of the
12

market because short-term instruments generally hold less

risk than long-term instruments; the farther into the future
the bond's maturity, the more time and, therefore,
uncertainty the bondholder faces before being paid back the
principal. To invest in one instrument for a longer period of
time, an investor needs to be compensated for undertaking
the additional risk.
Remember that as general current interest rates increase, the
price of a bond will decrease and its yield will increase.

2) Flat Yield Curve:

These curves indicate that the market environment is sending
mixed signals to investors, who are interpreting interest rate
movements in various ways. During such an environment, it is
difficult for the market to determine whether interest rates will
move significantly in either direction farther into the future. A
flat yield curve usually occurs when the market is making a
transition that emits different but simultaneous indications of
what interest rates will do. In other words, there may be some
13

signals that short-term interest rates will rise and other signals
that long-term interest rates will fall. This condition will create a
curve that is flatter than its normal positive slope. When the
yield curve is flat, investors can maximize their risk/return
tradeoff by choosing fixed-income securities with the least risk,
or highest credit quality. In the rare instances wherein longterm interest rates decline, a flat curve can sometimes lead to
an inverted curve.

3) Inverted Yield Curve:

These yield curves are rare, and they form during
extraordinary market conditions wherein the expectations of
investors are completely the inverse of those demonstrated by
the normal yield curve. In such abnormal market environments,
bonds with maturity dates further into the future are expected
to offer lower yields than bonds with shorter maturities. The
inverted yield curve indicates that the market currently expects
interest rates to decline as time moves farther into the future,
which in turn means the market expects yields of long-term
bonds to decline. Remember, also, that as interest rates
decrease, bond prices increase and yields decline.

14

You may be wondering why investors would choose to purchase

long-term fixed-income investments when there is an inverted
yield curve, which indicates that investors expect to receive
less compensation for taking on more risk. Some investors,
however, interpret an inverted curve as an indication that the
economy will soon experience a slowdown, which causes future
interest rates to give even lower yields. Before a slowdown, it is
better to lock money into long-term investments at present
prevailing yields, because future yields will be even lower.

The Theoretical Spot Rate Curve:

Unfortunately, the basic yield curve does not account for
securities that have varying coupon rates. When the yield to
maturity was calculated, we assumed that the coupons were
reinvested at an interest rate equal to the coupon rate,
therefore, the bond was priced at par as though prevailing
interest rates were equal to the bond's coupon rate.

The spot-rate curve addresses this assumption and accounts for

the fact that many Treasuries offer varying coupons and would
therefore not accurately represent similar noncallable fixedincome securities. If for instance you compared a 10-year bond
paying a 7% coupon with a 10-year Treasury bond that
currently has a coupon of 4%, your comparison wouldn't mean
much. Both of the bonds have the same term to maturity, but
the 4% coupon of the Treasury bond would not be an
appropriate benchmark for the bond paying 7%. The spot-rate
curve, however, offers a more accurate measure as it adjusts
the yield curve so it reflects any variations in the interest rate
of the plotted benchmark. The interest rate taken from the plot
is known as the spot rate.

15

The spot-rate curve is created by plotting the yields of zerocoupon Treasury bills and their corresponding maturities. The
spot rate given by each zero-coupon security and the spot-rate
curve are used together for determining the value of each zerocoupon component of a noncallable fixed-income security.
Remember, in this case, that the term structure of interest
rates is graphed as though each coupon payment of a
noncallable fixed-income security were a zero-coupon bond.

T-bills are issued by the government, but they do not have

maturities greater than one year. As a result, the bootstrapping
method is used to fill in interest rates for zero-coupon securities
greater than one year. Bootstrapping is a complicated and
involved process and will not be detailed in this section (to your
relief!); however, it is important to remember that the
bootstrapping method equates a T-bill's value to the value of all
zero-coupon components that form the security.

The Credit Spread

The credit spread, or quality spread, is the additional yield an
investor receives for acquiring a corporate bond instead of a
16

similar federal instrument. As illustrated in the graph below, the

spread is demonstrated as the yield curve of the corporate
bond and is plotted with the term structure of interest rates.
Remember that the term structure of interest rates is a gauge
of the direction of interest rates and the general state of the
economy. Corporate fixed-income securities have more risk of
default than federal securities and, as a result, the prices of
corporate securities are usually lower, while corporate bonds
usually have a higher yield.

