Transcript Bond Valuation - Financial Management

What is the Debt
Market?

The Debt Market is the market where fixed
income securities of various types and features
are issued and traded. Debt Markets are
therefore, markets for fixed income securities
issued by Central and State Governments,
Municipal Corporations, Govt. bodies and
commercial entities like Financial Institutions,
Banks, Public Sector Units, Public Ltd.
companies and also structured finance
instruments. (www.besindia.com,FAQ)
ROLE OF A HEALTHY
CORPORATE DEBT
 For
the issuer: low cost funds
 Alternative means of raising debt
 For the investor: portfolio
diversification
 Efficient pricing of credit risk
Definition of a Bond

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A bond is a security that obligates the issuer to make specified
interest and principal payments to the holder on specified dates.
 Coupon rate
 Face value (or par)
 Maturity (or term)
Bonds are sometimes called fixed income securities.
Types of Bonds
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Pure Discount or Zero-Coupon Bonds
 Pay no coupons prior to maturity.
 Pay the bond’s face value at maturity.
Coupon Bonds
 Pay a stated coupon at periodic intervals prior to maturity.
 Pay the bond’s face value at maturity.
Perpetual Bonds (Consols)
 No maturity date.
 Pay a stated coupon at periodic intervals.
Bond Issuers
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Government
Financial Institutions
Countries
Corporations
Government Bonds
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Treasury Bills (Gilts)
 No coupons (zero coupon security)
 Face value paid at maturity
 Maturities up to one year
Treasury Notes
 Coupons paid semiannually
 Face value paid at maturity
 Maturities from 2-10 years
Government Bonds

Treasury Bonds
 Coupons paid semiannually
 Face value paid at maturity
 Maturities over 10 years
 The 30-year bond is called the long bond.
Government Bonds
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No default risk. Considered to be riskfree.
Exempt from state and local taxes.
Sold regularly through a network of primary dealers.
Traded regularly in the over-the-counter market.
Corporate Bonds

Secured Bonds (Asset-Backed)
 Secured by real property
 Ownership of the property reverts to the bondholders upon
default.
Common Features of Corporate
Bonds
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Convertible bonds
Callable bonds
Sinking funds
Bond Ratings
Moody’s
S&P
Quality of Issue
Aaa
AAA
Highest quality. Very small risk of default.
Aa
AA
A
A
Baa
BBB
Ba
BB
B
B
Caa
CCC
Ca
CC
High specullative quality. May be in default.
C
C
Lowest rated. Poor prospects of repayment.
D
-
In default.
High quality. Small risk of default.
High-Medium quality. Strong attributes, but potentially
vulnerable.
Medium quality. Currently adequate, but potentially
unreliable.
Some speculative element. Long-run prospects
questionable.
Able to pay currently, but at risk of default in the
future.
Poor quality. Clear danger of default .
Valuing Zero Coupon Bonds
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What is the current market price of a U.S. Bond that matures in
exactly 5 years and has a face value of £1,000. The yield to
maturity is rd=7.5%.
1000
1.075
5
 £696.56
Bond Yields and Prices
The case of zero coupon bonds
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Consider three zero-coupon bonds, all with
» face value of F=100
» yield to maturity of r=10%, compounded annually.
We obtain the following table:
Time / Bond value
1
2
3
4
5
Bond 1
Bond 2
Bond 3
10%
$90.91
$75.13
$62.09
100
0
0
0
0
100
0
0
100
The Impact of Price Responses
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Suppose the yield would drop suddenly to 9%, or increase to
10%. How would prices respond?
Yield
10%
9%
% change
11%
% change
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Bond 1
Bond 2
Bond 3
1 Year
3 Year
5 Year
$90.91
$75.13
$62.09
$91.74
$77.22
$64.99
0.91%
2.70%
4.46%
$90.09
$73.12
$59.35
-0.91%
-2.75%
-4.63%
Bond prices move up if the yield drops, decrease if yield rises
Prices respond more strongly for higher maturities
Relationship Between Bond Prices
and Yields
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Bond prices are inversely related to interest rates (or yields).
A bond sells at par only if its coupon rate equals the coupon
rate
A bond sells at a premium if its coupon is above the coupon
rate.
A bond sells a a discount if its coupon is below the coupon
rate.
Bond Prices and Yields
Bond Price
Longer term bonds are more
sensitive to changes in interest
rates than shorter term bonds.
F
c
Yield
DEBT MARKET IN INDIA
DEBT MARKET
IN INDIA
Government
Securities Market
Corporate Debt
Market
Market for PSU
Bonds
Private Sector
Bonds
Main features of the Indian
corporate debt market
 Relative
size and importance
 Private placements
 Preference for rated paper
Reasons for Dominance
of Private Placement
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The dominance of private placement in total
issuances is attributable to the following factors:
Tailor made deals
mandatory lengthy issuance procedure for
public issues
the information disclosure requirements,
listing of bonds on stock exchange was not
required.
lower issuance costs.
Structure of
corporate debt market
in india
Market Micro Structure
Primary Corporate
Debt Market
Market structure consists of :
 Issuers,
 Instruments,
 Processes,
 Investors,
 Rating agencies ,
 Regulatory environment.
Issuers
Indian Debt Market has almost all possible variety of issuers as is the
case in many developed markets:
Large private sector corporate