When inflation rates are increasing (or the economy is

contracting) the credit spread between corporate and Treasury
securities widens. This is because investors must be offered
additional compensation (in the form of a higher coupon rate)
for acquiring the higher risk associated with corporate bonds.

When interest rates are declining (or the economy is

expanding), the credit spread between Federal and corporate
fixed-income securities generally narrows. The lower interest
rates give companies an opportunity to borrow money at lower
rates, which allows them to expand their operations and also
their cash flows. When interest rates are declining, the
17

economy is expanding in the long run, so the risk associated

with investing in a long-term corporate bond is also generally
lower.

Now you have a general understanding of the concepts and

uses of the yield curve. The yield curve is graphed using
government securities, which are used as benchmarks for fixed
income investments. The yield curve, in conjunction with the
credit spread, is used for pricing corporate bonds. Now that you
have a better understanding of the relationship between
interest rates, bond prices and yields, we are ready to examine
the degree to which bond prices change with respect to a
change in interest rates.

There are three basic theories that describe the term

structure of interest rates and explain the shape of the
yield curve.
1. Pure Expectations Theory:
The expectations hypothesis (also known as the unbiased
expectations theory, or pure expectations theory)
imagines a yield curve that reflects what bond investors expect
to earn on successive investments in short-term bonds during
the term to maturity of the long-term bond.
It suggests that the term structure of interest rates is
based on investor expectations about future rates of
inflation and corresponding future interest rates, assuming
that the real interest rate is the same for all maturities.

According to the theory, forward rates exclusively

represent expected future rates. Thus, the entire term
structure at a given time reflects the market's current
expectations of the family of future short-term rates.
Under this view, a rising term structure must indicate that
increasing rates of inflation are expected, and the market
18

expects short-term rates to rise throughout the relevant

future. Similarly, a flat term structure reflects an
expectation that future short-term rates will remain
relatively constant, while a falling term structure must
reflect an expectation of decreasing rates of inflation and
that future short-term rates will decline steadily.
This theory suffers from one serious shortcoming: it says
nothing about the risks inherent in investing in bonds and like
instruments. If forward rates were perfect predictors of future
interest rates, then the future prices of bonds would be known
with certainty!

2. Liquidity Preference Hypothesis

According to the liquidity preference hypothesis (also
known as the maturity premium theory), long-term bonds
are more risky than short-term bonds because:
Long-term bonds are less liquid.
Long-term bonds are more sensitive to changes in interest
rates.
The longer the maturity of a bond, the greater the price
volatility when interest rates change.
All else equal, rational investors will prefer the less risky, shortterm bonds. Therefore, long-term bonds should always provide
a maturity premium to compensate for the liquidity risk. Based
on this theory, an upward sloping yield curve may be caused by
one of the following two reasons:
1. Future interest rates will rise, or
2. Future interest rates will be unchanged or fall, but the
maturity premium will increase fast enough with maturity
so as to cause the yield curve to slope upward.
Flat or downward sloping yield curves are mainly caused by
declining future short-term interest rates.
19

3. Market Segmentation Theory:

Both of the above theories assume that an investor holding
bonds of one maturity can switch to holding bonds of another
maturity. The market segmentation theory contends that shape
of the yield curve is determined by supply of and demand for
securities within each maturity sector. It believes that the yield
curve mirrors the investment policies of institutional investors
who have different maturity preferences.
Banks need liquidity and prefer to invest in short-term
bonds, while corporations with seasonal fund needs prefer
to issue short-term bonds.
Life insurance companies prefer to invest in long-term
bonds to match their long-term liabilities, while real estate
companies prefer to issue long-term bonds due to their
long project cycles.
The bond market is segmented based on the maturity
preferences of investors and issuers. Within each market
segment, the prevailing yields are determined by the supply
and demand for the bonds. An upward sloping yield curve
indicates that:
Demand outstrips supply for short-term bonds, causing
low short-term rates.
Supply outstrips demand for long-term bonds, resulting in
high long-term rates.
If the yield curve is flat, that means both short-term and longterm bonds are in equilibrium so interest rates are the same for
all maturities. You should be able to draw similar conclusions for
other types of yield curves.
The Preferred Habitat Theory:
The Preferred Habitat Theory is a variant of the market
segmentation theory. It also asserts that investors prefer to
invest in particular maturity ranges. However, it argues that
20

investors will shift out of their preferred maturity sectors if they

are given a sufficient high maturity premium. In contrast, the
market segmentation theory asserts that investors will always
stick to their preferred maturity sectors.

21

Determinants of Coupon Rate of Bond

Growth Rate of Economy

Growth rate of economy can be considered as one of the critical
factor for determination of coupon rate of bond. High economy
growth leads to high demand of funds may leads to high rate of
coupon for bond and vice versa a healthy economic growth
leads to high liquidity in the market.
Inflation
Inflation is rise in general level of prices of goods and services
over time. Debtors may be helped by inflation due to reduction
of the real value of debt burden. So the burden will be shifted to
the investors. Low grade bonds are by definition subject to
default risk; hence low grade investors will be primarily
concerned with the risk of default. Deflationary episodes pose
particular problems for low grade firms since there is a lack of
pricing power in the broader macro economy. Hence, higher risk
firms are particularly vulnerable to the economic environment
within a deflationary environment. High grade bonds are
alternatively the subject of a very low level of default risk. The
primary concern for investors in high grade debt is the risk of
inflation, since bonds generally perform poorly under
inflationary conditions. When there is inflation, there is rising
risk in the economy, so the credit spread has to widen to
compensate the investors for the risk.
Tax Risk
22

If Bonds were originally issued with certain tax exemption

features and subsequently there developed an uncertainty
regarding their tax status in future, it could to lead to a price
loss.
Liquidity risk
Liquidity risk is the risk that the lender might not be able to
liquidate the debt on short notice. The difference in interest
rate due to liquidity risk is called liquidity spread. Instruments
such as bonds have active secondary markets. Other
instruments such as savings deposits are easily transferable to
cash. One the other hand 30-year US Government Savings
Bond is nontransferable. It can only be redeemed at half price
before maturity. The savings bond will obviously offer a higher
return.
Another interesting phenomenon observed from liquidity
spread is that on-the-run securities (primary market) have
lower interest rates compare to the off-the-run securities
(secondary market). This implies that there is a higher demand
for on-the-run securities
Demand & Supply of Bond
According to demand & supply of bonds in the will decides the
rate of coupon of bond. High demand of Bonds leads to lower
coupon rate and vice versa.
When Demand for bond is high:
A change in wealth. As wealth increases, people will buy
more bonds at each and every price, and the demand for
bonds rises, or shifts right. So when an expanding
economy increases both income and wealth, we expect
bond demand to increase too.
A change
bonds with
rates in the
hence the

in expected interest rates/returns. For

more than a year to maturity, rising interest
future will decrease the value of the bond (and
expected return). At each and every price,
23

fewer bonds will be demanded. Bond demand will fall, or

shift left when expected future interest rates fall. The size
of the decrease will be larger for longer term bonds.
A change in expected inflation. If investors expect the
inflation rate to rise, then they expect the real return on
their bond to fall, as future payments are able to buy less.
Higher inflation expectations decrease bond demand.
A change in the relative risk of bonds. At any given
price or expected return, if bonds become riskier than
other assets, people will switch to less risky assets. An
increase in the relative risk of bonds with decrease bond
demand.
A change in the relative liquidity of bonds. If it
becomes harder to resell bonds in the bond market
relative to other assets, people will switch to assets that
are easier to resell. A decrease in the relative liquidity of
bonds will decrease bond demand.
When of Supply of bond is high

A change in business conditions. Firms issue bonds to

finance the purchase of capital equipment and the
expansion of production. This makes sense only if this
expansion is expected to be profitable. As economic
conditions become more favorable, expected profitability
rises and bond supply will increase or shift right. Also tax
incentives for borrowing can also be considered a business
condition.
A change in expected inflation. While rising inflation
decreases the real return for those who buy bonds, it
decreases the real cost of borrowing for those who issue
bonds: For a given nominal interest rate (and bond price),
higher inflation means a lower real interest rate. Thus,
higher expected inflation increases bond supply.
A change in government borrowing. If the
government runs budget deficits, the U.S. Treasury must
issue additional bonds to finance the shortfall in tax
revenue. At each and every bond price, the quantity
supplied increases.
24