Public sector undertakings (union as well
as state)

Financial institutions

Banks

Medium and small companies.
Thus the spectrum appears to be complete.
Instruments
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Till recently - plain vanilla bonds .
Now- They include:
 Partly convertible debentures (PCDs),
 Fully convertible debentures (FCDs),
 Deep discount bonds (DDBs),
 Zero coupon bonds (ZCBs),
 Bonds with warrants,
 Floating rate notes (FRNs)
 Bonds and secured premium notes
(SPNs).
Important note

The coupon rates mostly depend on tenure and
credit rating. However, these may not be strictly
correlated in all cases. The maturities of bonds
generally vary in between one year to ten years.
However, the median could be around four to five
years. The maturity period by and large depends on
outlook on interest rates. In expectation of falling
interest rates environment, corporate, it is observed,
mostly go to shorter term instruments while the
opposite is true in case of possible hike in interest
rates. For the past few years interest rates have
been falling and short end issues are on the rise.
This is one of the reasons that many corporate are
reluctant to go for public issue route and listing of
their securities.
Investors
INDIA
 Diverse number of sophisticated/ institutional
investors are required.
 Institutional Investors in India are few in
number and the variety also is limited .
 Banks and financial institutions, by and large,
do not take active interest in Corporate Debt
Market
Rating agencies
 India
has a well developed Credit
Rating Agency system and rating
agencies are well experienced and
regarded. By and large, their ratings
do carry confidence in the market.
Structural Weaknesses
in primary market
Lack of large and diverse investors
 Lack of dedicated intermediaries
(Bond Manager)
 Heavy tilt towards private placement
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Secondary Corporate
Debt Market
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Trading Platform
Clearing and Settlement Mechanism
Instruments traded on WDM
Investors in WDM
Regulatory Environment
Continuous Automated
Market
Negotiated Market
Trading Platform
Stock exchange :brokers
OTC – Bilateral
Agreements
INDIA
NSE
Trade
simultaneously
Easy, efficient
WDM
TRADING SYSTEM
NEAT
Fully automated
Screen Based
Trading System
Order driven
system
Best
buy
Best
sell
Continuous Automated
Market
Matching
Buy Orders
Sell Orders
NEAT-WDM system
participants can set up their counter-party exposure limits
against all probable counter-parties
reduce/minimize the counter-party risk associated with the
counter-party to trade
A trade does not take place if both the buy/sell participants do
not invoke the counter-party exposure limit in the trading
system.
Negotiated Market:
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Trades are normally decided by the seller and the buyer
Deals structured outside
Deals disclosed to the market through
NEAT-WDM
system.
Buyers and sellers know each other
No counter-party exposure limit needs to be invoked
Clearing and Settlement
Mechanism
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Participants
Settlement
Primary
responsibility
Exchange
Settlement
Monitor
Trades are settled gross
Settlement is on a rolling basis
Settlement periods- ranging from same
day (T+0) to a maximum of (T+2).
Instruments traded on
WDM
Government securities,Treasury Bills, Bonds
Issued by PSU’s/ corporate/ banks like
Floating Rate Bonds, Zero Coupon Bonds,
Commercial Paper, Certificate of Deposit,
corporate debentures, State Government loans,
SLR and Non-SLR bonds issued by financial
institutions, units of mutual Funds and
securitized debt by banks, financial institutions,
corporate bodies, trusts and others.
Investors in WDM
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Large investors and a high average trade value characterize this
segment .
Till recently- purely informal market
After WDM- Transparent
Efficient
Monitoring and surveillance
Regulatory Environment
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Regulations of SEBI
Manner in which such moneys are raised
fair play
Make the retail investor aware of the risks inherent in the
investment
Disclosure and Investor Protection (DIP) Guidelines
BUSINESS GROWTH ON THE WDM SEGMENT
1400000.00
1200000.00
800000.00
Net traded value
(Rs. Cr.)
600000.00
Number of
trades
400000.00
200000.00
year
07
20
06
-
05
20
04
-
03
20
02
-
01
20
00
-
99
19
98
-
97
96
19
94
-
95
0.00
19
Rs.(crs)
1000000.00
Structural Weaknesses in
secondary market
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Absence of Clearing Corporation.
Dedicated trading platform.
Exclusive, well capitalized and
professional intermediaries.
Lack of reliable and up to date information.
Reason for underdeveloped
corporate debt market
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Poor Quality Paper
Inadequate liquidity
Debt Versus equity : Cost and risks
Incomplete access to information
Interest rate structure
Narrow investor base
Lack of transparency in trades,
Comprehensive regulatory framework
Lack of Debt Derivative Products
Lack of Product Standardisation
Corporate debt market in India
Features
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Less developed than Equity markets contrary to
world markets
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Liquidity mainly in Govt. securities and highly
rated corporate papers (AAA and AA)
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Primarily an over the counter (OTC) Market
Debt and equity markets in the World
BIBLIOGRAPHY
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Working Paper No. 9 Corporate Debt Market in India: Key Issues
and Some Policy Recommendations
www.bseindia.com
www.bis.org/publ/bppdf/bispap26m.pdf
www.rbi.org.in, reports, VII. Equity And Corporate Debt Market