The demand for bonds is the same as the supply of bond. Those
who buy bonds are providing loans to others and are receiving
interest.
The supply of bonds is the same as the demand for bond. Those
who supply or issue bonds are borrowing money and paying
interest.
Credit Risk
Ratings affect a bond's yield, or the percentage return investors
can expect on the bond. A highly rated bond typically has a
lower yield. That's because the issuer does not have to offer as
high a coupon rate to attract investors. A lower rated bond
typically has a higher yield. That's because investors need
extra incentive to compensate for the higher risk. Generally,
credit rating is the opinion of rating agencies on the degree of
certainty of debt servicing of corporations, which takes account
of both the default probability and the recovery rate.
However, this rating does not change in response to changes in
the macro-economic conditions. Therefore, it is suggested that
the credit rating would explain spreads, but only to a limited
degree. The default rate for a particular rating for any given
period is the number of defaults among the credits carrying
that rating, as percentage of the total number of outstanding
credits carrying that rating. Normally the Default rate rises as
the rating changes from AAA to the lower category. The higher
the probability of default higher is the risk in the bond which
leads to increase in the spread. So theoretically we can say
that; Default rate and Credit spread are positively related,
default rate being one of the most important factors in
determining Credit spread of the bond.

Tenure of Bond
Normally as the tenure of the bond increases, the risk also
increases hence the credit spread should also increase.
Research states that corporate rates are cointegrated with
25

government rates and the relation between credit spreads and

Treasury rates depends on the time horizon. In the short-run, an
increase in Treasury rates causes credit spreads to narrow. This
effect is reversed over the long-run and higher rates cause
spreads to widen.

Risk free rate

In the Merton framework the risk free rate has an impact upon
the value of the corporate bond for two reasons. First, an
increase in the risk free rate implies that the price of the put
option will decrease because the discounted present value of
expected future cash flows will have decreased. The corporate
bond investors experience a net increase in the value of their
long corporate bond position. The price of the corporate bond
increases and the spread over an equivalent risk-less bond
tightens.
The second effect arises from the structural assumption that
the firms risk-neutral growth path is a positive function of the
risk free rate. As the risk free rate increases firm value
increases, again lowering the price of a put option on the firm.
The overall effect of an increase in the risk free rate is to
decrease the effective costs of insurance against default on the
firms debt. The price of a put option to protect against that
default has fallen as the risk free rate has increased. Increases
in the risk free rate reduce the price of the put option, implying
that the corporate bond will increase in value, the corporate
yield will fall and the spread over an equivalent risk free bond
will tighten. Here we take the interest rate on central
government securities, which is the weighted average of the
central government securities with different maturities. Better
results are expected by taking the corresponding value of the
interest rate for different maturities and issuance time. But the
result would be almost the same.

26

Foreign Exchange Rate (Forex)

The foreign exchange rate is an indirect factor which influences
the credit spread. There is lot of funds flowing from the foreign
countries in form of volatile FIIs. When the rupee is appreciated
the foreign investment would be increased and if rupee is
depreciated, funds will flow out. This is due to the fact that the
appreciation of the rupee denotes the strengthening of the
Indian economy so the funds flow in. In the regression analysis
we have used percentage change in the dollar value of the
rupee (Rs/$).

Interest Rate Risk Management

Interest rate risk management comprises the various policies,

actions and techniques that an institution can use to reduce the
risk of diminution of its net equity as a result of adverse
changes in interest rates.

Various aspects of interest rate risk include the following:

1. Re-pricing risk: Variations in interest rates expose the
institutions income and the underlying value of its
instruments to fluctuations. This arises from timing
differences in the maturity of fixed rates and the re-pricing
of the floating rates of the institutions assets, liabilities
and off-balance sheet position
2. Yield Curve risk: This risk emanates from the changes in
the slope and shape of the yield curve.

27

3. Basis Risk (spread risk): Arises when assets and

liabilities are priced off different yield curves and the
spread between these curves shifts. When this yield curve
spreads change, income and market values may be
negatively affected. Such situations arise when an asset
that is re-priced regularly (say) based on the inflation
index is funded by a liability that is re-priced based (say)
on the central bank accommodation rate
4. Optionality: Options may be embedded within otherwise
standard instruments. The latter may include various
types of bonds or notes with caller put provisions, nonmaturity deposit instruments that give the depositor has
the right to withdraw their money, or loans that borrowers
may pre pay without penalty.
Framework for IRM

Broad principles to the foundation for interest rate risk

management.

Board of Directors to approve strategies and policies for

interest Rate Management.
Senior Management to take steps to monitor and control
these risks.
Board to rate exposure in order to monitor and control the
same.
Senior management should ensure that structure of the
banks business and the level of interest rate is effectively
managed. Appropriate policies and procedures are in place
to

control

these

risks.

Resources

evaluating and controlling this risk.

28

are

available

for

 Banks should clearly define individuals or committees who

are responsible for managing risk.
Risk management function should be independent of
position taking function to avoid conflict of interest.
IRM policies and procedures are clearly defined and
appropriate to the level of complexity of the operations of
the bank. These can be applied on a consistent base at
the group level and as appropriate at the level of the
individual affiliates.
Banks must understand the risk in new products before
they are introduced and subject to adequate controls.
Major hedging or risk management strategies should be
approved in advance, by the Board or appropriate
committee.
Banks should have interest rate risk measurement system
that captures all material sources of interest rate risk and
that assess the effect of interest rate changes in ways that
are consistent with the scope of their activities. The
assumptions underlying the model should be clearly
understood by the risk managers.
Banks must establish and enforce operating limits and
other practices that maintain exposure within levels
consistent internal policies.
Banks must measure their vulnerability to loss under
stressful

market

conditions.

This

should

include

breakdown of all underlying assumptions. The result there

from must be factored into the policies and the limits
determined.
Banks must have adequate information systems for
measuring, monitoring, controlling and reporting interest

29

rate risk. Timely reporting to senior management and

board cannot be over emphasized.
Banks must have adequate internal control systems
including independent review of the system. Supervisory
authorities must obtain from the bank adequate and
timely reports with which to evaluate the level of interest
rate risk. The information must take the range maturities
and currencies in each banks portfolio. It must include all
off balance sheet items as well as other well other
relevant factors.
Banks must hold capital commensurate with the level of
interest rate risk they run.
Banks must release to the public information on the level
of interest rate risk and the policies for its management.
Supervisory

authorities

should

assess

the

internal

measurement system of banks adequately capture the

interest risk in their banking book. If there is inadequacy
then the banks must bring up their system.
Banks

must

furnish

the

results

of

their

internal

measurement systems to the supervisory authority. If the

supervisory authority determines that the bank is not
carrying capital commensurate with the risk, it should
direct that the bank either reduce the risk or increase
the capital.

30

Risk Associated with Investing in Bonds

Interest Rate Risk

The price of the bond will change in the opposite direction
from the change in interest rate. As interest rate rises the
bond price decreases and vice versa.
If an investor has to sell a bond prior to the maturity date,
it means the realization of capital loss.
This risk depends on the type of the bond; callable
puttable etc????

31

Reinvestment Income or Reinvestment Risk

The additional income from such reinvestment called
interest on interest depends on the prevailing interest rate
levels at the time of reinvestment.
Call Risk
The issuer usually retains this right in order to have
flexibility to refinance the bond in the future is market
interest rate drops below the coupon rate
Disadvantage for investors for callable bond: cash flow
pattern not known with certainty, interest rate drop, and
capital appreciation will reduce.

Credit Risk
If the issuer of a bond will fail to satisfy the terms of the
obligation with respect to the timely payment of
interest and repayment of the amount borrowed.
Yield = market yield + risk associated with credit risk

Inflation Risk
32

 Purchasing power risk arises because of the variation in

the value of cash flow from the security due to inflation.

Exchange Rate Risk

Risk associated with the currency value for non-rupee
denominated bonds. e.g.: US Treasury bond.
Liquidity Risk
It depends on the size of the spread between bids and
asks price quoted. Wider the spread is risky.
For investors keeping till maturity, this is unimportant.
Market to market should be calculated portfolio value.

Volatility Risk
Value of bond will increase when expected interest rate
volatility increases.

33

What is the difference between the bond market and

the stock market?

Many people think that the bond market and the stock market
is one and the same. In fact, many people who invest in bond
market and the stock market either with their own personal
investment account or retirement plans also cannot tell the
difference between the two. Although, most people have a
general idea that stock market is associated with risk while
bonds offer relatively more safety.

34

Bond market versus stock market is a crucial differentiating

factor as both markets can earn you money but they are
different in terms of the potential risks and rewards. Let us try
and understand the difference between the bond market and
the stock market.
When you buy a share of stock, you actually end up taking the
ownership in the company whose stock you are investing in.
This means that you will end up sharing the profits as well as
the losses incurred by the company in the years to come. If a
companys revenue decreases, it would ultimately affect the
stock price of that company leading to a decline in the stock
price. However, if the companys revenue increases, the stock
price would go up because the company is generating more
profits.
Trading hours of bond markets vary from country to country. At
the New York Stock Exchange (NYSE), which is the largest
centralized bond market, trading hours are between 9.30 AM to
4.00 PM.
On the other hand, a bond does not allow you ownership in a
company. If a company wants to raise money without dividing
itself, they can decide to sell bonds instead of issuing stocks.
So, when you buy a bond of a company, you become more like
a creditor than an owner in the company, and you are paid
back over the life of the bond. As a bondholder, you will earn a
return on your money, which is a fixed percentage, and this
return is paid annually. So, if a bond is for 10 years, you will get
interest for each of those 10 years and then your principal
35

amount (the amount you invested) is returned to you at the

time of expiration of the bond.
The bond market is where investors go to trade (buy and sell)
debt securities, prominently bonds. The stock market is a place
where investors go to trade (buy and sell) equity securities like
common stocks and derivatives (options, futures etc). Stocks
are traded on stock exchanges. In the United States, the
prominent stock exchanges are: Nasdaq, Dow, S&P 500 and
AMEX. These markets are regulated by the Securities Exchange
Commission (SEC).

The differences in the bond and stock market lie in the manner
in which the different products are sold and the risk involved in
dealing with both markets. One major difference between both
markets is that the stock market has central places or
exchanges (stock exchanges) where stocks are bought and
sold. However, the bond market does not have a central trading
place for bonds; rather bonds are sold mainly over-the-counter
(OTC). The other difference between the stock and bond market
is the risk involved in investing in both. Investing in bond
market is usually less risky than investing in a stock market
because the bond market is not as volatile as the stock market
is.

36

Short

term

Treasury

yields

havent

moved

from

the

recessionary lows, but the five and ten year bonds are back in
recessionary ranges. The thirty year hasnt moved down as
much in yields, but that could change quickly if shorter
maturities continue their downward trend as investors reach for
yield (or if deflation does, in fact, ensue).
The stock market sees these low yields and argues that an
upward sloping curve is bullish for the economy. Also,
arguments exist that investing in dividend paying stocks is
better than investing in poor yielding bonds. This is true unless
we see an economic slowdown or deflation. In either case,
equities will lose value.
In the short term, you have greater chances of losing money in
the stock market than the bond market. However, in order to
figure out which is a better investment opportunity, you should
37

study your risk tolerance along with the kind of returns you are
looking for and according make the choice of investing either in
the bond market or the stock market.
BONDS ON NYSE
U.S. Government Bonds
These are bonds which are issued by the U.S. Treasury. They're
grouped in three categories.
U.S. Treasury bills -- maturities from 90 days to one
year
U.S. Treasury notes -- maturities from two to 10
years
U.S. Treasury bonds -- maturities from 10 to 30
years
Treasury are widely regarded as the safest bond investments,
because they are backed by "the full faith and credit" of the
U.S. government. In other words, unless something apocalyptic
occurs, you'll most certainly get paid back. Since bonds of
longer maturity tend to have higher interest rates (coupons)
because you're assuming more risk, a 30-year Treasury has
more upside than a 90-day T-bill or a five-year note. But it also
carries the potential for considerably more downside in terms of
inflation and credit risk
Compared to other types of bonds, however, even that 30-year
Treasury is considered safe. And there's another benefit to
Treasury: The income you earn is exempt from state and local
taxes.

38

Municipal Bonds
Municipal bonds are a step up on the risk scale from Treasury,
but they make up for it in tax trickery. Thanks to the U.S.
Constitution, the federal government can't tax interest on state
or local bonds (and vice versa). Better yet, a local government
will often exempt its own citizens from taxes on its bonds, so
that many municipals are safe from city, state and federal
taxes. (This happy state of affairs is known as being triple taxfree.)
These breaks, of course, come at a cost: Because tax-free
income is so enticing to high-income investors, triple tax-free
municipals generally offer a lower coupon rate than equivalent
taxable bonds. But depending on your tax rate, your net return
may be higher than it would be on a regular bond.

39

Corporate Bonds
Corporate bonds are generally the riskiest fixed-income
securities of all because companies -- even large, stable ones -are much more susceptible than governments to economic
problems, mismanagement and competition.
That said, corporate bonds can also be the most lucrative fixedincome investment, since you are generally rewarded for the
extra risk you're taking. The lower the company's credit quality,
the higher the interest you're paid. Corporates come in several
maturities:
Short term: one to five years
Intermediate term: five to 15 years
Long term: longer than 15 years
The credit quality of companies and governments is closely
monitored by two major debt-rating agencies: Standard &
Poor's and Moody's. They assign credit ratings based on the
entity's perceived ability to pay its debts over time. Those
ratings -- expressed as letters (Aaa, Aa, A, etc.) -- help

40

determine the interest rate that company or government has to

pay.
Corporations, of course, do everything they can to keep their
credit ratings high -- the difference between an A rating and a
Baa rating can mean millions of dollars in extra interest paid.
But even companies with less-than-investment-grade (Ba and
below) ratings issue bonds. These securities, known as highyield, or "junk," bonds, are generally too speculative for the
average investor, but they can provide spectacular returns.

Apart from the above mentioned bonds there are various other
bonds such as

Federal Agency Bonds

In addition to the U.S. Treasury and local municipalities, other
government agencies (usually at the federal level) issue bonds
to finance their activities. These agency bonds help support
projects relevant to public policy, such as farming, small
business, or loans to first-time home buyers. Agency bonds are
no small matter, however -- according to the Bond Market
Association, agency bonds worth $845 billion are now
outstanding in the market. These bonds do not carry the full41

faith-and-credit guarantee of government-issued bonds (for

example U.S. Treasuries), but investors are likely to hold them
in high regard because they have been issued by a government
agency. That translates into more favourable interest rates for
the agency, and the opportunity to support sectors of the
economy that might not otherwise be able to find affordable
sources of funding.

Among the federal agencies that issue bonds are:

Federal National Mortgage Association (Fannie Mae)
Federal Home Loan Mortgage Corporation (Freddie Mac)
Farm Credit System Financial Assistance Corporation
Federal Agricultural Mortgage Corporation (Farmer Mac)
Federal Home Loan Banks
Student Loan Marketing Association (Sallie Mae)
College Construction Loan Insurance Association (Connie
Lee)
Small Business Administration (SBA)
Tennessee Valley Authority (TVA)
While most investors in federal agency securities are
institutional, individuals can also invest in this segment of the
debt securities market.

Revenue Bonds

A municipal debt on which the payment of interest and

principal depends on revenues from the particular asset that
42

the bond issue is used to finance. Examples of such projects are

toll roads and bridges, housing developments, and airport
expansions. Revenue bonds are generally considered of lower
quality than general obligation bonds, but there is a great
amount of variance in risk depending on the particular assets
financed.

Equity Index Notes

Equity Index-Linked Notes pay a variable returned based upon
the performance of an equity market index, such as the
Standard & Poors 500 Composite Price Index of U.S. stocks,
measured from a predetermined level.
These notes are issued so that a conservative investor may
participate in equity market returns while at the same time
ensuring that principal will be repaid at maturity regardless of
the equity market's performance. This feature eliminates the
risk of losing principal that is inherent in traditional stock and
mutual fund investments.
These notes usually have a maturity of anywhere between twoand-eight years. Typical notes allow an investor the choice of (i)
holding the note to maturity and receiving any variable return
at maturity, (ii) selling the note in the secondary market prior to
maturity, or (iii) electing to receive early payment of variable
return prior to maturity based on any index performance up to
the time of election and receiving the principal amount at
maturity.

Sovereign Bonds
A sovereign bond is a bond issued by a national government.
The term usually refers to bonds issued in foreign currencies,
while bonds issued by national governments in the country's
43

own currency are referred to as government bonds. The total

amount owed to the holders of the sovereign bonds is called
sovereign debt.

44